Money Trends / Liquidity

Highlights EM equity breadth has moved into negative territory, DM-based excess liquidity measures are set to roll-over, and China-based liquidity measures are also weak. Individually, each of these factors are not enough to raise alarm bells, but together they point to a period of heightened risks for EM assets and commodity currencies. AUD/CAD and NZD/JPY are set to suffer in this environment. EUR/USD will rise to 1.15-1.16, but unlike in 2015, it should not receive much of a fillip from EM volatility. Feature Chart I-1Technical Risk In EM Technical Risk In EM Technical Risk In EM An interesting development has unfolded in emerging markets. While the pause in the EM rally has hit investors' radar screens, the more puzzling event concerns breadth. Not only has the advanced/decline line rolled over, but more worrisomely, it has recently moved into negative territory. Historically, when more stocks are declining rather than advancing, EM equities tend to experience sharp selloffs (Chart I-1). This development is important when put into a global context. EM stocks and related assets like commodity currencies have been buoyed by plentiful global liquidity conditions. However, global liquidity is set to deteriorate. A rocky second half may emerge in EM assets. Global Liquidity Is Slowing Following in the Federal Reserve's footsteps, DM central banks are moving away from monetary accommodation. Last week, European Central Bank President Mario Draghi made a speech that was interpreted as representing an abandonment of the ECB's dovish bias. With the anticipation that its bond-buying program will be tapered early in 2018 and reports that the ECB is having problems buying its quota of German and Finnish bonds, global bonds suffered, with Bund and T-Note yields moving up 33 and 23 basis points since June 27, respectively. The ECB is not the only central bank to have changed its tack. The Bank of Canada's communications have been crystal clear that it intends to increase rates this summer, or early fall at the latest. Even the perennially dovish Riksbank is moving away from its easy bias, as Sweden's resource utilization points to a continued acceleration in core inflation. But does this even matter? The global economy is strong, and beginning to remove accommodation is not quite the same thing as pushing rates into tight territory. The advanced economies are unlikely to suffer much from this development. However, the picture for EM is more concerning. Some key leading indicators of EM activity have already begun to roll over. For example, Taiwanese IP, a key bellwether of overall EM strength, is now contracting on a year-on-year basis (Chart I-2, top panel). Meanwhile EM PMIs rolled over three months ago and EM narrow money growth, a key forecaster of EM profits, is slowing sharply (Chart I-2, bottom panel). Despite these negative developments, EM stocks have remained resilient. The factor underpinning this impressive performance has been the rise in global liquidity. More technically, the rise in the global Marshallian K - the ratio of money to nominal GDP - over the past six months. Excess money has had to go somewhere. Among the many refuges, EM has been a key pole of attraction, with massive inflows supporting assets prices. The 8% appreciation in EM currencies versus the dollar since their January 2016 trough has been a vivid illustration of this phenomenon. The driver of the rise in excess money has been the ratio's numerator, dollar-based liquidity. The Fed's various QE programs were key determinants of dollar-based liquidity (Chart I-3). However, its tapering in late 2014 was enough to prompt a contraction of the measure. Now that the Fed is intent on decreasing its balance sheet while the ECB tapers and other smaller DM central banks begin increasing rates, the small improvement witnessed in the past three months is likely to end. The recent weakness in gold prices, despite the softness in the dollar, could be a sign that markets are beginning to sniff out the imminent tightening of global liquidity conditions. Chart I-2EM/China Profits Growth To Roll Over (I) EM Growth ##br##Has Deteriorated, Profits Will Suffer EM/China Profits Growth To Roll Over (I) EM Growth Has Deteriorated, Profits Will Suffer EM/China Profits Growth To Roll Over (I) EM Growth Has Deteriorated, Profits Will Suffer Chart I-3The Fed Balance Sheet Runoff ##br##Will Hurt Global Liquidity The Fed Balance Sheet Runoff Will Hurt Global Liquidity The Fed Balance Sheet Runoff Will Hurt Global Liquidity Additionally, not only are global central banks, led by the Fed, tightening or looking to tighten policy, they are doing so despite an absence of actual inflation. As a result, this means DM real yields are set to rise. As Chart I-4 illustrates, rising real DM yields have historically been a harbinger of poor EM bond performance. In fact, the action in DM real yields since mid-2016 already points to a problematic second half for EM bonds. As a result, EM bond investors are likely to suffer some losses in the coming months. Such losses would not only tighten EM financial conditions, but would also be symptomatic of capital leaving the region. Less money in those markets simply means less liquidity. With EM corporate spreads near historical lows, a repricing of credit risk on the back of softening global and EM liquidity is likely to prompt both a selloff in EM stocks and in EM currencies (Chart I-5). As a result, DM commodity currencies, the NZD and AUD in particular, could suffer. Chart I-4EM Financial Conditions##br## Are Set To Deteriorate EM Financial Conditions Are Set To Deteriorate EM Financial Conditions Are Set To Deteriorate Chart I-5If Liquidity Dries, Spreads Widen ##br##And EM Stocks Fall If Liquidity Dries, Spreads Widen And EM Stocks Fall If Liquidity Dries, Spreads Widen And EM Stocks Fall Bottom Line: In November 2016, a new leg of the EM rally began - a move driven by an expansion in global liquidity, even as a key bellwether of EM economic activity rolled over in the interim. Global excess liquidity is set to roll over as DM central banks abandon their dovish biases and the Fed begins to let its balance sheet run off. With EM weaker from a technical perspective, the second half of 2017 could be a tough environment for EM plays. Chinese Liquidity Joins The Fray In May 2015, EM equities in U.S.-dollar terms peaked just before global liquidity began to roll over. Compounding the risks, back then Chinese economic conditions were also problematic. Excess capacity and massive deflationary forces were wearing down on profits and investment. China is thus another key factor to watch. In this optic, beyond DM liquidity, a key driver of the rebound in EM last year was actually Chinese liquidity conditions. In the second half of 2015, China's own Marshallian K - based on M2 relative to nominal GDP growth - was rebounding sharply, as the PBoC was easing policy and the fiscal authorities were pressing on the gas pedal, expanding both public expenditures and pushing credit growth through the economy. However, that was then. Today, China has joined the tightening party. The quarterly moving average of Chinese interbank rates has increased by 100 basis points over the past year. Crackdowns on real estate and excess leverage have also resumed. Most importantly, the issuance of bonds by small and medium banks - a key source of grease to total social financing - has also massively decelerated, which points to a sharp slowdown and even a contraction in the Chinese credit impulse (Chart I-6). Thanks to this development, the Chinese Marshallian K is now in negative territory. The global impact of tighter Chinese monetary conditions is also flashing a red flag. Our indicator is based on the relative performance of Chinese bank stocks and USD/HKD. Underperformance of Chinese banks tends to send warning signs that tightening policy is beginning to negatively affect the outlook for Chinese credit growth. Additionally, USD/HKD is at an 18-month high because Hong Kong interest rates have not been able to follow U.S. ones, as loan demand by mainland-China entities has been poor. Most of the time, this indicator tends to move with EM stock prices, providing very little information. However, as Chart I-7 illustrates, this gauge is at its most useful when it diverges from EM equity prices. In each case, such as in 2007, 2011, and 2014, the divergences between the falling price-based Chinese liquidity indicator and rising EM stock prices was resolved by a correction in the latter. Today, the indicator points to a large amount of downside risk for EM stocks. Chart I-6Chinese Credit Impulse Will Slow Chinese Credit Impulse Will Slow Chinese Credit Impulse Will Slow Chart I-7A Worrying Divergence A Worrying Divergence A Worrying Divergence Again, it is important to reiterate that in and of itself, such a divergence is not enough to prompt investors to run for the hills and ditch EM stocks and related plays. However, when this happens as DM liquidity is also set to deteriorate, and most crucially, when EM breadth turns negative, decreasing EM exposure makes sense. Bottom Line: Chinese liquidity conditions are also deteriorating. The People's Bank of China may not want to push the economy into another slowdown cycle, which will most likely limit how far the Chinese central bank will tighten policy. However, this tightening has not been priced in by EM equities, and is happening as DM central banks are also reducing accommodation and as EM breadth has greatly deteriorated. A sizeable correction in EM plays is becoming increasingly likely. Investment Implications Chart I-8Global Liquidity Leads EM ##br##By More Than A Year Global Liquidity Leads EM By More Than A Year Global Liquidity Leads EM By More Than A Year A tightening of dollar-based liquidity and Chinese-based liquidity is a big problem for non-China EM economies. EM economies outside of China and OPEC nations still run an annual current account deficit of more than US$200 billion. They need liquidity. Moreover, they still have at least US$3.6 trillion in foreign-currency debt. With liquidity conditions deteriorating, we should expect a widening of EM spreads, falling EM stock prices and falling commodity currencies. In fact, we are today in the window of maximum risk. Chart I-8 shows the combined G7 and Chinese Marshallian K, standardized. This indicator tends to have long leads over EM equity prices. It turned negative in the summer of 2006, though EM stock prices did not peak until the fourth quarter of 2007. It turned negative again in the early days of 2010, but EM equity prices did not peak until April 2011. The indicator moved below zero in mid-2014, yet EM equities only sold off in the second quarter of 2015. This time around, the combined liquidity indicator became negative in early 2016, suggesting great risks for EM assets and related plays in the second half of 2017. High carry EM currencies like the BRL or the TRY are at risk. The ZAR looks especially poorly positioned as well but the RUB seems better cushioned against these risks. The MXN could suffer too as Mexico has a lot of U.S. dollar-denominated debt. Nonetheless, MXN remains much cheaper than the BRL and could still outperform its Brazilian brethren. The SGD is very sensitive to global liquidity conditions, as Singapore is a key banking center for EM, and could also suffer substantially against the USD. In terms of timing for the G10 currency markets, the deterioration of EM breadth has historically been a dangerous sign for commodity currencies (Chart I-9). This combination of deteriorating liquidity and breadth is often associated with a sharp selloff in NZD/JPY (Chart I-10). Investors should short this cross, and we are re-opening this trade this week. Chart I-9Commodity Currencies##br## Prefer A Fresh Breadth... Commodity Currencies Prefer A Fresh Breadth... Commodity Currencies Prefer A Fresh Breadth... Chart I-10...So Does ##br##NZD/JPY ...So Does NZD/JPY ...So Does NZD/JPY The dynamics highlighted above also explain why despite our positive stance on Canada and the CAD, we are not willing to chase the selloff in USD/CAD further, and prefer to play the CAD's strength through its crosses. The risk-reward ratio seems better this way, as we are not as negatively exposed to an EM selloff as we would be buying the CAD against the USD. Indeed, a cleaner way to play the BoC's change of tone while gaining exposure to an EM-risk off theme, is to short AUD/CAD, a trade that is already on our book. On the domestic front, this week the Reserve Bank of Australia disappointed markets and did not try to indicate a change in stance away from its dovish bias. Markets have taken notice, with the AUD incapable of rallying against a weak USD, despite very strong trade data yesterday. Meanwhile, the BoC is telegraphing a rate hike in the very near future. Additionally, an abnormal gap has emerged between AUD/CAD and AUD/USD. As Chart I-11 shows, historically, AUD/CAD and AUD/USD have tracked one another. This makes sense. The Australian economy is very levered to Asian growth and liquidity dynamics, while Canada is a crucial link in the North American supply chain. With the U.S. and Canadian business cycles so tightly integrated, the CAD tends to mimic the greenback when compared to non-USD currencies. Chart I-11AUD/CAD Is A Short AUD/CAD Is A Short AUD/CAD Is A Short The points in time when AUD/CAD has been much stronger than the AUD/USD deserve closer attention. They are periods of booms in EM Asia, such as the middle of the 1990s, or 2004 to 2005. Today, AUD/CAD is again out of line with AUD/USD, reflecting the boom in EM assets prices in 2016 and in the first half of 2017. However, if our view is correct that EM is entering a dangerous zone, AUD/CAD should weaken further. Chart I-12When Investors Are Short, ##br##EUR/USD Likes EM Selloffs When Investors Are Short, EUR/USD Likes EM Selloffs When Investors Are Short, EUR/USD Likes EM Selloffs Last but certainly not least the euro. EUR/USD has much momentum and could continue to rally into the 1.15-1.16 zone. In fact, historically, EM shocks have been able to lift the euro, albeit temporarily. This definitely was the case in 2015 when EM sold off: in April 2015, when EM began to weaken, in August 2015, when a temporary selling climax emerged after the Chinese floated the CNY, and in December 2015, after the Fed hiked. The euro spiked in all three instances. However, investors were very short EUR/USD entering each of these periods, and the ensuing rallies were short-covering rallies (Chart I-12). This time around, investors are very long the euro, suggesting that the euro has not been used as a funding vehicle to the same extent as it was in 2015. Additionally, in all these previous episodes, EUR/USD traded at a small discount to the fair value implied by real rate differentials, today it is trading at a premium. Thus, the same kind of short-covering rally is unlikely. As a result, we do not anticipate EUR/USD to break out of its range on the back of an EM risk-off event. That being said, EUR could outperform GBP in this type of environment. The pound remains very dependent on global liquidity conditions to finance its current account deficit of more than 4% of GDP. With big financial institutions announcing more divesture from the U.K., these hot-money flows could prove even more crucial. As a result, we are removing our call to short EUR/GBP if it moves above 0.88, and expect a move in EUR/GBP toward 0.92-0.93 in the second half of 2017. