New Zealand

Highlights Global Volatility Vs. Inflation: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Feature Chart of the WeekThe Comeback Kids The Comeback Kids The Comeback Kids After a lengthy period of convalescence following the February VIX spike, some calm has been restored to financial markets. Global equities are staging a recovery from the correction seen earlier this year, with major indices like the U.S. S&P 500 and the MSCI All-Country World Index breaking out above key technical levels last week (Chart of the Week). Volatility in developed economy credit has also died down a bit, although corporate bond spreads still remain above the lows of the year in most countries. The resiliency of risk assets is even more impressive when viewed against the continuing climb of oil prices, fueled further by President Trump's announcement last week that the U.S. was pulling out of the Iran nuclear deal. With the benchmark Brent oil price now within hailing distance of $80/bbl, developed market government bond yields remain under upward pressure through higher inflation expectations (bottom panel). Yet as been the case for the past several months, the greatest upward pressure on global bond yields has been seen in the U.S., where the benchmark 10-year Treasury yield is once again knocking on the door of the 3% level. Global growth has lost some momentum in the first few months of the year, but not by enough to cause any loosening of capacity pressures through rising unemployment rates. Until the latter occurs, central banks will remain focused on the slow-but-steady rise in inflation pressures. This will limit any material decline in government bond yields as markets must price in both higher inflation expectations and some degree of interest rate increases. Not every central bank will deliver on what is currently discounted in terms of rate hikes, however, which continues to create more attractive relative fixed income country allocation opportunities now than have been seen in the past few years. We continue to recommend an overall below-benchmark portfolio duration stance, favoring corporate credit over sovereign debt. Within dedicated government bond portfolios, we favor underweight exposures in the U.S., Canada and core Europe while overweighting Australia, the U.K. and Japan. Lower U.S. Volatility Does Not Necessarily Mean Greater Global Stability The surge in market volatility earlier in the year began in the U.S. following the "wage inflation scare" in early February. The idea that dormant U.S. wage inflation could finally have awakened shook markets out of their slumber, driving the VIX index sharply higher (with some nudging from volatility-linked ETFs and other leveraged vehicles). Yet other markets saw a surge in vol, like currencies and the MOVE index of U.S. Treasury option prices (Chart 2). The latter development underscores one of our key investment themes for 2018, which is that the low market volatility environment will end through higher bond volatility.1 Faster U.S. inflation was expected to be trigger for that pickup in U.S. bond volatility, which would lead to a more aggressive path of Fed rate hikes and more uncertainty about the U.S. growth outlook beyond 2018. We did not expect that inflation-driven surge in bond volatility until the latter half of this year, but what happened in early February showed how the investing backdrop can turn ugly once inflation makes a comeback. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks (top panel). Combined with some easing of pressures seen in funding markets through the wider LIBOR-OIS spread (bottom panel), the backdrop is in place for continued recovery in U.S. equity and credit markets. It's a different story in non-U.S. markets, however. Softening global growth in the first quarter of the year, combined with steady increases in U.S. interest rate hike expectations, has resulted in the U.S. dollar staging a recovery after the pounding it took in 2017 (Chart 3). That combination of higher U.S. bond yields, a stronger dollar and weaker growth is a classic toxic brew for Emerging Market (EM) assets, which have been underperforming under the weight of investor outflows. None of those factors looks set to reverse in the near term, and we continue to recommend underweight allocations to EM fixed income (especially corporate debt). Chart 2The VIX Storm Has Blown Over The VIX Storm Has Blown Over The VIX Storm Has Blown Over Chart 3Not All Risk Assets Have Been Stabilizing Not All Risk Assets Have Been Stabilizing Not All Risk Assets Have Been Stabilizing Within the major developed markets, the most important factor at the moment is diverging inflation trends rather than growth. While U.S. inflation continues to drift higher, inflation in the euro area and U.K. has lost momentum (Chart 4). Surprisingly, Japanese inflation has finally started to show a bit of life - even after a period of yen appreciation - but perhaps that is because domestic inflation is finally awakening with annual wage growth hitting a 15-year high of 2.1% in March (3rd panel). Core inflation remains well below the Bank of Japan's 2% target, however. Meanwhile, last week's release of the April U.S. CPI data showed that inflation was still moving higher despite the outcome being slightly worse than expected (Chart 5). Importantly, some large and important elements of the CPI, like Shelter costs (33% of the total CPI index) and core goods prices (20%), saw a pickup in year-over-year inflation in line with our models and leading indicators. Given that U.S. real GDP growth leads core CPI inflation by about five quarters (top panel), this suggests that all of our inflation indicators are pointing to additional increases in U.S. inflation in the next 3-6 months. Chart 4Diverging Trends In Global Inflation Diverging Trends In Global Inflation Diverging Trends In Global Inflation Chart 5U.S. Inflation Momentum Still Trending Higher U.S. Inflation Momentum Still Trending Higher U.S. Inflation Momentum Still Trending Higher With U.S. inflation heading higher and non-U.S. developed market inflation languishing, there is still much more upside risk for U.S. Treasury yields than for the other government bond markets, mostly via higher U.S. inflation expectations. Stay underweight the U.S. within global hedged bond portfolios and remain long U.S. inflation protection by favoring TIPS over nominal Treasuries. Bottom Line: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: Outperformance To Continue Under New RBNZ Leadership Chart 6Good Timing On Our Bullish NZ Call Good Timing On Our Bullish NZ Call Good Timing On Our Bullish NZ Call One of the more successful trade recommendations we have made over the past year was to go long New Zealand government bonds versus U.S. Treasuries and German government debt in May 2017.2 Our call was predicated on a simple premise. The Reserve Bank of New Zealand (RBNZ) would maintain a dovish policy bias far longer than markets were expecting because of subdued inflation, at a time when the Fed would be hiking interest rates and the markets would begin to discount an end to the ECB's asset purchase program. Since we initiated that recommendation one year ago, headline New Zealand CPI inflation has slowed from 1.9% to 1%, while the RBNZ has kept policy rates unchanged. The spread between 5-year New Zealand government debt and 5-year U.S. Treasuries has collapsed from +74bps to -56bps, while the 5-year New Zealand-Germany spread has tightened from 292bps to 234bps. The overall New Zealand government bond index has outperformed the Barclays Global Treasury index by 120bps, currency hedged into U.S. dollars (Chart 6). Looking ahead, it may prove difficult to repeat those numbers from current levels. Yet it is even more challenging to construct a bearish case for New Zealand debt - the economy still looks sluggish, inflation is languishing well below the RBNZ target, and there have been changes at the central bank that will likely keep a dovish bias to New Zealand monetary policy. A Big Shakeup At The RBNZ There are several major moves that have just taken place at the RBNZ that should ensure that the central bank will not be raising rates anytime soon. First, Adrian Orr took over as RBNZ Governor back in March, replacing Graeme Wheeler. Orr was the Chief Executive of the New Zealand government pension (superannuation) fund, but was also a former RBNZ Chief Economist and Deputy Governor. He has stated an intention to make the RBNZ a more open, communicative central bank than Wheeler, who shunned media interviews and limited the number of on-the-record speeches by RBNZ officials. This will make the central bank a more transparent entity and limit the ability of the central bank from doing unexpected policy moves, as it has done in the past. The transparency will increase next year when the RBNZ moves to a full policy committee approach, where interest rates will be decided by a vote rather than a decision solely made by the Governor. Second, the New Zealand government has altered the RBNZ's monetary policy mandate following a review after the victory by the Labour party in last year's election. The central bank must now not only target price stability, but also seek to "maximize sustainable employment" in the New Zealand economy, not unlike the dual mandates of the U.S. Federal Reserve or Reserve Bank of Australia. This marks a major shift for the RBNZ, which was the first central bank to introduce an official inflation target in 1989. This change fulfils the new Labour-led government's campaign promise to promote job creation, which also includes restricting immigration. New Zealand Finance Minister Grant Robertson did state last November that the government would only consider candidates for RBNZ Governor that would be "willing and ready to adopt the new processes" of its review of the RBNZ's policy mandate.3 Robertson also noted that the new framework might result in monetary policy staying more accommodative from time to time. This smacks of increased government pressure on the RBNZ to keep policy as loose as possible to boost economic growth. Governor Orr has already had to go on the defensive, publicly stated that the central bank had "always" been considering short-term swings in employment when making its interest rate decisions. At a minimum, the case for future interest rate increases would have to be very strong under the new policy framework, focused on inflation seriously threatening the upside of the RBNZ's 1-3% target band. Economy Looking Sluggish After last week's monetary policy meeting, where the central bank kept the Overnight Cash Rate at 1.75% and downgraded its growth projections, Orr noted that the markets had "finally seemed to listen" to the RBNZ's message that policy rates would be on hold for a long time. He pointed to the decline in the New Zealand dollar (NZD) to a six-month low following the meeting as a "good thing for a trading nation" like New Zealand.4 His blunt, yet cautious, tone fits with developments in the New Zealand economy of late. Growth slowed over the course of 2017, with real GDP expanding at a 2.9% year-over-year rate in the fourth quarter after averaging 3.5% growth since 2014. The two major drags on growth were consumer spending and residential investment, both of which decelerated from unsustainably high growth rates in the prior few years that were fueled by high rates of net immigration (Chart 7). In the May 2018 Monetary Policy Report (MPR) released last week, the RBNZ noted that it expects net immigration to fall for three reasons: a strengthening Australian labor market, tighter visa requirements and the departure of those with temporary visas.5 The RBNZ is projecting immigration levels will steadily decline over the next four years, returning to levels last seen in 2011 in 2020, which will cause consumer spending growth to slow from over 4% to 2% by the end of the projection period (middle panel). That will also act as a major drag on housing activity, with no significant growth in real residential investment expected until 2020 (bottom panel). This will come on top of other regulatory changes introduced in 2016 to cool an overheated housing market (limiting loan-to-value ratios on mortgage lending). The RBNZ now expects real GDP growth to slow to 2.8% in 2018, a pace below its estimate of potential GDP growth of 3.2%. Not only is consumer spending and housing expected to slow, but the business sector is also projected to remain sluggish. Business confidence and capacity utilization are both well off the 2017 peak, thanks mainly to the slump in the dairy sector, which remains a critical part of the New Zealand economy (Chart 8). The fall in dairy prices and milk production was reportedly caused by poor weather conditions and falling demand from China, but the declines may be bottoming out (bottom panel). Besides the agricultural sectors, manufacturing and service sectors are still in decent shape, with the PMIs for both still above 50 even after last year's declines (top panel). The softer China demand story is not just about dairy, however. Growth in overall export demand from China has slowed dramatically over the past year, from 50% year-on-year down to -4.3% in March (Chart 9, 2nd panel). Australian export demand has also decelerated, which is critical given that those two countries represent 40% of total New Zealand exports. The RBNZ export survey, which has been a reliable leading indicator for New Zealand export growth, shows that exports are likely to continue falling over the next 6-8 months (top panel). With the overall commodity price index have clearly slowed (bottom panel), it is likely that the terms of trade will remain a drag on New Zealand economic growth, and the NZD, through a deteriorating current account deficit (now -3% of GDP) in the coming months. Chart 7Immigration-Fueled Growth Set To Reverse In NZ Immigration-Fueled Growth Set To Reverse In NZ Immigration-Fueled Growth Set To Reverse In NZ Chart 8Dairy Still Matters For NZ Dairy Still Matters For NZ Dairy Still Matters For NZ Chart 9NZ Exports Getting Hit NZ Exports Getting Hit NZ Exports Getting Hit Where's The Inflation? Despite the recent cooling of growth, the New Zealand unemployment rate is well below the OECD's estimate of the full employment NAIRU. Unlike other developed market countries with low unemployment rates, however, New Zealand's labor force participation rate is currently close to an historical high near 71% (Chart 10). While a high participation rate should mean that New Zealand is truly at full employment, wage growth remains anemic even with booming levels of job vacancies (3rd panel). The growth in average hourly pay for overall workers is still below the rate of headline CPI inflation, although this will get a bump with a 4.8% minimum wage increase being adapted last month. Overall, New Zealand's headline CPI inflation reached the RBNZ's target rate only once in Q1 2017, after several years of staying below that 2% benchmark, then started to slow down again over the rest of last year (Chart 11). Currently, headline and core CPI inflation are only 1.1% and 0.9%, respectively. This is now at the lower bound of the RBNZ's 1-3% target band, justifying the central bank's dovish bias. Chart 10Low Unemployment With No Wage Growth Low Unemployment With No Wage Growth Low Unemployment With No Wage Growth Chart 11No Inflation Problems For The New RBNZ Governor No Inflation Problems For The New RBNZ Governor No Inflation Problems For The New RBNZ Governor Within the main components of the index, non-tradables (i.e. domestically based) inflation has maintained stable growth near 2%, but tradables (i.e. globally based) prices are in outright deflation. This remains the biggest source for the undershoot of the RBNZ's inflation target over the past year - shockingly, a period when oil prices surged higher and the trade-weighted NZD softened. Yet the low levels of inflation are not filtering though into household expectations, with survey data showing that inflation is expected to stay above 2% next year, and even rise to 3% over the next five years. Policy To Stay On Hold For A Lot Longer The RBNZ is not as optimistic as households on inflation, however. The central bank is projecting that the headline CPI index will only rise by 1.1% in 2018 and will not return to the 2% target until 2021. On the back of this, the RBNZ is also projecting that the Overnight Cash Rate will remain at 1.75% until the end of 2020. Chart 12NZ Bonds Will Continue To Outperform NZ Bonds Will Continue To Outperform NZ Bonds Will Continue To Outperform The market is still pricing in one 25bp rate hike over the next 12 months, according to our calculations from the Overnight Index Swaps market (Chart 12). We see no reason for the RBNZ to not be taken at its word about holding rates steady, especially given the new dovish elements of the RBNZ's revised mandate. With price and wage inflation still so surprisingly low, the RBNZ can go for its maximum employment mandate and maintain highly accommodative monetary conditions. This includes both low policy rates and keeping the currency as weak as possible. We would recommend leaning against the mild increase in New Zealand bond yields, and the modest flattening of the yield curve, currently priced into the forwards (3rd and 4th panels). That suggests maintaining an above-benchmark duration stance for dedicated New Zealand fixed income investors. It also means adapting a bullish stance on New Zealand government bonds from a relative perspective to other developed markets. We are maintaining our current recommended spread trades for 5-year New Zealand bonds versus 5-year U.S. Treasuries and 5-year German debt. We have maintained the U.S. trade on a currency-hedged basis, as we typically do with all our recommendations. For the New Zealand-Germany spread trade, however, we made a rare exception and entered that trade on an unhedged basis. This was because we had a strong view that the euro would depreciate against most major currencies last year, including the NZD. That did not occur last year as the euro surged higher, which meant that our New Zealand-Germany trade took losses as NZD/EUR declined. For now, we are keeping that trade on an unhedged basis given the depressed level of NZD/EUR, but we will keep a tight stop going forward in the event of a broader breakdown in the NZD. Bottom Line: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 https://www.reuters.com/article/us-newzealand-economy-finmin/new-zealand-finance-minister-says-new-rbnz-governor-must-take-on-dual-mandate-idUSKBN1DG0EY?il=0 4 https://www.reuters.com/article/us-newzealand-economy-rbnz-orr/rbnz-governor-says-markets-finally-getting-the-hint-on-low-rates-idUSKBN1IC0LS 5 https://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement/mps-may-2018 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Serenity Now Serenity Now Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. When the chartbook was last published in September 2017, the main message was that less accommodative monetary policy was required in the developed economies. This was largely driven by solid global growth and diminishing economic slack visible in measures like falling unemployment rates and rising capacity utilization. Since then, there have been multiple rate hikes in the U.S., single rate increases in Canada and the U.K., and a slowing of the pace of central bank asset purchases in the euro area and Japan. No other central banks have made any moves, however, with inflation still struggling to return to policymaker targets in most countries. A new element that central banks are dealing with is the increased financial market volatility seen in 2018. Yet the BCA Central Bank Monitors continue to point to a need for tighter monetary policy in all countries (Chart of the Week). This means policymakers are unlikely to "come to the rescue" of less stable financial markets through more dovish (and bond bullish) policy without evidence that slower global growth was leading to an easing of cyclical inflation pressures. Chart of the WeekGreater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Greater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Greater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Feature An Overview Of The BCA Central Bank Monitors Chart 2The Cyclical Backdrop Remains Bond Bearish The Cyclical Backdrop Remains Bond Bearish The Cyclical Backdrop Remains Bond Bearish The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are above the zero line for all countries for which we have built the indicator. This implies that the conditions are not yet present to expect a period of declining global bond yields driven by more dovish central banks. Yet differences in the trajectories of the Monitors have opened up. The BoE, RBA and RBNZ Monitors have fallen well off their peaks, while the Fed, ECB, BoC and even the BoJ Monitors are all still at or close to recent highs. In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against our 12-Month Discounters, which measure the expected change in interest rates over the following year taken from OIS curves. Fed Monitor: Market Turbulence Not Yet Enough To Change Fed Plans Our Fed Monitor remains in the "tight money required" zone, signalling that cyclical pressures are still pointing toward additional Fed rate hikes (Chart 3A). FOMC officials are now expressing strong conviction that the Fed's growth and inflation forecasts for 2018 will be realized, and even upgraded those projections last month. That increased confidence comes amid signs that core inflation is finally moving higher after last year's surprising slump (Chart 3B). Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. No Spare Capacity In The U.S. No Spare Capacity In The U.S. The growth and inflation subcomponents of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published last September. In particular, the inflation subcomponent is on the cusp of breaching the zero line for the first time since 2011 (Chart 3C). The Fed Monitor (unlike the other Central Bank Monitors) includes a Financial Conditions component that is rolling over from very elevated (i.e. supportive) levels. Chart 3CSteady Pressure On The Fed To Tighten, But More From Growth Than Inflation Steady Pressure On The Fed To Tighten Steady Pressure On The Fed To Tighten The sharp sell-off in U.S. equity markets seen since early February is a development that would typically give the Fed pause on the need to tighten monetary policy further. Yet there are no real signs - yet - that any slowing of U.S. growth is in the cards for the next few quarters. Leading indicators are still climbing, employment growth has been accelerating in recent months, and both consumer and business confidence remain around multi-year highs. The Fed is likely to deliver on its projection of an additional 50bps of rate hikes in 2018, which is already discounted in money markets (Chart 3D). Additional increases beyond that in 2019 are still likely to occur, barring any signs that the current financial market volatility is altering the current rising trends in growth and inflation. Chart 3DThe Fed Will Continue To Hike In 2018 & 2019 The Fed Will Continue To Hike In 2018 The Fed Will Continue To Hike In 2018 BoE Monitor: Diminishing Pressures To Hike The Bank of England (BoE) Monitor is drifting lower, but remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has raised the base rate only once over that period - in November of last year. On the surface, inflation pressures remain strong. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, largely because the British pound is now up 9% off the post-Brexit 2016 lows. Rapid declines in pipeline price pressures (PPI, imported goods price inflation) point to additional slowing of CPI inflation in the next several months. Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Tight Capacity In The U.K. Tight Capacity In The U.K. Meanwhile, the economic picture looks mixed. Leading economic indicators have rolled over, as have cyclical measures like the manufacturing PMI and industrial production. Yet at the same time, recent readings on both consumer and business confidence have shown modest improvement. Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator are now falling (Chart 4C). Given the decelerating path of leading economic indicators, and with the currency-fueled rise in U.K. inflation now starting to reverse, we think the BoE will be hard pressed to deliver more than the 41bps of rate hikes over the next year currently discounted in U.K. money markets (Chart 4D). Chart 4CGrowth & Inflation Components Of The BoE Monitor Are Slowing Growth & Inflation Components Of The BoE Monitor Are Slowing Growth & Inflation Components Of The BoE Monitor Are Slowing Chart 4DThe BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted The BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted The BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted We continue to recommend an overweight stance on Gilts, which continue to trade as a "defensive" lower-beta alternative to U.S. Treasuries and core European debt, within dedicated global government bond portfolios. ECB Monitor: Tapering? Yes. Rate Hikes? No. Our European Central Bank (ECB) Monitor has been grinding higher over the past couple of years and broke sustainably above zero in July 2017 (Chart 5A). The broad-based cyclical economic upturn in the euro area has continued to absorb spare capacity, with the unemployment rate for the entire region now down to 8.6%, right at the OECD's NAIRU estimate (Chart 5B). Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area Economy Now At Full Capacity Euro Area Economy Now At Full Capacity Euro Area Economy Now At Full Capacity Despite strong growth, headline (1.1%) and core (1.0%) inflation remain well below the ECB's target of "just below" 2%. This lack of upward momentum flies in the face of the inflation subcomponent of our ECB Monitor, which has been steadily moving higher for the past three years (Chart 5C). Chart 5CRising Pressure On ECB To Tighten Monetary Conditions Rising Pressure On ECB To Tighten Monetary Conditions Rising Pressure On ECB To Tighten Monetary Conditions The ECB remains on track to deliver some of the monetary tightening that our ECB Monitor is calling for later this year, but it will not be through interest rate hikes (Chart 5D). ECB officials have made it clear that a tapering of asset purchases will take place when the current program ends this September. However, it will take more evidence that inflation will sustainably return to the ECB's target before rate hikes will commence. Chart 5DECB Will Deal With Tightening Pressures First By Tapering Asset Purchases ECB Will Deal With Tightening Pressures First By Tapering Asset Purchases ECB Will Deal With Tightening Pressures First By Tapering Asset Purchases The recent softening of cyclical euro area economic data like manufacturing PMIs, combined with underwhelming inflation prints, justifies the ECB's cautiousness on rates. Although leading economic indicators are still pointing to another year of above-trend growth in 2018. The likelihood of a taper later this year leads us to recommend a moderate underweight stance on core European government bonds, but with a neutral stance on Peripheral European debt which benefits from an expanding economy. BoJ Monitor: Still Far Too Soon To Expect Any Policy Changes The Bank of Japan (BoJ) Monitor has inched into the "tighter money required" zone for the first time since 2007 (Chart 6A), thanks largely to a robust economy. Yet while growth has been enjoying strong momentum, inflation remains stuck below the BoJ's 2% target - even with record low unemployment and a positive output gap (Chart 6B). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BJapanese Inflation Still Too Low Japanese Inflation Still Too Low Japanese Inflation Still Too Low Japanese businesses remain reluctant to boost wages despite robust profitability and a tight labor market. This makes it difficult for the BoJ to hit the 2% inflation target even using extreme policy tools like negative interest rates and asset purchases. Yet even these policies are approaching limits. Liquidity in the Japanese government bond (JGB) market is severely impaired with the BoJ now owning nearly one-half of all outstanding JGBs. This is the main reason why the BoJ shifted from targeting a 0% yield on the 10-year JGB back in September 2016, aiming to target the price of bonds purchased instead of the quantity. With both the inflation and growth components of our BoJ Monitor are now above the zero line (Chart 6C), a case could be made for the BoJ to consider raising its yield target on the 10-year JGB. In our view, any shift in the BoJ yield curve target will only happen if the yen is much weaker (the 115-120 range), core inflation and wage growth both hit at least 1.5%, and global bond yields hit new cyclical highs (i.e. the 10-year U.S. Treasury yield approaching 3.5%). Chart 6CGrowth & Inflation Pressures Have Picked Up In Japan Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation We continue to recommend an overweight stance on Japan, as the BoJ remains a long way from signaling to the markets that interest rate expectations must begin to rise (Chart 6D). Chart 6DThe BoJ Will Not Signal Any Change In Policy In 2018 The BoJ Will Not Signal Any Change In Policy In 2018 The BoJ Will Not Signal Any Change In Policy In 2018 BoC Monitor: Still Following The Fed The Bank of Canada (BoC) Monitor has stayed above the zero line since the beginning of 2017 (Chart 7A). The BoC has hiked rates three times since last summer, with Canada's robust growth justifying the tightening of monetary policy. Real GDP expanded by 3% in 2017, enough to push Canada's output gap into positive territory and drive the unemployment rate (5.8%) to below NAIRU (6.5%). As a result, both headline and core inflation are now back to the midpoint of the BoC's 1-3% target range (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BNo Spare Capacity In The Canadian Economy No Spare Capacity In The Canadian Economy No Spare Capacity In The Canadian Economy Growth has cooled a bit recently, though, most notably in consumer spending and housing data. In addition, the inflation component of the BoC Monitor has slowed and is diverging from the rising growth component (Chart 7C). These developments may be a sign that previous BoC hikes are starting to have an impact, although overall GDP growth remains well above trend and leading economic indicators are not slowing. Chart 7CA Divergence In The Growth & Inflation Components Of The BoC Monitor A Divergence In The Growth & Inflation Components Of The BoC Monitor A Divergence In The Growth & Inflation Components Of The BoC Monitor Looking ahead, the Trump administration's rising protectionist rhetoric is a potential threat to both Canada's economy and the value of the Canadian dollar. However, Canada was exempted from the recent tariffs imposed on U.S. steel and aluminum imports, suggesting that Trump may only seek a renegotiation, rather than a tearing up, of NAFTA. We continue to recommend an underweight stance on Canadian government bonds. Only 51bps of rate hikes are discounted over the rest of 2018 (Chart 7D), a pace that can be surpassed if the BoC follows its typical behavior of following the policy lead of the U.S. Fed, which is still expected to deliver 2-3 more rate hikes this year. Chart 7DThe BoC Will Continue Its Hiking Cycle This Year The BoC Will Continue Its Hiking Cycle This Year The BoC Will Continue Its Hiking Cycle This Year RBA Monitor: Lagging Behind While our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory, it has pulled back considerably over the past four months and is now near the zero line (Chart 8A). This move suggests that there is no imminent need to adjust monetary policy, given tepid inflation pressures. Despite the recent surge in employment growth, labor markets still have plenty of slack. Part time employment as a percentage of total employment and the underemployment rate are both near all-time highs. Wage growth is weak and a substantial recovery is unlikely given that real GDP growth slowed in Q4 and the output gap is still wide (Chart 8B). Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BAustralian Inflation Remains Subdued Australian Inflation Remains Subdued Australian Inflation Remains Subdued Looking ahead, consumption is at risk. Real wage growth has been nonexistent, so households have supported their spending by reducing savings. However, the rate of increase for house prices has slowed and prices in Sydney actually declined in Q4. If overall house prices were to decline going forward, then the lack of a wealth effect boost would force already massively-indebted consumers to reverse the savings downtrend and cut spending. Both headline and underlying inflation remain below the RBA's target range of 2-3%, with policymakers expecting underlying inflation to reach 2% only in June of 2019 with just a gradual improvement in labor markets. The inflation component of our RBA Monitor has already declined significantly on the back of collapsing iron ore prices, softening survey-based inflation measures and cooling house prices (Chart 8C). Chart 8CThe Inflation Component Of The RBA Monitor Has Plunged The Inflation Component Of The RBA Monitor Has Plunged The Inflation Component Of The RBA Monitor Has Plunged As such, we maintain our overweight position on Australian government debt, as the RBA will not even deliver the one 25bp rate hike in 2018 currently discounted by markets (Chart 8D). Chart 8DThe RBA Will Not Deliver The Discounted Rate Hikes In 2018 The RBA Will Not Deliver The Discounted Rate Hikes In 2018 The RBA Will Not Deliver The Discounted Rate Hikes In 2018 RBNZ Monitor: No Inflation, No Rate Hikes Our Reserve Bank of New Zealand (RBNZ) Monitor, which was the most elevated of all our Central Bank Monitors in last September's update, has plunged sharply since then (Chart 9A). Inflation remains stubbornly below the midpoint of the RBNZ's 1-3% target range, even with a tight labor market and no spare capacity in the New Zealand economy (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ At Full Employment, But Inflation Peaking NZ At Full Employment, But Inflation Peaking NZ At Full Employment, But Inflation Peaking Both the growth and inflation sub-components have fallen sharply, with the inflation measure now down below the zero line (Chart 9C). A firmer New Zealand dollar, the flipside of the weaker U.S. dollar, has played a large role in dampening traded goods price inflation. Chart 9CStrong NZ Inflation Pressures, But Growth May Be Peaking Strong NZ Inflation Pressures, But Growth May Be Peaking Strong NZ Inflation Pressures, But Growth May Be Peaking The February RBNZ Monetary Policy Report expressed an optimistic view on growth supported by elevated terms of trade, population growth, fiscal stimulus and low interest rates. Headline CPI inflation, however, is not projected to rise back to 2% level until 2020. Unsurprisingly, the RBNZ is signaling no change in policy rates until then, even with the central bank projecting the New Zealand dollar to weaken in the next couple of years. We have been recommending long positions in New Zealand government debt versus other developed market debt since last May. New Zealand bonds have outperformed strongly over that period, as markets have priced in no change in rates from RBNZ (Chart 9D) unlike other countries where rate hikes were repriced and, in some cases, delivered. With the RBNZ on hold for at least this year and likely much of 2019, we our staying long New Zealand government bonds. Chart 9DRBNZ Will Stay On Hold In 2018 RBNZ Will Stay On Hold In 2018 RBNZ Will Stay On Hold In 2018 Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Policymakers Are In A Tough Spot BCA Central Bank Monitor Chartbook: Policymakers Are In A Tough Spot Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Data based on Bloomberg/Barclays global treasury/aggregate indexes from December 1990 to January 2018 supports the argument that foreign government bonds are not worthy of investing in when unhedged, due to extremely high volatility. On a hedged basis, however, foreign bonds are a good source of risk reduction for bond portfolios. Hedging not only reduces volatility of a foreign government bond portfolio, it reduces it so much that on a risk adjusted-return basis, foreign government bonds outperform both domestic government bonds and domestic credit for investors in Australia, New Zealand, the U.K., the U.S. and Canada. Aussie and kiwi fixed income investors stand out as the biggest beneficiaries of investing overseas, because hedged foreign government bonds not only provide lower volatility compared to domestic bonds, but also higher returns. This empirical evidence does not support the strong home bias of Aussie and kiwi investors. Investors in the euro area also benefit from the risk reduction of hedged foreign exposure. However, they also suffer significant return reduction - such that the improvement in risk-adjusted returns is not significant. Investors in Japan do enjoy higher returns from foreign government bonds, hedged and unhedged, yet at the cost of much higher volatility, with risk-adjusted returns also not justifying investing overseas. This empirical finding does not lend support to the "search for yield" strategy that has been very popular among Japanese investors. Feature Practitioners and academics do not often agree with one another on investment management issues, but when it comes to whether to hedge foreign government bonds, both accept that foreign government bonds should be fully hedged because currency volatility overwhelms bond volatility. Yet hedged total returns from foreign government bonds are very similar to those from domestic bonds for investors in the U.S., U.K. and Canada, while worse in the euro area. Only in Japan, Australia and New Zealand do investors enjoy higher hedged returns from investing in foreign bonds, as shown in Chart 1 based on Bloomberg/Barclays Global Treasury Indexes hedged to their respective home currencies. So why do investors in the U.S., U.K. and euro area, whose own government bond markets currently account for about 60% of the global treasury index universe (Chart 2), even bother to invest in foreign government bonds? Even for those who may achieve higher returns overseas, would they not be better off just buying domestic corporate bonds (for the potentially higher returns from taking domestic credit risk) rather than venturing into foreign countries and taking the trouble to hedge currency risk? Indeed, home bias among bond investors globally is a lot higher than among equity investors. Chart 1Domestic Vs. Foreign Bonds Domestic Vs. Foreign Bonds Domestic Vs. Foreign Bonds Chart 2Country Weights In Global Treasury Index Country Weights In Global Treasury Index Country Weights In Global Treasury Index In this report, we present empirical evidence based on Bloomberg/Barclays domestic treasury indexes and aggregate bond indexes, hedged and unhedged global treasury indexes in seven different currencies (USD, EUR, JPY, GBP, CAD, AUD and NZD), in the context of strategic asset allocation. In a future report, we will attempt to identify the driving forces underpinning the decisions between investing in domestic bonds versus foreign bonds in the context of tactical asset allocation. Hedged Foreign Government Bonds Are a Good Source Of Diversification When a foreign bond is hedged back to the domestic currency, its total return correlation with domestic bonds is quite high. As shown in Chart 3, domestic bonds and their respective hedged foreign bonds have an average correlation of around 70% for all currencies, with the exception of the JPY. For Japanese investors, hedged foreign bonds have a much lower correlation with JGBs, averaging around 30%. Intuitively, there should not be a high incentive for USD, GBP, CAD, EUR, AUD and NZD based investors to invest in foreign bonds, while JPY based investors should benefit from the diversification of hedged foreign bonds. In reality, the very high home bias among fixed income investors in general and the popularity of search-for-yield carry trades among Japanese individual investors seems to support this. Is there empirical evidence that shows the same thing? Table 1 presents statistics from Bloomberg/Barclays domestic treasury indexes and their respective market cap-weighted foreign treasury indexes, hedged and unhedged, in USD, JPY, GBP, EUR, CAD, AUD and NZD. Please see Appendix 1 for the hedged return calculation. Chart 3High Correlations High Correlations High Correlations Table 1Domestic And Foreign Government Bond Profile (Dec 1999 - Jan 2018) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? On an unhedged basis, foreign bonds have much higher volatility compared to domestic bonds for all investors. In terms of return, only Japanese investors enjoy higher yields overseas. On a risk-adjusted return basis, all investors are worse off in investing in unhedged foreign bonds. This is in line with the "conventional wisdom" acknowledged by both academics and practitioners. Hedging not only reduces the corresponding foreign bond portfolio's volatility, it reduces it so much, for all currencies other than the JPY, that the foreign bond portfolio has lower volatility than domestic bonds. As such, in terms of risk-adjusted return, hedged foreign bonds outperform domestic government bonds in all countries except Japan. This implies that on a risk-adjusted return basis, Japanese investors should not invest in hedged foreign bonds at all, while other investors should. Even more shockingly, Table 1 shows that AUD and NZD investors would have achieved both higher returns and lower volatility by investing in hedged foreign bonds. These implications appear to fly in the face of common sense for AUD and NZD investors, because their domestic bonds have much higher returns than others, while in reality Japanese retail investors are keen on "carry trades" as a way to enhance yields. What has caused such significant discrepancies? Could it be simply due to the time period chosen? Chart 4 and Chart 5 present the results of the same analysis performed over different periods: the whole period from 1990, when the majority of the Bloomberg/Barclays indexes first became available; pre-euro (1990-2000); after the euro and before the global financial crisis (GFC); and after the GFC (the extremely low-yield period). Surprisingly, the relative performance of hedged foreign bonds versus domestic bonds for each currency has been quite consistent across all the time periods in terms of risk-adjusted returns, even though