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback slipped on weak as the ADP employment, the ISM-non manufacturing employment component, and continuing as well as initial jobless claims all underperformed expectations. While the dollar reacted negatively to this news, the Fed's hawkish stance should ultimately help the USD. Supplementing the increases in interest rates, are plans to reverse the multi-year quantitative easing program.The FOMC is also increasingly worried about the "quite high" stock valuations which, could lead to financial instability. U.S. 10-year yields have gone up 4 basis points following the release of the minutes, after the 20 bps spike following initial Fed comments on June 27. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro's strength extends as the union experienced strong services and composite PMI measures this Wednesday. While it is true that the ECB may be looking to draw back its excessively easy monetary policy, Draghi and Praet have highlighted that accommodative policy is still needed as inflationary pressures are not yet entrenched. The euro's recent appreciation and weak producer price numbers could vindicate this view. The euro's strength has also weighed on manufacturing activity, as PMIs underperformed expectations. This is likely to weigh on EUR/USD going forward, especially as European stocks have been underperofming U.S. ones in recent weeks. EUR/SEK can face considerable pressure ahead due to the Riksbank's change in rhetoric. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Europe's Divine Comedy Part II: Italy In Purgatorio - June 21, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: National inflation came in at 0.4%, while Tokyo ex fresh food and energy inflation contracted by 0.2%. Both of these measures underperformed expectations. On the other hand, Japan's job-to-applicant ratio continues to climb, coming in at 1.49, and outperforming expectations. This last data point is key, as it highlights that the Japanese labor market is very tight, and that the stage is set for inflation to come back to Japan. However, as evidenced by the recent disappointments in data, the currency holds the key to unleash inflation in Japan. Thus, not only is a selloff in the yen needed for inflation to remerge, but this selloff would feed on itself, as a falling currency and a tight labor market would raise inflation (and thus lower real rates, as Japanese 10-year rates are anchored at 0), which would push the yen down further. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Markit manufacturing PMI declined from last month's reading and also came in below expectations at 54.3. Construction PMI also declined and came in below expectations at 53.4 However credit had a strong showing as net lending to individuals, consumer credit and mortgage approvals all came in above expectations at 5.3 billion pounds, 1.73 billion pounds and 65 thousand respectively. Various BoE members have stated that rising interest rates might be necessary to keep a lid on the island's high inflation. Although there are still some voices within the BoE who are more cautious, given the uncertainty that Brexit poses, overall the BoE has shown a much more hawkish tone in recent weeks. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD has experienced considerable weakness this week, following a drawback in inflation estimates for June by the TD Securities measure, of 2.3% from 2.8% and a less hawkish than anticipated RBA. While retail sales beat expectations of 0.2% - coming in at 0.6% - the pace of appreciation in the RBA Commodity Index in SDR terms continues to slow Nevertheless, these factors were not the only contributors to the recent AUD weakness. Australia remains highly levered to emerging markets, and the Fed tightening remains a major risk for the AUD. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The annual trade balance underperformed expectations, coming in at a deficit of 3.75 billion U.S. dollars. However the ANZ business confidence index continued climbing, and now stands at the highest level in 8 months Overall the New Zealand economy continues to be one of the best performing in the G10. If one were to be guided merely by domestic factors, the RBNZ should be the next central bank to hike after the Fed. However the picture is slightly more nuanced, as the RBNZ is still worried about foreign developments, particularly EM weakness. This justifies why they continue to state that "monetary policy will remain accommodative for a considerable period". Thus, we continue to be bullish on the NZD against the AUD, while we are shorting it against the JPY, as a mean to benefit from a potential EM dislocation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 USD/CAD has broken down from a crucial technical level following Poloz's statements about the Canadian economy. He states that the "cuts have done their job". When asked about oil, the reply was reassuring, declaring that the expected level of WTI is at USD 40-50 bbl, which implies that fluctuations within that band should not influence movements the BoC path, helping the CAD in the process. He also suggested that "the adjustment we've been talking about... is largely complete now". While inflation is weak, the BoC governor highlighted that forward looking indicators for inflation should be monitored instead of current inflation. These variables are pointing to stronger growth, and are in line with the bank's expectations of a closing output gap in the first half of 2018. While this may be true, a strengthening CAD will remain a risk for inflation. Report Links: Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Although real retail sales yearly growth came in negative at -0.3%, it outperformed expectations and was better than last month. Additionally, the SVME PMI came also blew away expectations, increasing from last month's 55.6 reading to 60.1. However Consumer price inflation came in at -0.1%, underperforming expectations. The Swiss economy continues to be haunted by the ghost of deflation. Nonetheless, some economic indicators appear to be ticking up, most likely as a result of the sharp rally in EUR/CHF. We continue to believe that a rally of EUR/CHF beyond 1.1 is unlikely, as most of the good news in the euro area are already priced into the euro. Furthermore, any disappointments, particularly in EM could trigger a selloff in this cross. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The Labor Force survey, which measures the number of unemployed people as a percentage of the total civilian labor force came in at 4.6%, increased since last month. This measure shows that despite the increase in oil prices the Norwegian labour market continues to be tepid. The Norges Bank agrees with our assessment, as it lowered its projected near term policy rate path. Furthermore, they projected that rates in Norway will not rise until the beginning of 2019. The reasons for this are two fold: first, inflation should continue to remain weak, as the pass through from the collapse in the currency has faded. Additionally, bubbly real estate prices, which were the only factor, which could incite the Norges Bank to become more hawkish, have gone down, following reform in lending standards. Thus, despite its good value, the NOK will continue to underperform amongst commodity currencies. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 It is true that the Riksbank recently hinted towards a more neutral stance, acknowledging "that inflation has recently been slightly higher than expected", which has made it "less likely than before that the Riksbank will cut the repo rate in the near term". However, the Riksbank also highlighted the fact that the bank is "prepared to implement further monetary policy easing if necessary to stabilize inflation". A very nuanced statement referred to the exchange rate, which "is important that [it] does not appreciate too rapidly", further stating that "this could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." This conclusively highlights that the bank is wary of diverging rates lifting undesirably on the krona, which is a limiting factor for substantial krona strength in the near term. However, the change of guard at the helm of this central bank in early 2018 could change all this caution. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights While the yield curve is a critical indicator for developed economies, its significance in China should be put in proper perspective, as the country's market-based financial intermediation is much less important compared with the West. The inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. The near term impact of MSCI's A Share inclusion should be negligible for the broader market. Valuation indicators of the select 222 large-cap names are much more attractive compared with their domestic peers, which may well provide a catalyst for some catch-up rally. Feature Chart 1China's Inverted Yield Curve China's Inverted Yield Curve China's Inverted Yield Curve The Chinese authorities' tightening measures on the financial sector have significantly pushed up interest rates across the curve, particularly in the short end, leading to rapid yield-curve flattening. By some measures, long-dated interest rates are currently lower than short rates, generating an inverted yield curve (Chart 1). Some have viewed an inverted Chinese yield curve as a harbinger of an impending material growth slowdown. While the yield curve is undoubtedly a critical indicator for developed economies, its significance in China should be put in proper perspective. In short, bank loans still play a dominant role in financial intermediation, the interest rates on which are still largely determined by the policy lending rate. Therefore, a simple comparison of the Chinese yield curve to its counterparts in the West misreads the situation and is overly alarmist. Moreover, we suspect that the phase of maximum strength of policy tightening is over, at least in the near term. Therefore, Chinese interest rates are likely to fall in the coming three to six months. This week we recommend a long position in Chinese onshore corporate bonds. Why The Yield Curve Matters Less For China To be sure, the yield curve is among the most relevant and watched indicators in some developed economies. In the U.S., for example, an inverted yield curve, defined as U.S. 10-year Treasury yields resting below three-month Treasury yields, has historically been a reliable indicator in predicting economic recessions (Chart 2). Evidence from other developed economies such as Japan and Europe is less compelling, but a flat/inverted yield curve is still generally regarded as a market signal for growth problems. Chart 2U.S. Yield Curve Inversion Predicts Economic Recession U.S. Yield Curve Inversion Predicts Economic Recession U.S. Yield Curve Inversion Predicts Economic Recession The reasons for the linkage between yield curve inversion and economic recessions have been the subject of lengthy debates among academia, policymakers and investors. From a financial market perspective, it is generally accepted that an inverted yield curve occurs when the bond market anticipates a significant slowdown in growth and/or decline in inflation, which bids down long-term yields, while policymakers fail to respond in a timely manner, which holds short-term rates at elevated levels. Yield curve inversion is typically followed by aggressive monetary easing as central banks wake up to the economic reality predicted by the bond market. Economically, the costs of funding in most developed countries are tightly linked with interest rates in the bond markets. One of banks' key functions as financial intermediaries is to transform maturity - i.e. to "borrow short and lend long," and therefore interest rates of bank loans are tied to government bond yields at the longer end, while their costs of funding are linked to the shorter end. Therefore, an inverted yield curve typically compresses banks' interest margins, which tends to hinder credit origination and slow down business activity. For example, Chart 3 shows that U.S. mortgage interest rates historically have been tightly linked with 10-year Treasury yields, while interest rates of banks' deposit base and interbank rates for "wholesale" funding are both determined by short-term Treasury yields, which is in turn determined by the fed funds rate. In China, the yield curve plays a much smaller role than in the developed world, simply because the country's market-based financial intermediation is much less important. Traditionally both lending rates and deposit rates of commercial banks were rigidly set by the People's Bank of China, and there was little lending/borrowing activity outside the formal commercial banking system. The situation has been gradually changing in recent years as a result of financial reforms. Banks are given flexibility to set their own interest rates, and non-bank lending, or shadow banking activity that is more driven by market interest rates, has expanded. However, commercial banks still play a dominant role. Chart 3U.S. Bank Loan Rates Follow Treasury Yields Closely U.S. Bank Loan Rates Follow Treasury Yields Closely U.S. Bank Loan Rates Follow Treasury Yields Closely Chart 4China: Bank Loans Still Dominate China: Bank Loans Still Dominate China: Bank Loans Still Dominate Bank loans currently account for over 70% of China's total non-equity social financing, both in terms of flow and total outstanding stock (Chart 4). Commercial banks' average lending rate still closely tracks the PBoC policy benchmark. Banks' prime lending rate moves in lock step with PBoC interest rate adjustments, and average interest rates on new mortgages are also primarily determined by the policy rate (Chart 5). Banks' cost of funding is also primarily determined by retail deposit interest rates, which are in turn set by the PBoC. Retail deposits account for about 80% of total loanable funds for large banks, or 70% for smaller banks (Chart 6). Repo and interbank transactions, which are subject to the central bank's liquidity tightening, only account for 14% of smaller lenders' source of funds, or a mere 2% for large lenders. Chart 5Chinese Bank Loan Rates ##br##Still Track PBoC Benchmarks Chinese Bank Loan Rates Still Track PBoC Benchmarks Chinese Bank Loan Rates Still Track PBoC Benchmarks Chart 6Retail Deposits Are Still The Dominant Funding Source ##br##For Commercial Banks Retail Deposits Are Still The