absolute performance varied in different periods. Chart 4Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time (1) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Chart 5Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time (2) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? So when it comes to investing in hedged foreign government bonds, investors with different home currencies should bear the following observations in mind: For Japanese investors, the slightly higher yield enhancement from hedged foreign bonds comes with sharply higher volatility compared to JGBs. The risk-adjusted return does not justify investing in foreign bonds.1 This is mostly because Japanese bonds have below-average volatility, while hedged foreign bonds have above-average volatility. For euro area investors, the lower volatility from foreign bonds is at the expense of lower returns. The improvement in risk-adjusted returns is not significant enough to justify the extra work in hedging. U.K. gilts have the highest volatility. As such, U.K. investors have benefited the most in risk reduction from buying hedged foreign bonds, to the slight detriment of returns. Consequently, they are better off investing in hedged foreign government bonds if improving risk-adjusted return is the objective. The Aussie and kiwi government bond markets are very small in terms of market cap (Chart 2). Fortunately, hedged foreign bonds not only have lower volatility than domestic bonds, they also provide much higher returns. Indeed, Aussie and kiwi investors are the most suitable candidates for going global. For U.S. and Canadian investors, hedged foreign portfolios and domestic indexes share similar returns, but foreign portfolios have much lower volatility, hence better risk-adjusted returns. Hedging currencies is not an easy task. Would investors not be better off taking domestic credit risks than investing in hedged foreign government bonds? Domestic Credit Or Hedged Foreign Government Bonds? The Bloomberg/Barclays domestic aggregate bond indexes are comprised of treasuries, government-related, corporate, and securitized bonds. Chart 6 shows the total returns of the aggregate bond indexes and the corresponding treasury weights in each country index. It is clear that Japan's credit portion is very small, while the U.S. and Canadian credit markets dominate their corresponding treasury markets. In the euro area and Australia, credit accounts for about half of the aggregate index, while it is only about 30% in the U.K. Since some aggregate indexes have a short history (Chart 6), we use the corresponding treasury index to fill in the missing links. In the case of New Zealand, an aggregate index does not exist at all, local treasury bonds are used instead in our analysis below. Table 2 presents the risk/return profiles of the Bloomberg/Barclays domestic aggregate bond indexes, and the same market cap-weighted global treasury index hedged and unhedged in USD JPY, GBP, EUR, CAD, AUD and NZD. Chart 6Aggregate Bond Index Composition Aggregate Bond Index Composition Aggregate Bond Index Composition Table 2Domestic Aggregate Bond Index Vs. Hedged Global Treasury Index (Dec 1999 - Jan 2018) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Domestic credits also improve the risk-adjusted returns for all the investors, and for investors in the U.S., Canada and Australia, credits also add returns while reducing volatility compared to their respective treasury indexes. However, the hedged global treasury index has much lower volatility than the domestic aggregate index such that on a risk-adjusted-return basis, the hedged global treasury index still outperforms the local aggregate index for all investors except those in Japan and the euro area. Similar to the findings in the previous section, this observation also holds true across all the time periods as shown in Charts 7 and 8. Aussie and kiwi investors stand out again as the best beneficiaries of going global because the hedged global treasury indexes not only have lower volatility than the domestic aggregate bond indexes, they also provide higher returns. Chart 7Domestic Aggregate Vs. Global Treasury: Consistent Performance Across Time (3) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Chart 8Domestic Aggregate Vs. Global Treasury: Consistent Performance Across Time (4) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? This raises an interesting question for asset allocators: which bond index should one use to measure the performances of global bond managers? It is common for some pension funds and mutual funds to use a domestic aggregate bond index as a benchmark to measure their bond managers' performance. In such a case, what are you really paying for if your managers have the discretion to buy hedged foreign government bonds? Another interesting observation is that the hedged global treasury index has almost the same volatility around 2.85% in different currencies. This essentially levels out the playing-field for bond managers globally in terms of volatility, a very important criteria for bond investors. Is High Home Bias Justifiable? There are many well-known reasons that explain why home bias in bond portfolios is typically high. But are investors giving up too much for the comfort of "staying home"? Chart 9 shows the effects of adding hedged foreign government bonds into a portfolio of domestic aggregate bonds for each investor based on two timeframes - from 1990 and from 1999 to the present. The messages are clear: If investors are comfortable with the volatility in their domestic aggregate bond index, which is already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with currency hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. Chart 9Is High Home Bias Justifiable? Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K., the euro area and Canada are better off investing a large portion overseas. In short, while there may be some justification for most fixed-income investors to maintain a home bias, empirical evidence does not lend strong support to Aussie and kiwi investors having a home bias at all. Chart 9 shows that Australian and New Zealand investors should consider investing 70-90% of their fixed income portfolio in hedged foreign government bonds for higher returns and lower volatility. Implications For Asset Allocators Chart 10What Drives The Dynamics Between ##br## Foreign And Domestic Bonds? What Drives The Dynamics Between Foreign And Domestic Bonds? What Drives The Dynamics Between Foreign And Domestic Bonds? The analysis presented in this report is by nature based on historical data. The findings may not apply to the future, especially because the periods for which we have data cover only the great bull market in government bonds. However, this exercise does provide some interesting aspects for consideration: Should hedged foreign government bonds have a presence in strategic asset allocation? If your fixed income managers have the discretion to invest in foreign government bonds, then is it appropriate for you to use a domestic aggregate bond index to measure their performance? In the context of strategic asset allocation, the answer to the first question is yes and to the second is no, as implied by the analysis in this report. In the context of tactical asset allocation, however, the answer may well be different. In a later report, we will attempt to identify the factors that drive the dynamics between domestic and hedged foreign bonds because the most obvious factor, interest rate differentials, cannot fully explain it as shown in Chart 10. Stay tuned. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com 1 Granted, Japanese retail investors do not pay attention to risk adjusted returns as much as institutional investors do. Therefore their buying unhedged foreign bonds is consistent with their yield enhancement objective, albeit at much higher volatility. Appendix 1: Bond Hedged Return Calculation We use the same methodology as Bloomberg/Barclays1 to calculate hedged return using one-month forward contracts and re-balancing on a monthly basis. This is unlike equity hedging, where the gain or loss of the underlying index during the month is not hedged.2 A bond index can be reasonably assumed to grow at the nominal yield (yield to worst is used). Only the gain/loss that is different from the stated yield during the month is not hedged, but converted back to the home currency at the month-end spot rate. Hedged return using forward contract: 1+Rd,t+1= (Pt+1 * St+1 ) / (Pt * St ) + Ht*(Ft - St+1)/ St..............................................(1) Where: Pt and Pt+1 are the foreign bond total return index levels at time t and t+1 in corresponding foreign currencies; St and St+1 are the foreign currency exchange rates versus the domestic currency at time t and t+1, quoted as one unit of foreign currency equal to how many units of domestic currency; Ht = (1 + Yt/2)(1/6) is the hedged notional; Yt is the yield to worst; Ft is the foreign currency's one-month forward rate at time t for delivery at time t+1; Rd,t+1 is the hedged total return in domestic currency of the foreign hedge index between time t and t+1. 1 https://www.bbhub.io/indices/sites/2/2017/03/Index-Methodology-2017-03-17-FINAL-FINAL.pdf 2 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com

Dear Client, Wednesday, we sent you a Special Report by our Global Investment Strategist, Peter Berezin titled: The Return of Vol, which fleshed out BCA's view on the recent volatility spike and the associated market selloff. BCA believes that markets are realizing that U.S. inflation is not forever dead. As such, market volatility is set to rise, even if global equities can make new highs. From an FX perspective, a rise in U.S. inflation, especially when accompanied by the kind of spending programs announced this week in Washington DC, could result in a period of strength for the U.S. dollar. Additionally, since financial markets tend to experience clusters of volatility, the recent bout of volatility can stay in place for a while. High volatility tends to be negative for carry trades, hence EM currencies could suffer this quarter. The Australian dollar and the euro could also decline under this scenario. However, the yen and CHF may experience upside, but mostly against other currencies than the greenback. In this present report, we are updating our views on the G10 central banks. Best regards, Mathieu Savary Feature In our Special Report published last summer titled "Who Hikes Next?" we examined which of the G10 central banks would be next to join the Federal Reserve on its tightening path.1 Seven months later, we now know that the Bank of Canada and, to a lesser extent, the Bank of England, were respective second and third to begin raising their own policy rates. It is now time to revisit the topic and see which central banks are most likely to adjust their policy further. As Chart 1 shows, global goods prices have picked up steam, which has been translated in an ebbing of global deflationary forces. A few factors lie behind this improvement. First, China is not exporting deflation around the world anymore because the trade-weighted yuan has been stable and producer price inflation, which currently stands at 5%, has been in positive territory for 15 straight months. Second, thanks to ebullient global growth, global capacity utilization has grown significantly. Third, oil prices have climbed further. This development has been particularly meaningful as it has contributed to a significant pick-up in market-based inflation expectations. But as in every economic cycle, some risks are worth monitoring. As we have highlighted before, global money growth has slowed, Chinese monetary conditions have tightened meaningfully and Asian manufacturing activity has decelerated in a wide swath of countries. Even BCA's Global Capex Indicator (Chart 1, bottom panel), which flashed an unabashed green light last June, has begun to roll over. The recent market shakeup has also reminded investors that higher bond yields do have an impact on asset prices and economic growth. Despite these worries, we expect more central banks to join the fray this year and begin removing accommodation one way or another. Others will shy away, but they will guide markets toward expecting less monetary accommodation next year. Finally, some central banks will likely stand pat, and will leave their policy settings unchanged. Chart 2 illustrates where we think G10 central banks stand in their respective hiking cycles. Chart 1The Reasons Why Central Banks Are Tightening The Reasons Why Central Banks Are Tightening The Reasons Why Central Banks Are Tightening Chart 2G10 Central Banks Map Who Hikes Again? Who Hikes Again? The Hikers 1) The U.S. Chart 3U.S. U.S. U.S. The Federal Reserve will continue to tighten policy this year. To begin with, its communications on the topic have been extremely clear: the Federal Open Market Committee wants to increase interest rates three times in 2018. The Fed has good reasons for this hawkish stance. The gap between the real policy rate and the recent average of real GDP growth remains in stimulative territory (Chart 3). Meanwhile, U.S. financial conditions have rarely been easier, yet the economy is receiving a boost thanks to tax cuts and spending increases. There is, therefore, little mystery as to why survey data point to healthy GDP growth for the first half of 2018. In fact, the Atlanta Fed GDPnow model currently forecasts a growth rate of 4.0% for the first quarter of this year. This is an inflationary combination. It is not just growth conditions that are creating tailwinds for the Fed. Resource utilization is also elevated. According to the CBO, the U.S. output gap closed last year, and the unemployment rate not only stands at its lowest level in 17 years, but it is also well below equilibrium. We are already seeing the symptoms of this state of affairs: the employment cost index is growing at 2.6%/annum, its highest rate in three years; the growth of average hourly earnings just hit 2.9%/annum, and even core inflation is bottoming. These developments will give comfort to the Fed that hiking rates three times this year is the right strategy. The Hikers 2) Canada Chart 4Canada Canada Canada The Bank of Canada has already increased rates three times since we first explored this topic last summer. Like the Fed, the BoC has strong justification behind its hawkish stance. While the policy rate is not as stimulative as it was last year, capacity utilization has become much tighter (Chart 4). The unemployment rate is now back in line with its underlying equilibrium, and the BoC's Business Outlook Survey shows that the quantity and intensity of labor shortages have become elevated, which has historically led to higher wages. Additionally, the OECD's approximation of the output gap has closed, something also acknowledged by the BoC's models. Core inflation has begun to respond, rising to 1.5% in December. The current backdrop suggests this trend has further to go. Moreover, as exports to the U.S. represent 20% of Canada's GDP, the economic vigor south of the border will only translate into further inflationary pressures up north. Based on these factors, we expect the BoC to increase rates as much as the Fed in 2018. This view is not without risks. NAFTA negotiations remain rocky, and the uncertainty emanating from trade policy could hurt Canadian capex. Additionally, Canadian house prices remain 31% above fair value, Canadians sport a debt load of 170% of disposable income, and a growing array of macro-prudential measures are being implemented to slow the housing market. If this combination bites deeply - which remains to be seen - the BoC may be forced to, at least, pause its tightening policy faster than anticipated. Still Hiking? 3) The U.K. Chart 5U.K. U.K. U.K. On many metrics, the Bank of England looks set to hike again in 2018. There is no denying that British monetary policy remains extremely easy, as the gap between the real policy rate and real GDP growth is still in massively stimulative territory (Chart 5). Moreover, according to the OECD, the output gap stands at 0.4% of potential GDP. This observation seems to be corroborated by the fact that the unemployment rate remains nearly 1% below its equilibrium value. Adding credence to these assertions, U.K. core inflation spiked as high as 2.9% one month ago. However, make no mistake: the spike in inflation, while facilitated by tight supply conditions, is still mostly a consequence of the pass-through created by the pound's collapse in 2016. Because the rate of change of the pound has stabilized, the U.K.'s inflation rate will fall back to earth. Moreover, the outlook for British consumption is murky as the household savings rate has plunged to a mere 5.2% of disposable income, and debt growth is peaking. Corporations too have curtailed their borrowings, pointing to a weak capex outlook. While the MPC would like to hike once or twice this year, since a policy tightening is contingent on elevated inflation, the central bank may once again disappoint. For now, rate hikes look likely, but this may change if inflation decelerates sharply. In The Starting Blocs For 2018 4) Sweden Chart 6Sweden Sweden Sweden The December policy statement by the Riksbank highlighted that while the world's oldest central bank will reinvest the proceeds from redemptions and coupon payments from its large bond portfolio, it still expects to begin lifting its benchmark rate in the middle of 2018. This is not a minute too soon. Swedish monetary conditions are incredibly easy: Real interest rates are 6% below the average real GDP growth of the past three years (Chart 6). Moreover, Sweden is facing growing capacity constraints. The unemployment rate is nearly 1% below equilibrium, and according to the OECD, the output gap stands at 1.5% of GDP, the most positive number among the G10. The Riksbank's own capacity utilization measure - an excellent leading indicator of inflation - is at a 10-year high, pointing to further acceleration in a core inflation that is already very close to 2%. Additionally, Sweden is in the thralls of a massive real estate bubble, a byproduct of extremely loose monetary policy. The external environment will remain the main source of risk to this hawkish outlook. On the plus side, the European Central Bank has begun tapering its QE program and should end new purchases in September 2018. This limits how high the SEK can spike against the euro - the currency of Sweden's main trading partner - if the Riksbank tightens policy. However, Asian industrial production has slowed sharply, and Swedish PMIs are already buckling. Any deepening of the recent selloff in risk assets, especially if it spreads further into commodities, could cause Riksbank Governor Stefan Ingves to retreat to his dovish safe place. In The Starting Blocs For 2019... Or 2018 5) New Zealand Chart 7New Zealand New Zealand New Zealand The Reserve Banks of New Zealand is slated to hike rates by mid-2019. However, risks are growing that the RBNZ could be forced into an earlier first hike. Policy is currently massively accommodating as the real official cash rate stands nearly 4% below the average real GDP growth of the past three years (Chart 7). At 1.4%, core inflation remains below the RBNZ's target, but it is on a rising trend, especially as the Kiwi economy is beyond full employment and the OECD's measure for New Zealand's output gap is at 0.8% of potential GDP. Moreover, GDP growth remains robust, and terms of trade have been improving as dairy prices are still firm, thus a further overheating in this economy is likely. The political front could also give impetus for the RBNZ to hike earlier than it recently suggested. The Ardern government has proposed increasing the minimum wage to NZ$20/hour by 2021, starting in April 2018. This could fuel already improving wages, and thus fan inflation. This government also plans to increase fiscal spending, which tends to exacerbate inflationary pressures when an economy is at full capacity. Thus, inflationary risks in New Zealand are skewed to the upside. In The Starting Blocs For 2019... Or 2018 6) Norway Chart 8Norway Norway Norway The Norges Bank anticipates it will begin to increase rates toward the middle of 2018. The Norwegian central bank is facing an interesting cross current. On the one hand, when compared with other nations on the list, the Norwegian economy seems less ripe to withstand higher rates. To begin with, because Norwegian core inflation has fallen precipitously in recent years, the gap between real interest rates and the average real GDP growth of the past three years has narrowed considerably (Chart 8). Moreover, the unemployment rate remains 0.9% above equilibrium, while a more broad-based measure of slack, the output gap, stands at -1.6% of potential GDP, at least according to the OECD. Moreover, core inflation only hovers near a 1.2% annual pace and is expected to stay below 2.5% in the coming years. Despite these negatives for Norway, some important positives also exist, which explains the Norges Bank's optimism. The Norwegian economy did not go through much of a financial crisis this cycle; as a result, Norwegian banks are healthy, and the Norwegian money multiplier never imploded as it did in other G10 countries. Also, the Norwegian krone is very cheap, adding a further reflationary impulse beyond low rates. Moreover, Norwegian GDP growth has experienced a rebound on the back of rallying oil prices. However, oil prices are nearing the top end of our energy strategists' forecasts, suggesting this tailwind is receding. Altogether, this confluence of factors suggests that similar to the RBNZ, the Norges Bank is likely to hike rates in early 2019 or late 2018. 2019 Take Off 7) Australia Chart 9Australia Australia Australia The Reserve Bank of Australia may well begin increasing interest rates in early 2019. Many factors would argue that the RBA could in fact increase interest rates earlier. Even though it is less accommodative than Sweden's or New Zealand's, Australian monetary policy is quite easy as the gap between the real policy rate and the average real GDP growth rate of the past three years is well into negative territory (Chart 9). Additionally, core inflation has rebounded hitting 1.9% recently, while trimmed-mean CPI stands at 1.8%. Among additional positives, Australia's national income is growing at a robust 4.3% annual pace and job creation is brisk, with payrolls expanding at an impressive 3.6% rate on a yearly basis. These positives mask some stiff headwinds. Rapid national income growth will likely peter out. It was the result of the very large rebound in the RBA's commodity price index, however, this benchmark, which was growing at a 53% annual rate in February 2017, is now contracting at a 1% annual rate. Additionally, the OECD's measure for the Australian output gap stands at -1.5%. While it is true that the unemployment rate is below its equilibrium rate, the RBA's labor underutilization measure remains near 25-year highs. This explains why robust job creation is not being translated into wage gains, and suggests that the RBA is right to expect trimmed-mean inflation to durably be at 2-2.25% only by the end of 2019. Moreover, the recent strength in the AUD will also weigh on inflation going forward. Netting out pros and cons suggests that the most likely first hike by the RBA will be in early 2019. 2019 Take Off 8) Euro Area Chart 10Euro Area Euro Area Euro Area The European Central Bank has begun tapering its QE program, and if the global economy does not experience any meaningful relapse, the ECB will end new purchases this September. However, a rate hike is not in the offing this year. To begin with, the ECB's communications on the topic have been rather clear: At its latest press conference, President Mario Draghi once again rejected any possibility of a move this year, and even Jens Weidmann, the Bundesbank's head, acknowledged that the current market pricing - a hike in the summer of 2019 - is about right. While it is true that the ECB's monetary policy setting is still very accommodative, the unemployment rate remains 0.8% above equilibrium, and outside of Germany, labor underutilization is still high. Moreover, the OECD's estimate of the euro area's output gap still stands at -0.5% of potential GDP (Chart 10). Another hurdle is core CPI which remains well below the ECB's objective; in fact, after hitting 1.2% in May, inflation excluding food and energy has now relapsed to 0.9%. Peripheral nations are experiencing even weaker inflation readings. With the ECB's inflation forecast still well below target until 2020, a rate hike will have to wait until next year. The Laggards 9) Switzerland Chart 11Switzerland Switzerland Switzerland The Swiss National Bank remains firmly among the lagging central banks within the G10. Because inflation is still at only 0.7%, the gap between real interest rates and average real GDP growth of the past three years is among the least stimulative in the G10 (Chart 11). Corroborating this observation, loan growth has averaged a paltry 4% over the course of the past three years. Moreover, the Swiss economy is still replete with excess capacity. The unemployment rate may be a low 3%, but it still stands 1.3% above equilibrium, and Swiss wage growth remains very depressed. Moreover, the OECD pegs the Swiss output gap at -1.2% of potential GDP. On a PPP basis, the Swiss franc remains 5% overvalued against the euro, Swiss core inflation was only 0.7% in December, but better than the -1% posted in early 2016. The SNB is likely to officially abandon its foreign asset purchases this year. The Swiss economy has recovered from its doldrums of the past several years, and most importantly, the euro crisis is now fully in the rearview mirror. This means that safe-haven flows out of the euro area, which were pushing the CHF to nosebleed valuation levels, have dried up. In fact, this year's weakness in the franc versus the euro was not accompanied by much increases in SNB sight deposits, suggesting this depreciation has been organic and not manufactured in Bern and Zurich. However, until core CPI moves closer to 2% and Swiss wages pick up, the SNB will likely lag the ECB when it comes to actual interest rate increases amid fears that the Swiss franc will rebound and tighten policy again. A late 2019 or early 2020 hike remains the most likely scenario. The Laggards 10) Japan Chart 12Japan Japan Japan The Bank of Japan is also faraway from increasing policy rates. This is not because the Japanese economy is replete with excess slack. It is not. The active job openings-to-applicants ratio stands at a whopping 44-year high, the unemployment rate is 0.8% below equilibrium and the OECD's estimate of the output gap is in positive territory (Chart 12). However, despite this very inflationary backdrop, inflation excluding food and energy remains a paltry 0.3%/annum. The BoJ has rightfully identified moribund inflation expectations as the key to unlocking this mystery. Decades of deflation have created a deflationary mindset among Japanese economic agents. As a result, wages and inflation itself are not experiencing much of a lift. The BoJ is tackling this issue head on, and has made it clear that it will not abandon its yield curve control strategy until inflation is well above its 2% target. In the BoJ's view, an inflationary overshoot is now necessary to shock deflationary mentalities, which will be the keystone to let inflation take off in durable fashion. For now, the tight negative relationship between Japanese financial conditions and inflation suggests the BoJ will do its utmost to contain the yen, which would undermine the progress made in recent quarters. As such, we do not foresee any rate hikes until well into 2019. QQE is likely to be abandoned first, as in practice the BoJ has not hit its JGB purchases target since the first half of 2016. Investment Implications The dollar could experience a further lift in the first half of 2018. Investors plunked the greenback last year and in the opening weeks of 2018 because they had been focusing on the far future - a future in which the ECB hikes rates faster than the Fed. But the reality remains that this year and next, the Fed will lift interest rates much more than the ECB. This means the euro is vulnerable to a pullback as it is very expensive relative to differentials at the front end of the curve. The outlook for EUR/USD will improve again once we get