Dominant Funding Source For Commercial Banks Retail Deposits Are Still The Dominant Funding Source For Commercial Banks The important point is that market signals from China's juvenile and volatile financial markets should be taken with a healthy dose of skepticism, and a simple comparison with the West is often misleading. For example, a significant decline in stock prices in developed economies may well herald a growth recession in their respective economies. In China, however, domestic stock prices have routinely gone through massive boom and bust cycles without any tangible impact on the broader economy, as the equity markets play a marginal role for both the corporate sector in terms of raising capital and for households in managing their wealth. In recent years, China's financial sector reforms have been gradually introducing market forces in setting interest rates, but the process is far from advanced enough to have a meaningful and direct impact on the cost of funding for both the corporate sector and banks. Overall, the inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. PBoC Tightening: Passing The Phase Of Maximum Strength Moreover, it is noteworthy that yield-curve flattening has been a global phenomenon rather than a China-specific development (Chart 7). What's different is that in other countries the flatter yield curve has been mostly due to falling yields of longer-dated bonds, while in China it has been entirely driven by a sharp increase in short-term yields due to the PBoC's liquidity tightening.1 Looking forward, the PBoC will maintain close scrutiny on the financial sector to keep financial excesses in check. However, we believe the phase of maximum strength of liquidity tightening is likely over, at least in the near term. There is no case for genuine monetary tightening, as inflation is extremely low and growth momentum is already softening. It is very unlikely that the PBoC will tighten monetary conditions further, amplifying deflationary pressures in the process.2 The PBoC's tightening measures have already significantly reduced the pace of leverage buildup and excesses in the financial system. Banks' exposure to non-bank financial institutions has tumbled, net issuance of commercial banks' negotiable certificates of deposits has turned negative of late, and overall off-balance-sheet lending by financial institutions, or shadow banking activity, has slowed sharply in recent months (Chart 8). In other words, the tightening campaign has achieved the intended consequences, diminishing the odds of further escalation. Chart 7Synchronized Yield Curve Flattening Synchronized Yield Curve Flattening Synchronized Yield Curve Flattening Chart 8Financial Excesses Are Being Reined In Financial Excesses Are Being Reined In Financial Excesses Are Being Reined In Global developments are also conducive for some loosening by the PBoC. Last week's rate hike by the Federal Reserve has further pushed down both U.S. interest rates and the dollar. The spread between Chinese 10-year government bond yields and U.S. Treasurys has widened sharply of late, which is helping stabilize the RMB (Chart 9). All of this has reduced pressure on the PBoC to follow the Fed with additional domestic tightening. Already, the PBoC has stepped in to ease liquidity pressure in the interbank system in recent weeks. After massive liquidity withdrawals early this year, the PBoC has been injecting liquidity into the interbank market through various open market operations in the past two months, according to our calculations - likely a key reason why interbank rates have stopped rising of late (Chart 10). Chart 9China - U.S. Interest Rate Spread Versus##br## Exchange Rate China - U.S. Interest Rate Spread Versus Exchange Rate China - U.S. Interest Rate Spread Versus Exchange Rate Chart 10The PBoC Is Stepping In ##br##To Ease Interbank Liquidity Pressure The PBoC Is Stepping In To Ease Interbank Liquidity Pressure The PBoC Is Stepping In To Ease Interbank Liquidity Pressure Chart 11Onshore Corporate Bonds ##br##Are Attractive Onshore Corporate Bonds Are Attractive Onshore Corporate Bonds Are Attractive Chinese corporate bonds will benefit the most, should the authorities stop further tightening (Chart 11). Onshore corporate spreads have widened sharply since late last year amid the PBoC crackdown, and are now substantially higher than in other countries. Chinese corporate spreads should recover without further escalation in liquidity tightening, and will also benefit from the ongoing profit recovery in the corporate sector. We expect both quality spreads and government bond yields to drop in the next three to six months, lifting corporate bond prices. Bottom Line: The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. A Word On The MSCI A-Share Inclusion MSCI Inc. announced this week its decision to include Chinese A shares in its widely followed emerging market and world equities indexes. The company will add 222 China A large-cap stocks to its EM benchmark at a 5% partial inclusion factor, which will account for about 0.73% of EM market cap. This marks a major milestone in China's capital market development and financial sector liberalization. Increasing participation of foreign institutional investors will also over the long run help improve China's corporate governance and regulatory practices - all of which are instrumental for improving the efficiency of domestic capital market as well as the efficiency of capital allocation. Table 1Valuation Of China A-Share Universe Chinese Financial Tightening: Passing The Phase Of Maximum Strength Chinese Financial Tightening: Passing The Phase Of Maximum Strength The near-term market impact, however, should be negligible. After all, the inclusion will take effect June next year. In addition, foreign investors already have access to these A share companies through the existing Stock Connect channels between Chinese domestic exchanges and Hong Kong. Moreover, potential capital inflows from global managed assets benchmarked to MSCI indexes in the initial step will be marginal. It is estimated that a total of US$18 billion, or RMB 125 billion, foreign capital may follow the MSCI decision into the A share market, a tiny fraction of A-shares' almost RMB 40 trillion market cap. That said, the valuation indicators of the select 222 large-cap names look attractive compared with their domestic peers, with median trailing P/E and P/B ratios at 23 and 2 times, substantially lower than other major domestic indexes (Table 1). MSCI inclusion may well provide a catalyst for some catch-up rally. We will follow up on this issue in the following weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "A Chinese Slowdown: How Much Downside?," dated June 8, 2017, and "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The latest reading from all the indicators confirms that the growth improvement in the manufacturing sector since early last year has moderated, while the sharp recovery in producer prices has stalled. However, it is premature to be overly alarmed by a pending Chinese growth relapse. Betting on a material Chinese slowdown solely based on some sort of credit "impulse" estimate misses the big picture. The dramatic decline in real interest rates rather than an increase in new lending is what played a pivotal role in Chinese reflation since last year. Strategically we lean against being overly bearish. The Chinese economy will likely continue to moderate, but the downside risk appears low at the moment and overall business activity will remain buoyant. Feature Investors have become less sanguine on China's growth outlook in recent weeks, as the latest macro numbers are no longer unanimously positive. Concerns about a significant relapse in the Chinese economy are re-emerging, and the authorities' recent policy tightening has further heightened investors' anxiety levels. Judging from our recent conversations with clients, "China risk" is now clearly back on the radar. China's growth recovery since early last year played a major role in boosting some global risk assets such as commodities prices and emerging market equities. By the same token, will a China slowdown end the global reflation trade? The Divergence In Manufacturing PMIs Chart 1The Divergences In PMIs The Divergences In PMIs The Divergences In PMIs Investors' anxiety over China's cyclical trend has been amplified by the recent divergence between the official manufacturing Purchasing Manager Index (PMI) and the one compiled by Caixin Media group, a private source. The official survey for May still showed expansion, while the private PMI dropped slightly below the critical 50 threshold (Chart 1, top panel). Historically such divergences are not uncommon, and the private PMI appears to show sharper swings than its official counterpart, probably due to its smaller sample size and its focus on smaller private firms. Meanwhile, there were some commonalities: the sub-indices of output and new orders for both surveys remained above the expansionary threshold, while input costs and output prices for both dropped into contractionary territory. Taken together, the latest reading from all the indicators confirms that the growth improvement in the manufacturing sector since early last year has moderated, while the sharp recovery in producer prices has stalled - consistent with other recent macro variables. Meanwhile, the service industry is still showing solid expansion, according to both surveys, underpinning overall business activity (Chart 1, bottom panel). In short, it is premature to be overly alarmed by a pending Chinese growth relapse. Credit "Price" Versus "Volume": What Matters More? A common narrative to describe the reason behind China's ongoing growth moderation is policy tightening on both the monetary and fiscal fronts. As the argument goes, last year's growth recovery was driven by a massive increase in credit and fiscal spending, which has since been scaled back. As this credit and fiscal "impulse" fades away, the Chinese economy will tumble, sending shockwaves across the world. In our view, betting on a material Chinese slowdown solely based on some sort of credit "impulse" estimate misses the big picture, and is dangerously misguided. At BCA, we have long paid close attention to credit cycles and their impact on the growth outlook. However, there is no evidence that China's growth recovery since early last year was due to a massive increase in credit expansion and fiscal spending. In fact, total new credit provided by commercial banks and the "shadow banking sector" has been largely stable in recent years, and last year's credit "impulse," measured as the annual change in credit flows, was fairly modest - especially compared with previous bouts of sharp spikes (Chart 2). Similarly, Chinese fiscal spending actually decelerated sharply throughout last year, and dropped by over 10% in December, compared with a year earlier. Even if last year's fiscal retrenchment impacts the economy with a time lag, it is important to note that fiscal spending has already rebounded in recent months, which will become a tailwind for growth down the road. In our view, China's growth recovery since last year has a lot more to do with the "price" of credit rather than "volume." (Chart 3) Real interest rates dropped from double-digit levels that prevailed between 2012 and early 2016 to negative, thanks to a sharp increase in producer prices, while credit growth remained in a broad downtrend. In other words, the dramatic decline in real interest rates rather than an increase in new lending is what played a pivotal role in Chinese reflation. Chart 2Not Much 'Impulse' Not Much 'Impulse' Not Much 'Impulse' Chart 3Credit: 'Price' Matters More Than 'Volume' Credit: 'Price' Matters More Than 'Volume' Credit: 'Price' Matters More Than 'Volume' China's PPI has rolled over, which together with the authorities' attempts to tighten has begun to lift real interest rates. This will likely continue to generate some growth headwinds - a risk that clearly warrants close attention. However, monetary conditions currently are still very accommodative, and there is no reason to expect an overkill to choke off the economy. Why Growth Will Not Falter? Moreover, the bearish argument on China's cyclical outlook is fundamentally rooted in the assumption that the country's economy is dangerously imbalanced1 - a shaky house of cards propped up by policy stimulus that will immediately fall down once the policy pump-priming stops. While the structural profile of the Chinese economy will remain a major global macro issue subject to heated debates going forward, the bearish argument underestimates the economy's resilience, and therefore exaggerates the downside risks. First, it is important to note that China's growth challenges in previous years were to a large extent due to excessively tight monetary conditions, a costly policy mistake that amplified deflationary pressures. Real interest rates were kept at double digits for 5 consecutive years between 2012 and early 2016 while other major central banks were all trying desperately to lower borrowing costs within their respective economies. Furthermore, the trade-weighted RMB appreciated by 20% between 2012 and 2015. In fact, the RMB was the only major currency that appreciated in trade-weighted terms during this period (Chart 4), essentially shouldered deflationary stress for the rest of the world. In addition, Chinese regulators tried hard to block credit flows in an ill-conceived attempt to de-lever - which only prolonged credit intermediation channels and pushed loan demand to even costlier "shadow" institutions.2 All of these factors inflicted dramatic deflationary pain on Chinese manufacturers. Indeed, that the Chinese economy did not implode under the double-whammy of weak global demand and draconian domestic policy tightening - and staged a quick turnaround when monetary conditions eased - underscores the surprising resilience of the Chinese corporate sector. Second, the growth recovery since early last year has significantly improved financial conditions within the corporate sector and eased its balance sheet stress. Overall, companies have increased earnings, reduced inventories and beefed up cash positions (Chart 5). The situation can certainly deteriorate, but the sector is also better prepared for deflationary shocks than in previous years. Chart 4The RMB Shift The RMB Shift The RMB Shift Chart 5Inventory Is Still Very Low Inventory Is Still Very Low Inventory Is Still Very Low Third, even if China's corporate sector, especially industrial enterprises, are indeed as fragile as some bearish analysts claim, Chinese households and the service sector have much healthier fundamentals and therefore are less vulnerable. Consumer confidence has improved significantly in recent months following the growth acceleration, which should further help household consumption. The service sector now accounts for 52% of Chinese GDP, 30% larger than manufacturing. Household consumption and the service sector will provide an important anchor for business activity and prevent a major relapse in economic growth, even if the industrial sector slows more than we currently expect. Finally, the global growth environment is also largely supportive for the Chinese economy. The European economy has been showing some remarkable strength of late, and U.S. growth is likely to pick up after the recent soft patch, as per our U.S. specialists - both of which should bode well for Chinese exports. It is worth noting the recent weaker macro numbers out of China have followed growth disappointments in the U.S. (Chart 6). In fact, the ebbs and flows of "growth surprises" in the world's two largest economies in recent years have been largely in sync, albeit with China experiencing more pronounced volatility. In addition, the risk of an immediate escalation of protectionist backlash between the U.S. and China has also been lowered following President Xi's state visit to the U.S. in April.3 Overall, the Chinese economy is unlikely to slow materially, if the U.S. economy does reasonably well. Chart 6U.S. And China: Synchronized 'Surprises' U.S. And China: Synchronized 'Surprises' U.S. And China: Synchronized 'Surprises' All in all, we expect the Chinese economy will likely continue to moderate, but the downside risk appears low at the moment. In a reported titled "Chinese Growth: Testing Time Ahead," dated April 6th, we warned that "growth figures coming out of China in the coming months may be viewed as less market friendly."4 Recent Chinese data and investor reactions confirm this judgment. Nonetheless, we maintain the view that the Chinese economy's growth improvement remains largely intact, which will reinforce the upturn in the global business cycle and support global risk assets. Strategically we lean against being overly bearish, and we remain cyclically positive on Chinese equities, particularly H shares. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Reports, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, and "More On The Chinese Debt Debate," dated April 20, 2017 available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Reports, "Reflecting On The Trump-Xi Summit," dated April 13, 2017 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Reflation Trade: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. New Zealand: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean government bond market. Feature "I know it makes no difference to what you're going through; but I see the tip of the iceberg, and I worry about you." - Rush Is The Liquidity Party Starting To Wind Down? Global financial markets continue to enjoy the "sweet spot" of a solidly expanding global economy, but without enough inflation pressure to force central banks to slam on the monetary brakes. That backdrop is starting to change, though. Odds are rising that the European Central Bank (ECB) will begin tapering its bond buying next year, with some hints of that possibly being announced as soon as next week's monetary policy meeting. At the same time, the Bank of Japan (BoJ) - faced with the operational constraints of buying an ever-increasing share of Japanese financial assets - is focused on targeting long-term interest rates rather than increasing liquidity. Even the Federal Reserve is now talking about reducing its massive balance sheet later this year. The liquidity tailwind to global growth and risk assets is now at risk of becoming a headwind. Already, the growth rate of the major central bank balance sheets has rolled over and is on course to decelerate further over the next year (Chart of the Week). Importantly, this downshift in global liquidity momentum is happening as signs of slowing growth have appeared in some major economies like China and the U.S. (Chart 2). Chart of the WeekLiquidity Tailwind To Risk##BR##Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Chart 2Growth Momentum##BR##Already Starting To Cool Off Growth Momentum Already Starting To Cool Off Growth Momentum Already Starting To Cool Off We remain concerned that the Chinese economy will see a policy-induced deceleration in the 2nd half of the year. However, we still expect the U.S. to rebound after the soft patch of growth in the first quarter, and we see nothing in the Euro Area data to suggest that the current solid expansion is at risk of fading quickly. This should allow inflation expectations to drift upward toward the central bank targets given the apparent lack of spare capacity on both sides of the Atlantic (Chart 3). Chart 3Fed & ECB Facing##BR##Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints We still expect the Fed to deliver another two rate hikes before year-end and the ECB to begin its exit strategy from the current extraordinary monetary policies by slowing the pace of asset purchases starting early next year. For now, the backdrop will remain supportive for the outperformance of growth-sensitive assets like corporate credit and equities over government bonds in the U.S. and Europe over the balance of 2017. However, the early signals sent by "leading leading" indicators such as our Global Leading Economic Indicator diffusion index (Chart 2, top panel) suggests that liquidity and growth trends will become far more challenging for the markets in 2018. Bottom Line: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. Maintain a below-benchmark duration exposure and an overweight allocation to corporate debt in global fixed income portfolios. New Zealand: Safety From A Global Bond Apocalypse? A growing number of the world's most wealthiest (and, arguably, most paranoid) people are reportedly buying real estate in New Zealand as a safe haven place to live if modern civilization collapses.1 While the immediate need for taking such precautions can be debated, there is sound logic in treating New Zealand as a location far removed from the current geopolitical and socio-economic problems of the world. We now see a case for treating New Zealand bonds as a potential "safe haven" market for global fixed income investors. The Economic Backdrop Has Become More Muddled We have been running a SHORT position in New Zealand (paying 12-month OIS rates) in our Tactical Overlay portfolio since last November. Our view then was that the New Zealand economy would surprise to the upside in 2017 and inflation was likely to start drifting upward. This would pressure the Reserve Bank of New Zealand (RBNZ) to raise the Official Cash Rate (OCR) from the highly accommodative level of 1.75%. So far, that expectation has not panned out as the RBNZ has held rates steady amid a more uncertain outlook for the New Zealand economy. Growth indicators have been a bit mixed over the past few months, but the current uptick in the manufacturing purchasing managers' index (PMI) is pointing to real GDP expanding around 3% on a year-over-year basis (Chart 4). If maintained for the full year, this would be slightly above the RBNZ's estimate of potential growth at 2.8%. There are some downside risks, however, given that consumer and business confidence are both below previous cyclical peaks and fiscal policy is expected to be mildly restrictive in 2017 (bottom three panels). The housing market remains a key cyclical wild card. Residential construction has been a significant source of growth over the past few years, driven by a surge in net immigration into New Zealand and declining interest rates (Chart 5). However, the RBNZ is projecting immigration inflows to slow from the current high level, largely due to improving labor market conditions in the developed economies (most notably, Australia, which is the largest source of New Zealand immigrants). Chart 4Stable NZ Growth...For Now Stable NZ Growth...For Now Stable NZ Growth...For Now Chart 5NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out Slower immigration would reduce the demand for New Zealand housing at a time when mortgage rates have already been rising off the record lows seen in 2016 (bottom panel). This has occurred without any rate hikes from the RBNZ, as rising global bond yields have put upward pressure on New Zealand bank funding costs, which have been passed through to higher mortgage rates. The RBNZ is currently projecting growth in house prices to slow sharply from last year's robust 15% pace to just 5% in 2017. The main drivers are higher borrowing costs and the ongoing impact of macro-prudential regulations against high loan-to-value ratio mortgage lending. Importantly, slower housing activity will not only have a direct impact on GDP growth through softer construction, but will also indirectly dampen consumer spending growth via wealth effects. Yet even with this expected drag on growth from housing, the New Zealand economy is still expected to face capacity constraints over the rest of the year. Higher Uncertainty Over Price Pressures Both the RBNZ and the International Monetary Fund estimate that the output gap has fully closed and is projected to move into positive territory this year (Chart 6). At the same time, the current unemployment rate of 4.9% is below the OECD's estimate of the full employment level and the RBNZ projects a further decline in joblessness in 2017 (third panel). Despite this evidence of the economy reaching capacity constraints, both wage growth and price inflation remain subdued and inflation expectations remain well-anchored around 2% - the midpoint of the RBNZ's 1-3% target range. Wage costs are particularly depressed, growing only 1% on a year-over-year basis in Q1. This may be related to the rise in the labor force participation rate - up to an all-time high of 70.6% in Q1 from a cyclical low of 68.2% at the end of 2015 - that has increased the available supply of labor. The most recent headline inflation print for Q1 was quite strong, taking the year-over-year growth rate up to 2.2%. Yet in the RBNZ's April Monetary Policy Statement (MPS), the central bank took a surprisingly dovish tone, citing uncertainty over the true degree of slack in the economy and downside risks to growth that would prevent a further acceleration of inflation.2 The RBNZ now forecasts inflation to not rise above 2.2% this year and to fall back to 1.1% in both 2018, led by a sharp decline in growth for tradeables, mostly energy and food inflation (Chart 7). Importantly, this forecast includes the recent decline in the trade-weighted New Zealand Dollar (NZD). Non-tradeables inflation is also expected to stabilize on the back of slower housing-related items in the consumer price index. Chart 6RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... Chart 7...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools A Weaker Case For Tighter Monetary Policy The official RBNZ projection is that the OCR will stay unchanged at 1.75% until September 2019. The market expectation priced into the NZD OIS curve calls for 27bps of hikes over the next twelve months (Chart 8). Our New Zealand Central Bank Monitor has been suggesting the need for tighter monetary policy since mid-2016, but appears to be rolling over (2nd panel). The diminished rate hike expectations have coincided with a decline in the NZD and a sharp underperformance of New Zealand equities. The markets are giving a consistent signal on softening growth prospects in New Zealand, confirming the central bank's more recent dovish turn. Chart 8Market Expectations Of##BR##RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Given the newfound uncertainties over the New Zealand growth and inflation outlook, the case for owning New Zealand interest rate exposure has grown a little bit stronger. Admittedly, we do not envision a major pullback in growth, and inflation may not fall by as much as the RBNZ is expecting given how little spare capacity there appears to be in the economy. Yet there is now just enough uncertainty to keep the central bank on hold for longer than expected, as was noted in the "scenario analysis" section of the April MPS.3 The RBNZ noted that if the level of spare capacity is smaller than currently assumed, then the latest growth forecast will result in inflation eventually moving to 2.0% in 2018 and 2.3% in 2019, resulting in the OCR needing to rise to 2.25% in two years. Alternatively, if housing demand slows even faster than current projections, inflation would be below the 2% target during the next two years and the OCR would need to fall to 1.25% by the end of 2018. Our takeaway from this is that, even in the more positive scenario, interest rates are not expected to rise by much more than the markets are currently discounting. Position For Tighter New Zealand Spreads Versus Treasuries & Bunds The economic risks in New Zealand now appear evenly balanced. This argues for stable monetary policy and diminished bond volatility. Current market forwards for both government bonds and NZD swaps shows that very little movement in interest rates is expected over the next year (Chart 9). We generally agree with this pricing, although the uncertainty over the degree of spare capacity, and underlying inflation pressures, make a directional view on interest rates or the shape of the yield curve an unattractive risk proposition. A more interesting opportunity presents itself in looking at spread trades between New Zealand government bonds versus other developed market sovereign debt. The yield betas for New Zealand versus the U.S. and Germany have fallen steadily over the past year (Chart 10), indicating that New Zealand bonds can be more insulated from the rise in yields that we expect for U.S. Treasuries and German Bunds over the latter half of 2017. Given the competitively high yields on offer in New Zealand, even on a currency-hedged basis (bottom panel), we see a case for going long New Zealand interest rate exposure versus U.S. and Germany. Chart 9Higher NZ Bond Yields##BR##Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Chart 10NZ Bonds: Now Lower Beta##BR##With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields At current yield levels, going long New Zealand versus Germany looks more compelling relative to spread compression trades versus U.S. Treasuries. We see strong potential for New Zealand-Germany spreads to tighten faster than the forwards over the next six months (Chart 11), largely through rising German yields as the ECB signals that a tapering of bond purchases is set to begin next year. The downside potential for New Zealand-U.S. spread compression looks less likely from current tight levels, although if Treasury yields rise by as much as we expect in the coming months, some spread tightening should occur here, as well. Chart 11Go Long 5Yr NZ Bonds Vs##BR##USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Based on our analysis, we are closing our current NZD rates trade in our Tactical Overlay portfolio with a tiny profit of +3bps , and entering two new trades: long 5-year NZD government bonds versus 5-year U.S. Treasuries, on a currency-hedged basis; and long 5yr NZD government bonds versus 5-year German government debt, on a currency-unhedged basis.4 We are choosing to hedge the currency exposure back into USD for the former given the view of BCA's currency strategists that the EUR/USD exchange rate is now stretched too far to the upside and is at risk of declining as the Fed delivers on additional rate hikes in the coming months.5 In other words, we see a greater potential for a decline in NZD/USD than NZD/EUR in the next 3-6 months. Bottom Line: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation, in contrast to the strong likelihood of additional Fed rate hikes and an ECB taper announcement in the next few months. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: A Bad Moon Rising For Bond Yields Chart 12Markets Not Worried##BR##About The New President Markets Not Worried About The New President Markets Not Worried About The New President The new South Korean president, Moon Jae-In was elected on May 9th, ending a year of political turmoil after the previous president's scandal and impeachment. Our colleagues at BCA Geopolitical Strategy view Moon and his Democratic Party as a major shift to the political left.6 The new president's policy agenda is aimed at economic stimulus for the working class alongside reforms of the country's chaebol industrial giants. Korean financial markets have greeted the election result positively, with the benchmark KOSPI equity index up 2.7%, and the Korean won up 1% versus the U.S. dollar, from the pre-election levels on May 8th. (Chart 12). This is consistent with past market behavior, as the won tends to be less reactive toward domestic events (i.e. after the previous president's impeachment, the won actually strengthened) and more sensitive to international uncertainties (i.e. North Korea-U.S. military tensions, as occurred in mid-March). Korean interest rates, however, have shown little response to the change in leadership in Seoul, with bond yields unchanged since the election. We see this as presenting an opportunity for fixed income investors. Clearly, the new regime in Seoul represents a real change for the Korean people, but it also represents a potential shift in the economic backdrop - namely, through an expected large fiscal stimulus from the new government - that will impart a steepening bias to the Korean interest rate curve. A Sluggish Economy Greets The New President While the steady, if unspectacular, pace of global growth in the past few years has been enough to absorb spare capacity in many countries, South Korea's sub-par economic performance has left the country with a widening output gap (Chart 13). Policymakers are well aware that consumer spending, which contributes about 60% of GDP, has been steadily weakening alongside slowing credit growth. Chart 13Sluggish Growth In South Korea Sluggish Growth In South Korea Sluggish Growth In South Korea The new government will attempt to boost domestic consumption, and thus overall growth, by increasing social welfare spending. Moon's economic agenda calls for raising the minimum wage by 55% by 2020, increasing subsidies for education costs and parental leave, and doubling the basic pension payment for the elderly regardless of their income level. It might prove to be very effective in the short term at boosting consumer spending, but this may not prove to be a sustainable driver of growth in South Korea, where the marginal swings in the economy have historically been driven more by exports. Youth joblessness is another problem that Moon will attempt to tackle with his ambitious economic program. While the labor market may appear healthy, with an overall unemployment rate of only 3.7%, the situation is far more challenging for young adults in South Korea - the jobless rate for those aged 20-29 is 11.3%. One of the reasons for such a high unemployment rate among young South Koreans is that university graduates, of which there are many in this highly-educated nation, expect (and look for) high-paying jobs, but cannot find enough of them.7 The labor market has become more competitive in recent years as weak economic growth has limited the ability of private sector, especially large corporations, to hire as much. To solve this problem, the new government has promised to create 810,000 jobs in the public sector. Creating public sector jobs may temporarily solve the high unemployment rate, but in the long run, this will also cause larger fiscal burdens for taxpayers. Position For A Steeper South Korean Yield Curve Headline CPI inflation in South Korea is currently hovering around the 2% target of the Bank of Korea (BoK), while core CPI growth is lower at 1.3%. The BoK has maintain the policy rate at 1.25% since June 2016, with a bias towards additional easing given the lack of sustained inflationary pressure amid weak domestic demand. The BoK did sound a slightly more upbeat tone on the economy at last week's monetary policy meeting, led by the spillover effects from improving global growth rather than a more bullish expectation on the Korean consumer. Importantly, the central bank still expects inflation pressures to remain subdued - no surprise given the large output gap. The BoK did note that it is monitoring several factors in judging future policy decisions: the pace of rate hikes by the Fed, trends in global trade, geopolitical tensions, the pace of household debt accumulation and "the directions of the new government's fiscal policies." The latter may end up being the most important factor, as President Moon is proposing an increase in government spending equal to 0.7% of GDP - an amount equal to ½ of the estimated output gap coming after a 2016 budget surplus of 1% of GDP. This increase in fiscal spending could directly drive up the longer-end of Korean yield curve, as this would result in a narrower budget surpluses and greater KGB issuance. At the same time, the lack of domestic inflation pressures, even with the fiscal stimulus, will keep the BoK on an easing bias that will keep short dated yields well anchored. Therefore, we see the potential for the Korean yield curve to eventually steepen and break the downward-sloping trendline in place since 2014 (Chart 14). We recommend positioning for this move by entering a 2-year/10-year steepening trade in the Korean yield curve. Admittedly, this trade is more structural than tactical in nature, as the Moon stimulus policies will take time to unfold. Importantly, a flattening of the 2-year/10-year KGB curve is currently priced into the forwards, meaning that positioning now for a steepener does not incur negative carry (Chart 15). Chart 14More Fiscal Stimulus =##BR##Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve Chart 15Enter A 2Yr/10Yr##BR##Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Also, Korean 10-year bond yields are currently exhibiting a strong correlation to similar maturity U.S. Treasuries with a yield beta around 1.0 (bottom panel). Given our view that longer-dated U.S. yields have upside risk from both additional Fed rate increases and higher U.S. inflation expectations, that high yield beta suggests that the Korean yield curve could suffer some of the same cyclical bear-steepening pressures that we expect for U.S. Treasuries in the next 3-6 months. Bottom Line: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end curve of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean bond curve. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 https://www.theguardian.com/technology/2017/jan/29/silicon-valley-new-zealand-apocalypse-escape 2 The central bank noted that its "suite" of output gap estimates, using varying methodologies, have an unusually wide range at the moment between -1.5% and +2%. 3 http://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement 4 These trades can be done using interest rate swaps as well (receiving NZD rates vs paying USD & EUR rates), as swap spreads are expected to remain broadly stable in all three regions. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Bloody Potomac", dated May 19 2017, available at fes.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets" dated May 24 2017, available at gps.bcaresearch.com. 7 According to the OECD, Korea's college enrollment rate was a whopping 87% as recently as 2014. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Distant Early Warning Distant Early Warning Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Chart 1 C1 C1 Senior officials at the Federal Reserve have begun preparing the market for the eventual run down of the central bank's balance sheet. After several rounds of quantitative easing (QE), total assets held by the Fed currently stand at US$4.5 trillion - a dramatic increase from US$900 billion before the global financial crisis. Indeed, efforts to shrink the Fed's balance sheet are essentially reverse QE. As the 2013 'Taper Tantrum" suggests, such a profound change in U.S. monetary policy can have a significant impact on interest rates and broader financial assets, and Fed officials are working hard to properly anchor market expectations. In comparison, how the People's Bank of China manages its balance sheet is much less transparent and less understood by market participants, even though the PBoC has the biggest balance sheet among the world's major central banks (Chart 1). Currently, the PBoC's total assets amount to US$4.9 trillion, compared with about US$4.5 trillion for both the Fed and the European Central Bank (ECB). Moreover, its balance sheet has stopped growing since 2015 in local currency terms and has been shrinking in dollar terms, but the impact on the economy and financial markets has so far not been material. Generally speaking, a central bank uses its balance sheet to aid monetary policy. It controls the size and composition of its assets to affect interest rates, and in turn the economy. Through "operation twist" and QE, the Fed significantly increased its holdings of longer-dated Treasury securities and mortgage backed securities (MBS), which currently account for 95% of its assets (Table 1). Therefore, shrinkage of the Fed balance sheet means that the Fed's holdings of long-term securities will gradually be reduced - likely by allowing them to run off at maturity rather than selling them in the open market. This should nonetheless put some upward pressure on long-term risk-free rates going forward. Table 1The Fed's Balance Sheet Shrinking Of The PBoC's Balance Sheet Shrinking Of The PBoC's Balance Sheet In a Special Report we published six years ago, we pointed out the explosion in the PBoC's balance sheet and its unique features compared with other central banks.1 In a nutshell, the PBoC's biggest holdings on its asset side were U.S. Treasurys rather than domestic risk-free assets. The Chinese central bank was essentially engaging in a massive "currency swap" in which it accumulated U.S. Treasurys while dramatically increasing the country's monetary base. Meanwhile, it was also working hard to "sterilize" by forcing commercial banks to maintain an increasingly massive sum of required reserves with the central bank. These policy tools, however, were inherently crude and clumsy, with huge volatility in monetary market rates and overall financial volatility being a key after-effect. This week we are revisiting the PBoC's balance sheet to highlight some major shifts in recent years. Some developments are worth highlighting. Dynamics have completely reversed since 2015, when Chinese official reserves began to fall, leading to a shrinking in the PBoC's balance sheet by about US$500 billion since the all-time peak. The "sterilization" process has also been reversed, as the PBoC has been releasing liquidity back into the domestic financial system. The overall liquidity situation has been largely stable. Normally a decline in the PBoC's foreign asset holdings would lead to a decline in the reserve requirement ratio (RRR) to offset the liquidity outflows, leading to a simultaneous decline in both sides of the central bank's balance sheet. The PBoC, however, has been resisting shrinking its balance sheet. As its foreign asset holdings (U.S. Treasurys) have been declining, the PBoC has significantly ramped up domestic asset holdings by increasing direct claims on commercial banks through repos and other lending facilities. The central bank appears to be concerned that a lowered RRR will stoke more domestic capital outflows, which risks creating a vicious circle. How the PBoC manages domestic liquidity has seen major shifts in recent history, and will likely continue to evolve going forward. The RRR, as a monetary policy tool, will likely be gradually phased out.2 Over the long run, this will lead to important changes in the PBoC's balance sheet and the way it conducts monetary policy. In the short term, commercial banks' excess reserves are at close to record low levels. The odds are rising that the RRR will be lowered in the coming months, especially if the RMB stabilizes against the dollar, as we expect.3 Finally, it is worth noting that the most aggressive phase of the Fed's QE efforts coincided with the most rapid phase of the PBoC's balance sheet expansion. This means that both central banks were aggressive buyers of U.S. Treasurys and risk-free assets in previous years. Looking forward, if a shrinking Fed balance sheet leads to a sharp increase in U.S. interest rates and a dollar rally, it could force the PBoC to also liquidate its holdings of U.S. Treasurys to stabilize the RMB exchange rate. This means both the Fed and the PBoC could become marginal sellers of Treasurys, which would have a much more profound impact on U.S. interest rates and the growth outlook. Monitoring the PBoC's balance sheet will become increasingly important for Fed watchers. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Delving Into the PBoC'S Balance Sheet," dated July 27, 2011, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "More On The Chinese Debt Debate," dated April 20, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Can The RMB Appreciate Against The Dollar, Again?" dated May 11, 2017, available at cis.bcaresearch.com. Table 2 offers a simplified balance sheet of the People's Bank of China. Foreign assets still account for 65.6% of its total assets, down from a peak of 83% in 2014. In comparison, most other major central banks' assets are predominantly domestic government bonds. The explosive growth of the PBoC's holding of foreign assets had been the only source of its balance sheet expansion before 2015. In the past two years the PBoC's domestic assets have increased sharply. Overall the PBoC's balance sheet has stayed flat in the RMB terms. PBoC's holding of foreign and domestic assets has been matched by expansion of reserve money (monetary base) on the liability side of the PBoC's balance sheet, including currency issuances (M0 and cash in the vaults of depository institutions) and deposits of commercial banks in the central bank. Commercial banks' reserve deposits at the PBoC have continued to grow even though the PBoC balance sheet expansion has stalled. (Chart 2) Table 2The PBoC's Balance Sheet Shrinking Of The PBoC's Balance Sheet Shrinking Of The PBoC's Balance Sheet Chart 2 C2 C2 PBoC holdings of foreign assets include foreign exchange reserves and gold. Foreign reserves currently account for 63% of PBoC total assets, compared with a peak of 84% in 2014. Official record shows that gold is still a negligible share of its total assets. Other major items on the asset side of the PBoC's balance sheet include claims on the government, commercial banks and other financial corporations. The PBoC's claims on the government (entirely on the central government) account for 4.5% of its total assets. In 2007 the government set up a sovereign wealth management fund to manage part of the country's reserves. The government issued bonds to the PBoC in exchange for foreign exchange reserves, which was used as capital of the investment firm. Legally the PBoC is forbidden to directly hold government bonds. The PBoC's claims on other depository corporations (commercial banks) include loans and rediscounts to commercial banks and the net amount of repurchase agreements, which has increased sharply since 2016. The PBoC claims on other commercial banks were a major policy tool to control liquidity in the early 2000s. The central bank's claims on other financial corporations mainly include loans to the asset management firms that the government set up in the late 1990s to deal with bad loans spun off from commercial banks. There has been no change in this item in recent years. (Chart 3 and Chart 4) Chart 3 C3 C3 Chart 4 C4 C4 On the liability side of the PBoC's balance sheet, the dominant item is reserve money, which includes currency issuances and deposits of depository corporations. Taken together these items account for almost 90% of banks' total liabilities. However, currency issuances (M0 and cash in vault) have been hovering around 20% of the PBoC balance sheet in recent years. Deposits of depository corporations account for about 66%. Deposits of commercial banks in the central bank include required and free reserves. Currency issuance and free reserves make up China's "high power money" that can result in a much larger increase in money supply through the money multiplier. Therefore, adjusting the reserve requirement ratio (RRR) on banks has been a key policy tool for the PBoC to control "loanable" funds and liquidity. The central bank, however, been reluctant to adjust RRR since 2016 despite continued liquidity outflow. Commercial banks used to hold large amounts of free reserves with the central bank, which however have declined sharply in recent years. The massive reserves of commercial banks in the PBoC offer a critical liquidity buffer for banks at times of crisis. As banks' free reserves have been running thin, there is a building case for an RRR reduction in coming months. (Chart 5 and Chart 6) Chart 5 C5 C5 Chart 6 C6 C6 Other major items on the liability side of the PBoC's balance sheet include bond issues, government deposits and foreign liabilities. The central bank started to issue bonds (notes) in 2002 as a way to sterilize foreign capital inflows, a tool that has essentially been phased out. Currently, total outstanding bonds amount to RMB 50 billion, a mere 0.1% of the PBoC total liability, compared with almost 30% in 2007. The PBoC's foreign liabilities are deposits of international financial institutions, which account for a negligible share of its total assets. Government deposits account for 8.4% of the central bank's total liabilities, or RMB 2.88 trillion at the end of April 2017. The PBoC regularly auctions off fiscal deposits to commercial banks as a way to adjust interbank liquidity. (Chart 7 and Chart 8) Chart 7 C7 C7 Chart 8 C8 C8 There are four main items on the PBoC's balance sheet that the central bank uses at its discretion to manage domestic liquidity: claims on depository corporations (banks), deposits of depository corporations, liabilities to the government (fiscal deposits) and bond issues. Claims on depository corporations are on the asset side, and include loans and rediscounts to commercial banks and the net amount of repurchase agreements. The PBoC has significantly expanded some new liquidity tools, such as various lending facilities and open market operations. These assets are mostly short term, allowing the central bank flexibility to adjust the quantity quickly. Reserve deposits of commercial banks, central bank bond issues and fiscal deposits are on the liability side of the PBoC's balance sheet, but reserve deposits play by far the largest role in the central bank's sterilization efforts. Commercial banks reserve deposits are still hovering around record high levels. (Chart 9 and Chart 10) Chart 9 C9 C9 Chart10 C10 C10 Taken together, the ebbs and flows of the PBoC's sterilization operations coincide with the pace of country's foreign reserve accumulation. The PBoC was able to "sterilize" about 80% of foreign capital inflow before 2015, and it has been quickly adjusting its balance sheet to offset domestic capital outflows in the past two years. All these items on the PBoC's balance sheet should be cross-checked to assess its liquidity operations, rather than focusing on one item. Looking forward, the PBoC's liquidity operations will remain contingent on the situation of cross-border capital flows in the near term, and its monetary independence will remain compromised. Over the long run, a free-floating RMB exchange rate will diminish the purpose of PBoC's precautionary holdings of foreign reserves, which will in turn impact how the central bank manages its balance sheet for domestic considerations. (Chart 11 and Chart 12) Chart 11 C11 C11 Chart 12 C12 C12 Cyclical Investment Stance Equity Sector Recommendations

Feature EM risk assets refuse to sell off - regardless of new information and developments that historically would have caused these markets to tumble. Indeed, political turmoil and changes in Brazil and South Africa - two high-beta EM markets - have so far had limited impact on flows and market dynamics. Moreover, while our Reflation Confirming Indicator has rolled over, EM share prices have not reacted at all (Chart I-1). EM stocks have also decoupled with the equal-weighted average of global mining and energy equity indexes (Chart I-2). Chart 1Reflation Confirming Indicator And ##br##EM Stocks Reflation Confirming Indicator And EM Stocks Reflation Confirming Indicator And EM Stocks Chart 2Commodities Share Prices And ##br##EM Equities: Unsustainable Divergence Commodities Share Prices And EM Equities: Unsustainable Divergence Commodities Share Prices And EM Equities: Unsustainable Divergence We do not subscribe to the thesis that EM assets have permanently decoupled from both commodities and their domestic credit cycles, and that tried and tested indicators no longer work. Technology and social media share prices have been instrumental to this latest decoupling, as we wrote in last week's report.1 This group of stocks is in a full-blown mania phase, and it is hard to know when this will end. Yet, exponential price moves always occur at the end of a bull market, and are typically followed by bear markets. As we elaborated in last week's report, the investment call on social media and internet stocks is a bottom-up - not macro - call. Top-down analysis can add some value on the semiconductor cycle, and we suggested last week that it is likely topping out. This week new data releases support the thesis that Asian/global trade in general and the semiconductor cycle in particular are already decelerating. Korean exports data for the first 20 days of May, Japanese preliminary manufacturing PMI for May, and Taiwanese manufacturing output volume growth for April have all decelerated (Chart I-3). Finally, one technical piece of evidence that this rally is late is relative weakness in the equal-weighted MSCI equity indexes. In the EM space, the equally-weighted individual stock index has fared poorly against the EM market cap-weighted index since May 2016 (Chart I-4, top panel). In the U.S., the same measure of market breadth has deteriorated since December 2016 (Chart I-4, bottom panel). Chart 3Asia's Manufacturing Growth ##br##Is Already Decelerating Asia's Manufacturing Growth Is Already Decelerating Asia's Manufacturing Growth Is Already Decelerating Chart 4The EM And U.S. Equity Rally ##br##Has Been Driven By Large-Cap Stocks The EM And U.S. Equity Rally Has Been Driven By Large-Cap Stocks The EM And U.S. Equity Rally Has Been Driven By Large-Cap Stocks Bottom Line: EM financial markets are in the midst of irrational exuberance. The rally is late, but it is impossible to time the top. The forthcoming selloff will be large and protracted. Beware Of China's Budding Growth Slump Interest rates have risen in China sufficiently enough to cause a major growth slowdown in the mainland economy (Chart I-5). Liquidity tightening amid a lingering credit bubble could not be a more dangerous combination. In this context, financial markets are extremely complacent on EM/China plays. China's liquidity tightening continues, and is bound to create a decisive growth relapse in the months ahead, as well as dampen exports in countries that sell to China (Chart I-6). Chart 5China Growth To Slump China Growth To Slump China Growth To Slump Chart 6Exports To China To Slump Exports To China To Slump Exports To China To Slump Not only is the People's Bank of China (PBoC) guiding interest rates higher, but there is an ongoing regulatory crackdown on the financial system. Regulators are forcing banks to bring Wealth Management Products (WMPs) and other off-balance-sheet items onto their balance sheets. As a result, banks' capital adequacy and risk matrixes will deteriorate, and they will be forced to slow down credit creation. Chart 7EM Share Prices Ex. Tech Have Not Broken Out EM Share Prices Ex. Tech Have Not Broken Out EM Share Prices Ex. Tech Have Not Broken Out Remarkably, policymakers are determined to get things under control. According to The Wall Street Journal,2 key policymakers have issued strongly worded statements. "Strong medicine must be prescribed," said Guo Shuqing, chairman of the China Banking Regulatory Commission (CRBC), according to people familiar with the matter. "If the banking industry gets into a mess," he added, "I will resign." He was appointed as the head of the CRBC last October, and likely has a mandate from the President to tackle speculative excesses in the financial system. In its first quarter Monetary Policy Implementation Report,3 the PBoC repeatedly used the phrase "preventing bubbles." Besides, in his statements, the chairman of the PBoC has frequently emphasized the need to normalize credit growth and curb speculative activities. The former head of the insurance regulator, who has been "accommodating" and "tolerant" of risky activities by insurance companies, was jailed last fall for corruption. These are strong indications confirming that policymakers are determined to curb speculative financial activities. Provided how entrenched and large various speculative financial schemes and the credit bubble have become in China, it will be impossible to tackle speculative excesses without a slowdown in overall credit growth and associated harm to the real economy. This is not to say that policymakers are tightening with intentions to cause a growth collapse. Policymakers in all countries always tighten to cap inflation or credit excesses or normalize interest rates - i.e., they never tighten to cause a major shock to the real economy. This applies to Chinese policymakers at the moment, especially ahead of the party Congress later this year. That said, when the existing imbalances in the economy or financial system are sufficiently large, even minor tightening can cause a financial accident or growth relapse. It is not within policymakers' powers to predict or prevent it. They may alter their policy after the fact, but markets will sell off considerably beforehand. We do not know exactly how financial dynamics in China will evolve in the months ahead, but we are certain that the market consensus is too complacent and that EM asset prices are at major risk. Bottom Line: It is impossible to predict financial accidents (stress among specific institutions) but we are certain that China's credit growth and, consequently, capital spending are bound to slow considerably in the coming months. This bodes ill for producers of commodities and industrial goods both within and outside China. Accordingly, EM risk assets will suffer the most. As a final note, EM ex-technology share prices have not yet broken out and we do expect them to relapse from the current levels (Chart I-7). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?," dated May 17, 2017, link available at ems.bcaresearch.com. 2 Lingling Wei and Chao Deng, "China's War on Debt Causes Stocks to Drop, Bond Yields to Shoot Up and Defaults to Rise," May 5, 2017, The Wall Street Journal. 3 Please refer to http://www.pbc.gov.cn/zhengcehuobisi/125207/125227/125957/3307990/3307409/index.html (In Chinese only). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. The recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Chinese shares listed overseas will continue to grind higher. Domestic A shares will remain largely trendless. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. Feature Chinese domestic stocks and bonds have taken a beating of late as the authorities ramped up scrutiny to rein in excesses in the country's financial sector. While it is warranted to control accumulated financial risk - especially associated with shadow banking activity - the "campaign" style administrative crackdown has caused widespread confusion and mini-panics among domestic investors. The actions and corresponding reactions illustrate the authorities' primitive control tools, which are increasingly at odds with the rapidly developing financial sector, and how blanket actions can spur undue financial volatility and provoke unintended consequences. For now, we expect the economic fallout to be limited, unless the financial crackdown causes further spikes in interest rates and a sudden halt in credit flows. Chinese shares listed overseas will continue to grind higher in the absence of a major policy mishap that short-circuits the broad growth improvement and the profit cycle upturn. Domestic A shares will remain largely trendless, while the more richly valued bubbly segments of the market will continue to deflate. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. What Do They Want To Achieve? Policymakers' primary focus has been on cracking down on excessive speculation in financial markets and restricting lending activities that are not in compliance with legal and regulatory requirements. Financial sector deregulation in recent years has increasingly blurred the lines between banks, insurance companies, brokers and trust companies, and regulators are constantly challenged to monitor all the increasingly sophisticated moving parts. From the banking sector's point of view, regulators are concerned that lenders have been aggressively boosting their exposure to other banks and non-bank financial institutions instead of providing credit to the "real economy." Overall commercial banks' claims on other banks and non-bank financial institutions have increased from 12% of their total assets in 2006 to over 25% as of January 2017, while their liabilities to other banks and non-bank financial firms have increased from 7% to 12% (Chart 1). Smaller banks are even more dependent on interbank financing for loanable funds. Interbank transactions and repo activities account for about 14% of smaller lenders' total source of funding, compared with 2% for large banks (Chart 2). Some small banks regularly borrow at lower costs through the interbank market or use negotiable certificate of deposits to purchase "wealth management products" offering higher returns issued by other banks or financial institutions. The duration mismatch leads to constant pressure to roll over these short-term financial instruments. The increasing interdependence among the country's financial institutions also creates the risk of a chain reaction in the financial system should some type of credit event erupt. Chart 1Increasing Interdependence Among Financial Institutions China: Financial Crackdown And Market Implications China: Financial Crackdown And Market Implications The Chinese authorities have long regarded preventing systemic financial risk as a top priority, and the recent growth improvement has provided a window of opportunity for some housecleaning without a major adverse impact on the economy. Therefore, it is unlikely that regulators will back off from tightening regulatory supervision going forward. Overall, the authorities will continue to discourage overtrading within the financial system, and enforce full disclosure of off-balance-sheet items and shadow lending activities. The saving grace is that tightened macro prudential measures have already begun to curtail banks' aggressive expansion to non-bank financial institutions. Commercial banks' claims to these firms have slowed sharply since last year's peak (Chart 3). Meanwhile, the recent rise in interbank rates should also further discourage the perceived "risk-free" funding arbitrage to play the interest rate gap between long- and short-dated financial assets. All of this reduces the pressure of an escalation in the regulatory crackdown. Chart 2Smaller Banks Depend More On##br## Wholesale Funding Smaller Banks Depend More On Wholesale Funding Smaller Banks Depend More On Wholesale Funding Chart 3Banks' Exposure To Non-Bank Financial Firms ##br##Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Should Investors Be Concerned? In essence, banks' rising claims to other financial institutions means a lengthening of the credit intermediation channel, in which financing goes from credit providers through multiple layers of intermediaries to reach final borrowers in the real economy. In other words, banks, instead of lending directly to borrowers, channel loans to trust companies or securities brokers, who in turn transfer the funds to the real economy through "shadow banking" activities such as trust loans or various forms of "wealth management products", typically at higher rates. From this perspective, cracking down on lending excesses within the financial system in of itself should not have a material impact on credit flows to final corporate borrowers. In fact, streamlining the financial intermediation channel holds the promise of increasing accessibility to bank credit for the corporate sector and reducing its funding cost, which should benefit the overall economy in the long run. In the near term, liquidity tightening and the regulatory crackdown could push up interest rates and disrupt credit flows, which should be closely monitored to assess near-term negative impact on the economy. So far, the impact does not appear material. Chart 4Regulatory Crackdown ##br## Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Interbank rates have increased by about 100 basis points across the board since the beginning of this year, and 10-year government bond yields have risen by 50 basis points - both of which pale in comparison to the significant improvement in overall business activity. Nominal GDP growth expanded by 11.8% in the first quarter, compared with 9.6% in Q4, 2016. Furthermore, the central bank early this week re-started its medium-term lending facility (MLF), which was designed to avoid liquidity overkill in the domestic financial sector. Overall, the risk of overtightening of liquidity is not high. The regulatory crackdown since early this year has not had a meaningful impact on credit expansion. Banks' claims to other financial institutions have slowed sharply, but overall loan growth has been rather stable. Importantly, medium- and long-term loans to the corporate sector, pivotal for overall capital spending, have in fact accelerated (Chart 4). In short, increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. We expect the authorities to remain highly vigilant and avoid policy overkill. Reading Market Tea Leaves There have been some notable divergences among different classes of Chinese stocks (Chart 5). Chinext, the domestic small-cap venture board, has suffered heavy losses of late, while large-cap A shares have been much more resilient. Meanwhile, offshore Chinese shares have barely felt any pressure at all. H shares have moved higher of late, while Chinese firms listed in the U.S. have decisively broken out. The divergence between onshore and offshore Chinese stocks' performance confirms the recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Barring major policy mistakes, we expect the Chinese economy to stay buoyant, as discussed in detail in our recent report.1 As such, a few investment conclusions can be drawn. Tighter liquidity will likely continue to place downward pressure on domestic stock prices, but the downside is limited by overall buoyant activity and improving profits. We expect the broad-A share market will remain narrowly range-bound. Overseas-listed Chinese shares are not subject to domestic liquidity constraints, and will likely continue to grind higher supported by growth improvement, profit recovery and low valuation multiples. The small-cap Chinext market has long been viewed as the more speculative segment of the domestic financial market, with higher multiples and greater volatility than large-cap A shares. As such, this market will remain vulnerable to domestic liquidity tightening. Even after the most recent selloff, the bourse's trailing price-to-earnings ratio and price-to-book ratio are still at 38.4 and 4.6, respectively, much higher than for broader onshore and offshore Chinese stocks. The recent selloff in the onshore corporate bond market has also been driven by liquidity pressure, which in our view is overdone. While it's true that economic acceleration justifies higher yields, corporate spreads have also widened sharply, which is at odds with the broad growth acceleration and profit recovery. In addition, after the most recent selloff, Chinese corporate spreads are significantly higher than in most other major markets (Chart 6). In the near term, tighter liquidity may continue to induce more selling pressure in the domestic bond market. Cyclically we expect Chinese corporate bond spreads to narrow. Chart 5Diverging Market Trends Diverging Market Trends Diverging Market Trends Chart 6The Sharp Spike In Chinese Corporate ##br##Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Has China's Cyclical Recovery Peaked?" dated May 5, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing The Zenith Is Passing The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Bright U.S. Household Income Prospects Bright U.S. Household Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving ...Especially As A Key Profit Driver Is Improving ...Especially As A Key Profit Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Deteriorating Growth Outlook Deteriorating Growth Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening Chinese Monetary Conditions Are Tightening Chinese Monetary Conditions Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry China Industrial Growth Worry China Industrial Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Platinum's Dark Omen For EM Platinum's Dark Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally The Falling Participation In The EM Rally The Falling Participation In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Little Cushion In EM Assets Little Cushion In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price EUR/USD: Good News In The Price EUR/USD: Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient European Core CPI Rebound Should Prove Transient European Core CPI Rebound Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Animal spirits have soared, according to soft data from surveys. But 6-month credit impulses have slumped in the euro area, U.S. and China, according to hard data from the ECB, Federal Reserve and PBOC. The negative 6-month credit impulse - rather than soaring animal spirits - is more important for the cyclical direction of the global economy. A growth-pause would blindside financial markets. Lean against any rise in high-quality bond yields and equity prices until the conflict between soaring animal spirits and slumping credit impulses is resolved. Feature Animal spirits have soared since the surprise election of President Trump on November 8. For many investors, the heightened animal spirits - shown in surging sentiment and survey data (Chart I-2) - are a strong signal that the global economy is about to accelerate. Unfortunately, these investors could end up very disappointed. Chart of the Week6-Month Credit Impulses Have Slumped 6-Month Credit Impulses Have Slumped 6-Month Credit Impulses Have Slumped Chart I-2Animal Spirits Have Soared... Animal Spirits Have Soared... Animal Spirits Have Soared... The problem is that the hard data on bank credit are giving the exact opposite signal. Over the past few months, global credit flows have slumped (Chart of the Week, Chart I-3 and Chart I-4). Chart I-3...But Credit Impulses Have Slumped ...But Credit Impulses Have Slumped ...But Credit Impulses Have Slumped Chart I-4The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The ECB's latest Monetary Developments in the Euro Area shows that the euro area 6-month credit flow has shrunk by €26 billion. The most recent 6-month credit flow fell to €321 billion from €347 billion in the previous period. The U.S. Federal Reserve's latest weekly H8 release paints an even starker picture. The U.S. 6-month credit flow has shrunk by $271 billion, equivalent to 3% of U.S. GDP (at an annualised rate). The most recent 6-month credit flow plunged to just $152 billion from $423 billion in the previous period. For completeness, look at the world's other major economy, China. Given the lower credibility of official bank credit data in China we prefer to focus on the broad money supply numbers. The People's Bank of China does not seasonally adjust this data, but it is straightforward to do ourselves using standard seasonal adjustment functions. The seasonally-adjusted data shows that the most recent 6-month flow, at 8.1 trillion yuan, was slightly higher than the preceding 7.7 trillion yuan. Nevertheless, the resulting marginally positive China 6-month impulse is sharply down from previous months. Why Optimism Is Up, But Borrowing Is Down Let's explain why sentiment data and credit flows have headed in polar opposite directions since the shock electoral success of Donald Trump. Imagine that firms (or households) are willing to borrow $1 billion for investment projects at a long-term borrowing cost of 1.5%. Then, an unexpected event causes animal spirits to surge. Suddenly, firms will become more optimistic about the expected profits from the investment projects. At this higher net1 profitability, firms might be willing to borrow and invest more than $1 billion, let's say $1.5 billion. In which case, the sentiment data will be higher and so will the credit flow, resulting in a credit impulse of +$0.5 billion. Chart I-5A Sharp Rise In Borrowing Costs Has##br## Countered Heightened Animal Spirits A Sharp Rise In Borrowing Costs Has Countered Heightened Animal Spirits A Sharp Rise In Borrowing Costs Has Countered Heightened Animal Spirits Now imagine that in response to this improved economic outlook, the financial markets expect the central bank to hike interest rates quicker and further. So the markets push up the bond yield to 2.0%. For firms, this higher cost of long-term borrowing might now exactly neutralise the expected profit boost from the investment projects. At this unchanged net profitability, firms will continue to borrow and invest $1 billion. In which case, the sentiment data will be higher but the credit flow will be unchanged, resulting in a credit impulse of zero. Finally imagine that in response to the improved economic outlook, the financial markets get carried away. They push up the bond yield to 2.5%. Now, the much higher cost of long-term borrowing will more than neutralise the expected profit boost from the investment projects. At a sharply lower net profitability, firms will borrow and invest less than $1 billion, let's say $0.5 billion. In which case, the sentiment data will be higher but the credit flow will fall, resulting in a credit impulse of -$0.5 billion. Note that in all three cases, animal spirits are up sharply. For credit flows, these heightened animal spirits in isolation are a tailwind. But any associated rise in the cost of long-term borrowing is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from higher long-term borrowing costs. Today, we would suggest that for global credit flows, the tailwind from heightened animal spirits is weaker than the headwind from the sharpest rise in bond yields in a decade (Chart I-5). The result is a negative 6-month global credit impulse. And it is this negative 6-month credit impulse - rather than heightened animal spirits per se - that is more important for the cyclical direction of the global economy. The History Of "Animal Spirits" In the early nineteenth century, the 'British Currency School', led by David Ricardo, postulated that expansions and contractions of bank credit and the broad money supply are the main cause of the economic cycle. We are very strong advocates of Ricardo's Currency School thesis. In opposition to the Currency School, the 'British Banking School' believed that expansions and contractions of bank credit are merely the passive effects of the economic cycle. The true cause of the economic cycle is fluctuations in business speculation and expectations of profit, which ultimately come from psychological mood swings. A century later in 1936, John Maynard Keynes wrote The General Theory of Employment, Interest and Money. In it, Keynes reiterated the Banking School's psychological