closer to 2019. The CAD has niether much upside nor downside. Interest rate markets are pricing in as many interest rate increases as we are. The key for the CAD will once again be oil prices, but keep in mind that Brent prices are not far off from our energy strategists' target of US$67/bbl. The SEK and the NOK will likely experience upside versus the euro. Their central banks are also set to pull the trigger before the ECB. Moreover, these two currencies are very cheap. However, the ride is unlikely to be a smooth one. The budding slowdown in Asian manufacturing could generate temporary hiccups before yearend that will cause these extremely pro-cyclical currencies to swoon. The picture for the pound remains as murky as ever. On one hand, the BoE has begun to increase rates. However, this progress could run astray very easily if, as we expect, British inflation weakens anew. Moreover, Brexit negotiations with the rest of the EU are far from fully settled. Further, the trade-weighted pound is moving toward the top end of its post-Brexit range, making it highly vulnerable to even a modest disappointment. The Australian dollar is likely to experience a poor 2018, as the RBA is a long way from increasing interest rates, and on all the long-term metrics we track, the AUD is one of the most expensive currencies. A continuation of the recent spat of asset market volatility could prove to be unkind to the Aussie. The kiwi will likely outperform its antipodean brethren as we see upside risk for interest rates in New Zealand. Finally, Swiss and Japanese interest rates will remain near current levels for a few more years. This suggests that the Swiss franc and the yen have little durable upside this year. The same holds true for the first half of 2019. However, since Switzerland and Japan still sport hefty current account surpluses and supersized positive net international investment positions, the CHF and JPY will continue to behave as safe-haven currencies, rallying when global asset prices weaken. This means that since markets tend to experience volatility clusters, the recent bout of market volatility could continue, which will help both the Swiss franc and the yen over the coming weeks. This will be especially true if the CHF and JPY are bought against the EUR, AUD, CAD, and NZD. But beware: the yen is especially cheap, so any signs that inflation expectations of Japanese agents pick up could be associated with a sharp rally in the yen, as it will spell imminent doom for the BoJ's YCC strategy. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades

Dear Client, We are sending you this last issue of the year, a lighter fare than usual, highlighting 10 charts we find important. The first two charts tackle two of the key economic questions of the day: U.S. inflation and Chinese construction. The next seven charts are displays of technical action that has captured our attention for key currency pairs. The last chart tackles the topic du jour, bitcoin. We will resume regular publishing on January 5th, 2018. Finally, the Foreign Exchange Strategy team would like to thank you for your continued readership, and wishes you and your families a joyful holiday season as well as a healthy, happy and prosperous 2018. Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) U.S. Inflation Chart I-1AU.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) Chart I-1BU.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. inflation has been moribund in 2017, dismaying believers of the Philips curve, the Federal Reserve included. A few factors have been at play. The Fed sigma models show that the negative impact of a dollar rally on U.S. inflation is at its strongest with a two-year lag. Additionally, the fall in capacity utilization that happened following the industrial recession in late 2015/early 2016 continued to affect inflation negatively this year. These headwinds are passing. As the left panel of Chart I-1 illustrates, the easing in U.S. financial conditions this past year is likely to continue and become most salient for inflation in 2018. Meanwhile, the right panel of the chart shows that as the deceleration in money velocity growth forecasted the weakness in core inflation in 2017, its recent re-acceleration points to a pick-up in inflation next year. The Fed might be able to achieve its interest rate forecast of 3.1% in 2020 after all. 2) Chinese Housing Chart I-2AFrosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Chart I-2BFrosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Chinese monetary conditions have been tightened in 2017, fiscal expansion has been curtailed, and the growth of the M3 broad money supply has fallen to 8.8%. So far, the Chinese economy is hanging in, still benefiting from the fact that real interest rates have collapsed since November 2015 as producer price inflation rebounded from a 6% contraction to a 6% expansion today. This increase in producer prices has also helped industrial profits, which are expanding at a 23% pace, helping put a floor under industrial production. However, the outlook for residential investment needs to be monitored. Construction contributed 17% of GDP growth during the past two years. Chinese construction also contributed to 20% and 32% of the global consumption of refined copper and steel, respectively. This means that Chinese construction was a key driver of metal prices. Yet our leading indicator for Chinese house prices points toward a marked deceleration in the coming quarters. As the right panel of Chart I-2 shows, this could get translated into additional downside for iron ore. 3) EUR/USD Chart I-3The Euro Is At A Key Threshold The Euro Is At A Key Threshold The Euro Is At A Key Threshold 1.20 continues to represent a big hurdle to cross for EUR/USD. For the euro to punch above this mark, U.S. inflation will have to remain moribund in 2018. The rally in EUR/USD tracked an improvement in market estimates of the European Central Bank's terminal policy rate relative to the Fed's. Yet this improvement did not reflect an upgrade of the ECB's terminal rate itself, but rather a major downgrade of the Fed's, as U.S. inflation disappointed. If U.S. inflation rebounds as BCA anticipates, the dollar should be able to rally toward 1.10, especially as euro area inflation is unlikely to follow suit, as euro area financial conditions have tightened massively relative to the U.S. If U.S. inflation does not rebound, a move toward 1.30 is possible. Glimpsing at Chart I-3, it should also be obvious that any strength in the dollar next year is likely to prove a long-term buying opportunity for the euro. The EUR/USD has only traded below current levels when the U.S. dollar has been in the thralls of a major bubble. Additionally, global portfolios are deeply underweight euro area assets, therefore, a long-term rebalancing of portfolios toward euro area assets will support the euro down the road. Finally, when the next recession hits, the ECB is likely to have less room to stimulate its economy than the Fed will have. This means that during the next recession, the euro could behave like the yen has over the past 20 years: because the ECB will be impotent to fight deflationary pressures, falling euro area inflation will result in rising euro area real interest rates, especially against the U.S. This helped the yen then, and it could help the euro in the future, especially as the euro area's net international investment position is set to move into positive territory over the next 24 months. 4) EUR/GBP Chart I-4Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now EUR/GBP is at an interesting juncture. EUR/GBP has rarely traded above current levels (Chart I-4). On one hand, Brexit would suggest that EUR/GBP could actually rise. The uncertainty around the U.K. leaving the EU has caused the U.K. economy to be among the rare ones to not accelerate in unison with global growth this year, despite the stimulative effect of a lower pound. This suggests that the hands of the Bank of England will remain tied, limiting its capacity to increase the cash rate. Moreover, U.K. politics continue to take an increasingly populist tone, and the growing popularity of Jeremy Corbyn suggests that the discontent is present on all sides of the political spectrum. Populist policies are rarely good for a currency. On the other hand, the GBP is trading at such a discount to its fair value against both the USD and the EUR that historically, buying the pound at current levels has generated gains for investors with investment horizons measured in years. Moreover, if the EUR weakens in the first half of 2018, historical antecedents argue that EUR/GBP would also weaken in this context. When taken altogether, these factors suggest that EUR/GBP is likely to remain stuck in its post-Brexit trading range for as long as political uncertainty remains, especially as it is unlikely that the U.K. will receive a sweetheart FTA deal from the EU. Thus, while we expect EUR/GBP to retest 0.84 over the course of the next three to six months, at these levels we would buy EUR/GBP with a target of 0.90. 5) EUR/SEK Chart I-5EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK flirted with 10 this month. As Chart I-5 illustrates, this only happened during the financial crisis. Sweden is a much more pro-cyclical economy than the euro area, hence EUR/SEK exhibits very strong counter-cyclical behavior. It only trades above 10 when global growth is in tatters, and below 9 when it is booming. The recent spate of strength in EUR/SEK is thus perplexing, since global growth has been very robust and broad-based this year. The very easy policy of the Riksbank has been the main culprit. Timing a reversal in EUR/SEK is tricky, as it remains a function of the rhetoric of the Riksbank. But today, Swedish inflation is on the rise, with the CPIF, the inflation gauge targeted by the Swedish central bank, being at target. Thus, the days of super easy monetary policy in Sweden are numbered, especially as the output gap is a positive 1%, unemployment stands nearly 1% below equilibrium, and resource utilization measures have spiked up. Today, it makes sense to buy the SEK versus the euro. However, EUR/SEK is unlikely to move below 9, as the best of the global business cycle is probably behind us. 6) USD/JPY Chart I-6A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way USD/JPY is at an interesting technical juncture. This pair has been forming a very large tapering wedge in recent years (Chart I-6). This type of formation can be resolved in either a bullish fashion or a bearish one. Our current inclination is to bet on a bullish resolution for USD/JPY, as global bond yields seem to finally be regaining some vigor, which historically has been poison for the yen. Supporting our bias is the fact that we see more interest rate increases in the U.S. than are currently priced in, as we foresee a pick-up in inflation in 2018. The one thing that keeps us awake at night when thinking about our bullish disposition for USD/JPY is that EM carry trades have begun to weaken. Historically, this has led to a softening in global activity which foments further EM-carry-trade reversals and weakness in USD/JPY. Investors should keep an eye on this space. 7) AUD/USD Chart I-7AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand The Australian dollar possesses the poorest outlook among the G10 currencies. The Australian economy continues to be plagued by large amounts of overcapacity, inflation is still absent, and Australia is the economy most exposed to a slowdown in Chinese construction activity as Australian terms-of-trade shocks follow metals prices. Additionally, China's push to fight pollution points to weakening coal prices, another key export of Australia. Moreover, Chart I-7 illustrates that the AUD rarely trades above 0.8. To do so, it needs an especially robust global economy, with China firing on all cylinders. We do not think China is about to crash, but it is not about to accelerate either, especially when it comes to demand for metals. Thus, with AUD/USD trading at 0.77, we see more downside for this pair than upside. In fact, when observed in a broader, longer-term context, the rally since 2016 in the AUD looks like a consolidation within a larger downtrend. 8) AUD/CAD Chart I-8AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD seems to have hit its natural ceiling this year. Only in the first half of the 1990s and when China was reflating its economy with all its might right after the financial crisis was AUD/CAD able to punch above 1.03 (Chart I-8). We do not see a repeat of this performance in the coming two years. First, as we mentioned, BCA does not anticipate any re-acceleration in Chinese investment or EM demand. Second, AUD/CAD is expensive, trading 9% above its fair value. Third, BCA remains more bullish on oil prices than metals prices. Fourth, a weakening AUD/USD tends to be associated with a weakening AUD/CAD. Finally, if these four factors cause AUD/CAD to weaken below 0.964, a key upward trend line that has supported AUD/CAD since late 2008 will be broken, which should prompt additional selling in this cross. 9) AUD/NZD Chart I-9AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD is likely to remain stuck in its trading range established since 2013 (Chart I-9). To begin with, the Australian dollar is trading at a 10% premium to the NZD. This has happened three times over the previous 17 years. Each of these instances were followed by vicious corrections in this cross. Additionally, while the AUD is very exposed to a slowing in Chinese construction and the associated problems for base metals prices, the NZD is not. In fact, the NZD may even benefit from the new economic objectives set by China's leadership. One of these new key objectives is to rebalance the economy toward the consumer. Moreover, Chinese consumer preferences have seen a switch toward higher quality foodstuffs.1 Higher quality foodstuffs, meat and dairy in particular, are exactly what New Zealand exports. Thus, a relative negative terms-of-trade shock is likely to come for AUD/NZD. The one big negative to our view is the political situation in New Zealand. The recent wave of populism points toward a fall in the potential growth rate, and thus a fall in the terminal policy rate of the Reserve Bank of New Zealand. The limit on foreign investment in Kiwi housing is another negative.2 Thus, we are not yet willing to bet on AUD/NZD falling below parity. 