mood swing explanation of the cycle. To describe these mood swings, he came up with the now very familiar phrase "animal spirits". Keynes blamed the Great Depression on the collapse of these animal spirits, and a consequent collapse in investment and consumption. But Keynes was only partly right. Animal spirits in isolation do not cause the cycle. As discussed in the previous section, borrowing costs lean against mood swings in both directions. Optimism results in higher borrowing costs, countering the desire to borrow. Pessimism results in lower borrowing costs, countering the reluctance to borrow. And it is the net impact on credit flows that drives the cycle. The specific problem in the Depression was a slump in asset prices. This depressed the value of households' and firms' balance sheet assets to below the value of the liabilities - an extreme event which economist Richard Koo calls a 'balance sheet recession'. Crucially, in a balance sheet recession, no amount of borrowing cost reduction can counter the reluctance to borrow, because households' and firms' single-minded objective is to regain solvency. Hence for us, the Ricardian bank credit cycle - rather than Keynesian animal spirits - is the better explanation for the Great Depression, as well as for Japan's post-1990 bust and for the 2008-09 Great Recession. The Ricardian bank credit cycle also explains the more common and garden variety of economic fluctuations (Box I-1). Readers should review our February 2 report Slowdown: How And When? for the compelling theoretical and empirical evidence. Right now, the important message is that the global bank credit cycle is weakening. Box I-1The Mathematics Of Mini-Cycles Credit Slumps While Animal Spirits Soar. Why? Credit Slumps While Animal Spirits Soar. Why? Credit Slumps While Animal Spirits Soar: What Should Investors Do? Many commentators and investors look at sentiment and survey data and note that animal spirits have soared. On this basis, they expect global growth to accelerate. But to reiterate, animal spirits in isolation do not cause the economic cycle. Heightened animal spirits do generate a tailwind for credit creation, but any associated rise in the cost of long-term borrowing generates a headwind (Chart I-6). And it is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy (Chart I-7). Chart I-6Higher Borrowing Costs Weaken Credit Flows... Higher Borrowing Costs Weaken Credit Flows... Higher Borrowing Costs Weaken Credit Flows... Chart I-7...And Weaker Credit Flows Slow The Economy ...And Weaker Credit Flows Slow The Economy ...And Weaker Credit Flows Slow The Economy Today, the hard data on bank credit in the euro area, the U.S. and China show that 6-month impulses have slumped. The risk is that this could generate an unwelcome surprise. Rather than accelerate in the coming months, global growth may level off or even decelerate. Even if it were a short-lived pause, major financial markets - including all of those in Europe - would be blindsided. The risk-on mode so far in 2017 would turn out to be incongruous. At the very least, until the conflict between soaring animal spirits and weakening credit impulses is resolved, we will lean against any rise in high-quality bond yields and equity prices. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Profitability net of borrowing cost. Fractal Trading Model* Excessive optimism in global equity prices reinforces our near-term caution towards stocks. We are expressing this through a short position in the AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 Fractal Trading Model Fractal Trading Model * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Feature Dear Client, I am travelling this week so this report is a little different. It is the full transcript and slides of a client presentation I recently gave. The presentation summarises several years of in-house work on applying the Fractal Market Hypothesis to real-life investing. Dhaval Joshi The Efficient Market Hypothesis Is Wrong Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Good morning In the next 30 minutes or so I want to challenge the way you think about financial markets. You see, at school we are taught the mainstream models of financial markets: Modern Portfolio Theory, the Capital Asset Pricing Model and the Efficient Market Hypothesis. And we are led to believe that these models describe the real world. But I'm sad to say that these mainstream models are deeply flawed. They simply don't describe financial markets as they behave in the real world. And in your heart of hearts, you know it. Take the supposed bedrock of financial market theory, the Efficient Market Hypothesis, and look at the assumptions it makes about markets (Slide 2). Slide 2 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint One. That economic and market returns follow a Normal - which is to say a standard bell-curve - distribution. Really? Everybody knows that returns exhibit 'fat-tails' in which extreme events happen much more frequently than the bell-curve would suggest. By the way, this also means that a statement such as "the financial crisis was a five standard deviation - five-sigma - event with odds of 3 million to 1" is also complete nonsense. Accounting for the true fat-tails, the likelihood of extreme events is much higher than the flawed bell-curve models would suggest, as we should all now be painfully aware! Two. That the distribution is stationary - its mean doesn't change through time. Again, wrong. We know that economies and markets can and do experience regular regime-shifts or phase-shifts. Three. That markets have no memory - they exhibit no trends. Now this is getting silly! We all know that markets exhibit very strong trends. Four. That markets do not produce repeating patterns at any scale. Untrue. And five. That markets are continuously stable at all scales. Wrong again. I'm sure you'll all agree that none of these assumptions that underlie the Efficient Market Hypothesis describe the markets that we all know and work with. The good news is that there is a model that does describe the financial markets as they behave in the real world (Slide 3). It correctly assumes the return distribution is non-Normal, the mean can change over time, markets can trend, produce repeating patterns, and can generate instabilities at any scale. Slide 3 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint The model is called the Fractal Market Hypothesis, first proposed by Edgar Peters in 1991. Now I can see some looks of fear at the mention of this intimidating word 'fractal'. But hang in there, there really is nothing to fear. A fractal is just a pattern that repeats over and over at different scales. You come across fractals all the time, perhaps without realizing it. A cloud is a fractal - because a small part of a cloud is just a scaled-down version of the whole cloud. And for those of you who enjoy your vegetables, you will notice that cauliflowers and broccoli are fractals because the florets are just miniature versions of the whole vegetable. But perhaps the most familiar example is a tree (Slide 4). You can clearly see that a tree is just a simple pattern repeating over and over at different scales. Indeed, on this next slide (Slide 5), you see images of the twigs, branches, and trunk structure - and you could not tell them apart. Except that the twigs are on a scale of millimeters, the branches are on a scale of centimeters, and the trunk is on a scale of meters. Slide 4 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 5 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Let's switch back to financial markets. On this next slide (Slide 6), you see three images of ten successive points on the S&P500. Again, the three images look very similar. In fact, they're very different. The first is on a scale of weeks, the second on a scale of months, and the third on a scale of years. But just like the twigs, branches and trunk, you could not tell them apart without seeing the scale. In other words, financial markets are scale-invariant. They are fractals. Slide 6 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint But why? And so what? To answer these questions we must now introduce the four basic assumptions of the Fractal Market Hypothesis. One. Investors are not homogeneous. The market is composed of many participants with a large number of different time horizons (Slide 7) - ranging from the milliseconds or seconds for a high frequency trader, through the days or weeks for a hedge fund to the years or decades for a pension fund. Two. These different time horizons interpret the same fundamental information differently (Slide 8). For example, a short-term technical trader interprets a rising price as a buy signal. Whereas a long-term fundamental value investor interprets the same information as a sell signal. Slide 7 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 8 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Three. The market price reflects the combination of the short-term technical trader's interpretation of the information and the long-term value investor's interpretation of the same information (Slide 9). Crucially, this means the market is not efficient unless all time horizons are active in setting the price. Four. The stability of the market at a given price depends on plentiful liquidity - an adequate balancing of supply and demand at that price (Slide 10). When many different time horizons are active, the market is efficient and liquidity is plentiful. This is because different investors will disagree on the interpretation of the same information, and will trade with each other in volume without moving the price. Slide 9 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 10 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint However, if one time horizon becomes dominant, the market becomes inefficient and liquidity will evaporate. As investors become a 'groupthink herd', the healthy disagreement that is needed to create liquidity disappears. And the market loses its stability. So to answer the question 'why' markets are fractals, it is clear that the short-term investors generate the short-term patterns while long-term investors generate the long-term patterns. And to answer the question 'so what', it is clear that if the fractal structure breaks down, it is a warning sign that liquidity is evaporating and the market is losing its stability. Next we must discuss how we can measure the market's fractal structure, and for this I'm going to digress a little and ask you a famous question. How long is Britain's coastline? This is the question that the grandfather of fractals, Benoit Mandelbrot, first asked in 1967. Actually, it's a trick question. The answer is that there is no answer! You see a coastline is also a fractal. And the more detail you capture and measure, the longer it becomes (Slide 11). The point is that with a fractal structure you cannot measure its length or size. But the good news is that you can measure its extent of 'fractal-ness' using something called a fractal dimension. In fact the next slide (Slide 12) shows how Mandelbrot first defined the fractal dimension of Britain's coastline. Slide 11 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 12 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Then a couple of years ago we thought why don't we extend this concept to a financial market? After all, a price chart is similar to a coastline, except that distance is replaced with time. In fact, the maths is a little more complicated, but this is how we ended up defining the fractal dimension of a financial market (Slide 13). Bear in mind that you won't find this or any of the following analysis in any textbook because it is our own unique work. Rest assured, you don't need the maths to understand the concept intuitively. Think of it like this (Slide 14). A market that is not trending tends to sweep out 2-dimensional space. So its fractal dimension might be close to 2. But a market that is trending gets less and less fractal and closer and closer to a perfect 1-dimensional line. So its fractal dimension drops close to 1. Slide 13 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 14 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint And now we get to our findings, which are both remarkable and uplifting. When we applied our unique definition of fractal dimension to different financial markets in different historical timeframes, we discovered that the tipping point of instability turned out to be exactly the same across different historical eras, geographies and asset classes. We had come across a universal property of financial markets, irrespective of generation, culture or investment. Financial markets tended to reverse their near-term trend when the fractal structure between the 65-day investment horizon and the 1-day investment horizon disappeared. Specifically, when the 65-day fractal dimension dropped to 1.25. So we called this the "Universal Constant Of Finance". You can see that this universal constant applied to the top and initial bottom of the market during the 1929 Wall Street Crash (Slide 15), and to the top and bottom of the 1987 Crash (Slide 16). It also perfectly picked the tops and bottoms of the 1990 Nikkei Crash (Slide 17), and the 1993 Bond Market Crash (Slide 18). Slide 15 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 16 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 17 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 18 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Some financial markets also tended to reverse long-term trends when the fractal structure between the 60-month investment horizon and the 1-month investment horizon disappeared. Specifically, when the 60-month fractal dimension dropped to 1.25. You can see here (Slide 19) how this has perfectly picked many of the structural turning points in the dollar. And when we see the rare star-alignment of a long-term signal coinciding with a near-term signal, it can predict a very strong reversal in a short space of time. This is precisely what we saw ahead of crude oil's sharp bounce in early 2016 (Slide 20 and Slide 21). So to conclude (Slide 22): Slide 19 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 20 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 21 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Slide 22 Predicting Liquidity-Triggered Turning Points: The PowerPoint Predicting Liquidity-Triggered Turning Points: The PowerPoint Financial markets are efficient only when all investment horizons are present and active in setting the price. In other words, when the market has a rich fractal structure. When investment horizons converge to a groupthink herd, the fractal structure breaks down, and the fractal dimension nears its lower bound. This is a warning sign of an impending liquidity-triggered trend reversal, either short-term or long-term. I am now happy to take any questions. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com