10) Bitcoins Chart I-10Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Valuing bitcoins is an arduous exercise. A lack of clearly defined fundamentals is the key difficulty. It is also why bitcoin prices can move so violently. We have already covered the technological elements behind Bitcoin and the blockchain,3 but to uncover what could be driving investors' imaginations, we have to move back to the realm of economics and finance. One theory tries to value bitcoin by linking it to a mode of payment. Using this method, Dhaval Joshi, who writes our BCA European Investment Strategy service, estimates a fair value for BTC/USD. Using the quantity of money theory, he shows that if the market assumes that bitcoins can support US$0.5 trillion of global GDP, and if the velocity of money historically averages 1.5 times, with 21 million potential bitcoins in issuance, a bitcoin should be worth US$17,000.4 Changing estimates for velocity or how much of global GDP will be transacted using bitcoins varies this estimate. Another approach has been to value bitcoins as an asset with a limited supply, like gold. Using this methodology, the global gold stock is worth approximately US$7 trillion, but cryptocurrencies, with their high volatility, are unlikely to steal the yellow metal's entire market share. Instead, they might be able to carve out 25% of gold's current total market capitalization. In this case, cryptos would be worth US$1.75 trillion. Bitcoin could represent half of this amount, which equates to a total market capitalization of US$875 billion. With a stock of 21 million bitcoins, the "fair value" would be around US$42,000. A third approach exists, and it is the simplest (Occam Razor's alert?). As Peter Berezin argues in BCA's Global Investment Strategy service, global governments extract seigniorage benefits from issuing currency.5 As an example, by printing cash, the U.S. government can buy services and good worth roughly US$90 billion per year, at a near zero cost. This is a very significant amount. Governments are unlikely to ever give up this source of funding. Since crypto currencies are a direct threat to this, they will likely be made illegal as a result. This would imply a fair value of BTC/USD of zero. The current fair value is likely to be a probability weighted average of all three scenarios. We assign a 10% probability for the first case (mode of payment), a 10% probability to the second case (store of value), and an 80% probability to the last case (zero value due to illegality). This would give a current fair value of roughly US$6,000. At the current juncture, bitcoin trading is exhibiting strong herd-like tendencies. When groupthink takes over a market, as is the case right now with crypto-currencies in general and bitcoin in particular, a trend reversal is likely to materialize. Today, bitcoin's "fractal dimension" has hit the 1.25 neighborhood, where such reversals have tended to happen (Chart I-10). As such, a correction is very likely. The average correction since 2016 has been around 35%. Following similarly parabolic moves as the one observed over the past month, pullbacks have been closer to 45%. A retracement toward BTC/USD of 11,000 is very probable over the coming quarters. That being said, it is too early to call the ultimate top for bitcoin. With the narrative among the bitcoin investing public increasingly switching to bitcoin being a store of value akin to gold, a move to the US$40,000 neighborhood is, in fact, not a tail event. However, this is a move to play at one's own peril, since fair value is likely to be well below these levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Atkinson, Simon. "Why are China instant noodle sales going off the boil?" BBC News, BBC, 20 Dec. 2017, www.bbc.com/news/business-42390058. He, Laura. "China's growing middle class lose appetite for instant noodles." South China Morning Post, 20 Aug. 2017, www.scmp.com/business/companies/article/2107540/chinas-growing-middle-class-lose-appetite-instant-noodles. 2 For a more detailed discussion of the political situation in New Zealand as well as its potential impact, please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How to Transform Gold into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Blockchain And Cryptocurrencies" dated May 12, 2017, available at fes.bcaresearch.com 4 Please see European Investment Strategy Weekly Report, titled "Bitcoins And Fractals" dated December 21, 2017, available at eis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, titled "Don't Fear A Flatter Yield Curve" dated December 22, 2017, available gis.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 U.S. data was mixed: Housing starts increased by 1.3 million units, beating expectations, building permits also outperformed; Both the Philadelphia Fed Manufacturing Survey and Chicago Fed National Activity Index outperformed expectations; However, annualized Q3 GDP growth came in at 3.2%, less than the expected 3.3%; Growth in headline and core personal consumption deflators also failed to meet expectations, coming in at 1.5% and 1.3% respectively. Easier financial conditions are expected to slowly push the core PCE deflator back to the Fed's 2% target. This will allow Jerome Powell to continue in Janet Yellen's footsteps. As credit continues to grow, the large U.S. consumer sector will become an increasingly important tailwind to growth. The fiscal thrust from the new tax plan will could also accentuate growth and inflationary pressures. Therefore, investment and consumption activity are both likely to pick up next year. This will should support the Fed as well as the USD. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 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 European data was mixed: German ZEW Current Situation increased to 89.3, outperforming expectations of 88.5; European ZEW Current Situation slightly underperformed expectations of 18, coming in at 17.4; Manufacturing and services PMIs for Germany and Europe as a whole both outperformed expectations; European trade balance decreased to EUR 19 bn from EUR 25 bn, and the current account also underperformed; European CPI was in line with expectations, contracting at a monthly pace, and growing at a 0.9% annual pace, under the expected 1% rate. On the Back of strong momentum in activity indicators, the ECB upgraded its growth and inflation forecasts for the upcoming years. However, since inflation is expected to remain under target for the whole forecast horizon, the ECB is likely to tighten policy at a much slower pace than the Fed. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 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: Annual Import growth came in at 17.2%, surprising to the downside. Moreover, the All Industry Activity Index monthly growth also underperformed expectations, coming in at 0.3%. However, export annual growth surprised to the upside, coming in at 16.2%, an acceleration relative to last month's reading. On Wednesday, the Bank of Japan left its policy rate unchanged at -0.1%. Furthermore, the yield curve control policy, in which 10-year yields are kept around 0%, has been maintained. We stay bullish on USD/JPY, as we expect U.S. bond yields to rise when inflation picks up next year. However the yen could appreciate against commodity currencies if a risk-off period is triggered by tightening in China. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 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: Gfk Consumer confidence underperformed expectations, coming in at -13. This measure also decline from the November reading. However, CBI industrial Trend Survey for orders, surprised to the upside, coming in at 17. Finally, public sector borrowing also surprised to the upside, coming in at 8.118 Billion pounds. The pound has been flat against the U.S. dollar this week. Overall we remain skeptical in the ability of the Bank of England to tighten much in the near future, given that real disposable income growth is very depressed, house price growth continues to be tepid, and uncertainty weighs on capex. Moreover, inflation will likely come down from present levels, as the pass through from the pound depreciation dissipates. All of these factors will limit any upside to cable in the next months. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 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 rallied solidly in recent weeks thanks to buoyant data out of Australia and China. Last week's labor numbers were especially important in this regard. The growth in full-time employment has outperformed that of part-time since summer, while the underemployment rate has declined by 0.3% since 2017Q2.. Moreover, RBA officials identified further positives in the housing market: excessive price appreciation has slowed down considerably and household's balance sheets are improving. For now, the biggest risk to the Australian dollar remains the Chinese economy. Xi Jinping's commitment to clamp down on pollution, debt and inequalities is a bearish prospect for the AUD. Additionally, Chinese house prices could decline substantially - something which would have negative repercussions for the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 current account surprised to the downside, coming in at -2.6% of GDP. However this number did improve from last quarter's -2.8% reading. However, both imports and exports outperformed expectations, coming in at 5.82 billion and 4.63 billion respectively. Moreover, GDP growth outperformed expectations, coming in at 2.7%. However, this number did decline from the 2.8% reading in Q2. NZD/USD was flat this week, even as the USD weakened. We continue to believe that carry currencies like the NZD, will be affected by tightening of financial conditions in China. However, the NZD has upside against the AUD, as the New Zealand dollar is cheaper than the AUD, and it is not as levered to the Chinese industrial cycle as the Australian dollar is. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 Canadian data was strong this week: Retail sales increased month-on-month by 1.5%, outperforming expectations by 0.8%; core retail sales also increased by a 0.8% monthly pace; Core inflation is at 1.3%, outperforming the expected 0.8%; Headline CPI is at 2.1%, above the expected 2%; The Canadian economy is growing in line with our expectations. A strong U.S. economy has allowed the export sector to flourish, while high demand for jobs has caused the labor market to tighten substantially. As labor shortages intensify, wages should gain traction in the near future, paving way for the BoC to tighten at least twice next year. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 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 Recently, the SNB released its 4th quarter quarterly bulletin. This report highlighted that the Swiss economy continues to recover, and GDP growth is expected to reach 2% in 2018, after a 1% expansion this year. Furthermore, the bulletin remarked that the labor market continues to tighten, with unemployment reaching 3% and employment growth finally hitting its long term average. The SNB also remarked that although the output gap continues to be negative, measures of capacity utilization are very close to reaching their long term average. However, the SNB continues to be unapologetically committed to its dovish bias and to intervention in currency markets, as inflation in Switzerland continues to be too weak for the SNB to change its stance. Thus, the CHF is likely to continue depreciating. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 USD/NOK has appreciated by nearly 1.5% since last week, even as Brent has rallied by more than 2.5%. This dynamic highlights the fact that USD/NOK continues to be more correlated to interest rate differentials between Norway and the U.S. than to oil prices. Inflationary pressures and economic activity continue to be too tepid for the Norges to adopt a much more hawkish tone than it did last week. Meanwhile, the Fed is likely to surprise the market next year, by following up on its "dot plot". These dynamics will continue to put upward pressure on USD/NOK. Nevertheless, foreign exchange investors can still use the krone to bet on higher oil prices resulting from the extension of the OPEC supply cuts. The way to do so is by shorting EUR/NOK, which is more correlated with oil prices. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 Swedish data has bounced back considerably: Headline CPI increased by 1.9% annually and CPIF grew by 2% annually; The unemployment rate dropped substantially from 6.3% to 5.8%, while the seasonally adjusted figure dropped from 6.7% to 6.4%. This week, the Riksbank announced a formal end to additional bond purchases by the end of December. However, reinvestments will continue until the middle of 2019, which means that the Bank's holdings of government bonds will actually increase into 2019. Additionally, the Swedish central bank also forecasts the repo rate to begin gradually increasing in the middle of 2018. This makes sense as the Swedish economy is running beyond capacity conditions. Given Sweden's stellar growth period, an appreciation in the SEK is long-awaited, but this will have to wait until Governor Ingves convinces markets that his perennial dovish-bias is ebbing. At that point, any hint of hawkishness will cause a sharp appreciation in the SEK, especially against the euro. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We are exploring the key FX implications of the views presented in BCA's 2018 annual outlook. The dollar is likely to experience some upside in the first half of 2018, but then weaken as U.S. monetary policy becomes increasingly onerous. The euro should mirror these dynamics, bottoming toward 1.1 in mid-2018. The yen could continue to weaken for most of 2018. But as markets begin to collide with policy, the second half of 2018 should be friendlier to the yen as potential risk-off events emerge. Risk-off events should also support the CHF versus the EUR. The GBP will remain victim to Brexit negotiations. It is cheap, but on a risk adjusted basis, potentially elevated expected returns will come at the price of heavy volatility. The commodity currencies and the Scandinavian currencies will suffer when global volatility picks up. Feature Key Views From The Outlook This past Monday we sent you BCA's Annual Outlook, exploring the key macroeconomic themes that we expect will shape 2018. This year, the discussion between BCA's editors and Mr. X, and his daughter, Ms. X, yielded the following key views:1 The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly, which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between three and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Essentially, global economic growth remains robust, which opens a window for global policy makers to abandon their ultra-easy policy stance. Asset markets will have to ultimately adjust to this gradual tightening in global policy. This will be an environment where risk in DM economies should perform well in the first half of the year. However, as policy becomes increasingly constraining, risk assets are likely to fare more poorly in the second half of 2018. Implications For The FX Markets What are the key implications of these views for currency markets? The USD is likely to perform well in the first half of 2018. BCA believes that U.S. inflation should gather steam during the first two to three quarters of 2018. This suggests the Fed will be able to follow the path described by the dot plots - something interest rate markets are not ready for (Chart I-1). As investors are short the USD, upside risk to U.S. interest rates should result in a higher dollar (Chart I-2). Chart I-1BCA Sees Upside To Rates BCA Sees Upside To Rates BCA Sees Upside To Rates Chart I-2The Dollar Is A Pariah The Dollar Is A Pariah The Dollar Is A Pariah The euro is likely to continue to behave as the anti-dollar. The euro is currently over-owned and vulnerable to negative surprises. While the European economy remains very strong, growing at a 2.5% pace on an annual basis last quarter, inflation is set to ebb as our core CPI diffusion index has sharply decelerated (Chart I-3). This means that contrary to the U.S., the upside risk is limited in the European OIS curve. The divergence in our inflation forecast between the U.S. and the euro area should thus be translated in a lower EUR/USD in the first half of 2018. A target around 1.1 on EUR/USD makes sense for mid-2018. The euro is unlikely to find much downside beyond these levels, as it would be trading at a more than 15% discount to its purchasing-power-parity equilibrium - a level often associated with bottoms. Moreover, investors are still cyclically underweight European assets, which points to pent-up buying power in favor of the euro (Chart I-4). Chart I-3Dissipating Inflation Pressures##br## In Europe Dissipating Inflation Pressures In Europe Dissipating Inflation Pressures In Europe Chart I-4Portfolio Rebalancing Toward Europe ##br##Key To A Higher Euro Portfolio Rebalancing Toward Europe Key To A Higher Euro Portfolio Rebalancing Toward Europe Key To A Higher Euro The picture for the yen is likely to be buffeted by two factors. The Japanese economy seems to be on the mend. The recent decoupling between the Nikkei and the yen is very interesting (Chart I-5). The strength of Japanese stocks could highlight that Japan's domestic economy is gaining momentum, and is less in need of massively easy policy. Thus, the Bank of Japan may be moving away from the apex of its easy policy. Moreover, the rising probability of growing fiscal stimulus could further diminish the need for easy monetary policy. This is a consequence of Abe winning yet another supermajority, which raises the likelihood that he will begin campaigning on a referendum to amend the Japanese constitution. Despite this, the BoJ will still maintain among the loosest policy settings in the world. Moreover, USD/JPY remains closely correlated with Treasury yields and Treasury/JGB spreads (Chart I-6). BCA anticipates both these variables to continue to trend in a yen-negative fashion. If BCA's view that risk assets could peak during the second half of 2018 is correct, bond yields may peak around that time frame as well. Since the yen is trading at a massive discount (Chart I-7), mid-year may well prove a massive buying opportunity for yen bulls, especially if the U.S. yield curve ends 2018 in a near-flat state. Chart I-5Nikkei Trying To Tell Us Something Nikkei Trying To Tell Us Something Nikkei Trying To Tell Us Something Chart I-6Yen Still A Function Of T-Notes Yen Still A Function Of T-Notes Yen Still A Function Of T-Notes Chart I-7Yen Is Cheap Yen Is Cheap Yen Is Cheap The Swiss franc continues to trade at a 5% premium to its PPP fair-value against the euro. This means the Swiss National Bank will maintain very easy policy that will promote CHF weakness. However, the fight will remain difficult; once Switzerland's prodigious net international investment position of 130% of GDP is taken into account, the trade-weighted CHF trades in line with fair value (Chart I-8). Thus, the CHF will continue to behave as a funding, or risk-off, currency. So long as global market volatility remains well contained, EUR/CHF will experience appreciating pressure. If asset markets peak in the second half of 2018, EUR/CHF is likely to depreciate, which will prompt renewed intervention by the SNB to mitigate any deflationary impact of a stronger CHF. The pound does look very cheap, trading at an 18% discount against the USD (Chart I-9). However, Brexit remains a key problem. Brexit is about limiting immigration into the U.K., the key force that has generated the U.K.'s economic outperformance over the past 15 years (Chart I-10). Without higher trend growth than its neighbors, England will see its equilibrium real neutral rate fall, limiting the upside to the Bank of England's cash rate. As FDI into the U.K. is succumbing to the heightened level of uncertainty, a falling neutral rate means it will be more difficult to finance Britain's current account deficit of 5% of GDP. Thus, the pound is cheap for a reason. Until negotiations with the EU progress, the pound will continue to offer limited reward and plenty of volatility. Chart I-8CHF: Not What It May Seem CHF: Not What It May Seem CHF: Not What It May Seem Chart I-9GBP: A Value Trap? GBP: A Value Trap? GBP: A Value Trap? Chart I-10U.K. Trend Growth And Neutral Rate Will Fall U.K. Trend Growth And Neutral Rate Will Fall U.K. Trend Growth And Neutral Rate Will Fall Commodity currencies are at a difficult juncture. The AUD, CAD, and NZD could begin the year on a firm tone, if global growth remains robust in the early innings of 2018. However, they will suffer if global volatility rises, which seems unavoidable if markets and policy indeed collide in the second half of 2018 (Chart I-11). The pain for commodity currencies could be compounded by the fact that China looks set to start some potentially painful reforms. The AUD is the worst placed of the three as it is the most expensive, while the CAD is the best placed, as BCA's commodity strategists remain more positive on the energy complex than on the base metals market. Shorting AUD/JPY may prove to be a great hedge for investors who are long risk assets. The Scandinavian currencies are at an interesting juncture as well. Both the NOK and the SEK are extremely cheap on a trade-weighted basis and against the euro (Chart I-12). While strong oil prices should help the NOK, and the overheating Swedish economy should prompt investors to price in policy tightening by the Riksbank, neither of these fundamentals are lifting their respective currencies. The strength in EUR/SEK and EUR/NOK is likely to reverse in the first half of 2018. However, if BCA is correct that markets could begin to feel the pain from gradual tightening in global policy in the second half of 2018, the historically very cyclical Scandinavian currencies should only enjoy a short-lived rally against the euro. Chart I-11The End Of The Great Carry##br## Trade Is Coming The End Of The Great Carry Trade Is Coming The End Of The Great Carry Trade Is Coming Chart I-12Scandies Should Rally##br## In Early 2018 Scandies Should Rally In Early 2018 Scandies Should Rally In Early 2018 Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 The full report, The Bank Credit Analyst, titled "2018 Outlook - Policy And The Markets: On A Collision Course", dated November 20, 2017, is available at fes.bcaresearch.com Forecasts Forecast Summary

Highlights The three deflationary anchors of the global economy have abated: The U.S. private sector deleveraging is over, the euro area economy is escaping its post crisis hangover, and the destruction of excess capacity in China is advanced. This means that global central banks are in a better position than at any point this cycle to normalize policy, pointing to higher real rates. As a result, gold prices will suffer significant downside. The populist wave in New Zealand is based on inequalities and is here to stay. This will hurt the long-term outlook for the Kiwi. However, short-term NZD has upside, especially against the AUD. The BoE hiked rates, but upside surprises to policy is unlikely now. The pound remains at risk from Brexit negotiations. Feature Chart I-1Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold is at an interesting juncture. Gold prices, once adjusted for the trend in the U.S. dollar, have been forming a giant tapering wedge since 2011 (Chart I-1). This type of chart formation does not necessarily get resolved by an up-move, nor does it indicate a clear bearish pattern either. Instead, it points toward a potential big move in either direction. For investors, the key to assess whether this wedge will be resolved with a rally or a rout is the trend in global monetary conditions and real rates. In our view, the global economic improvement witnessed in 2017 suggests the world needs less accommodation than at any point since the onset of the great financial crisis. Thus, global accommodation will continue to recede, global real rates will rise and gold will suffer. The Exit Of The Great Deflationary Forces Since the financial crisis, in order to generate any modicum of growth, global monetary authorities have been forced to maintain an incredible degree of monetary accommodation in the global financial system. Central banks' balance sheets have expanded massively, with the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank all increasing their asset holdings by 16% of GDP, 26% of GDP, 70% of GDP, 17% of GDP and 97% of GDP respectively. Real rates too have been left at unfathomable levels, with average real policy rates in the U.S., the euro area, Japan and the U.K. standing at 0.13%, -1.15%, -0.19%, and -2.12%, respectively. Despite all this easing, core inflation in the OECD has only averaged 1.68% since 2010, and real growth 2.05% - well below the averages of 2.3% and 2.44%, respectively, from 2001 to 2007. Explaining this extraordinary situation have been three key anchors that have conspired to create strong deflationary forces that have necessitated all this stimulus: the first was U.S. private sector deleveraging, with at its epicenter the rebuilding of household balance sheets. The second was the euro area crisis, which also caused a forced deleveraging in the Spanish and Irish private sector as well as in the Greek and Portuguese public sectors. The third was China's purging of excess capacity in the steel and coal sectors, as well as various heavy industries. These three deflationary anchors seem to have finally passed. In the U.S., nonfinancial private credit is slowly showing signs of recovering. Households have curtailed their savings rate, suggesting a lower level of risk aversion. Even more importantly, the growth in savings deposits is sharply decelerating, which historically tends to be associated with a re-leveraging of the household sector and increasing consumption (Chart I-2). Strong new home sales point toward these developments. The corporate sector is also displaying an important change in behavior. Share buybacks are declining, and both capex intentions and actual capex are recovering smartly - powered by strong profit growth (Chart I-3). This is crucial as it suggests firms are not recycling the liquidity they generate through their operations or their borrowings in the financial markets. Thus, with banks easing their lending standards, additional debt accumulation by firms is likely to support aggregate demand, eliminating a key deflationary force in the global economy. Chart I-2Household Deleveraging Is Over Household Deleveraging Is Over Household Deleveraging Is Over Chart I-3Companies Are Borrowing To Invest Companies Are Borrowing To Invest Companies Are Borrowing To Invest Moreover, Jay Powell's nomination to helm the Fed is also important. He is a proponent of decreasing bank regulation, especially for small banks that greatly rely on loan formation for their earnings. A softening in regulatory stance on these institutions could contribute to higher credit growth in the U.S. With aggregate liquidity conditions of the private sector - shown by the ratio of liquid assets to liabilities - having already improved, and indicating that a turning point in U.S. inflation will soon be reached, more credit growth could further stoke inflation (Chart I-4). Europe as well is also escaping its own morose state. ECB President Mario Draghi's fateful words in July 2012 resulted in a compression of peripheral spreads as investors priced away the risk of a breakup of the euro area (Chart I-5). As a result, the massive policy easing associated with negative rates and the ECB's expanded asset purchase program was transmitted to the parts of the euro area that really needed that easing: the periphery. Now, Europe is booming: Monetary aggregates have regained traction, real GDP growth is growing at a 2.3% annual pace, PMIs are growing vigorously, and even the unemployment rate has fallen back below 9%. European inflation remains low, but nonetheless the nadir of -0.6% hit in 2015 has also passed (Chart I-6). Chart I-4Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Chart I-5Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Chart I-6Europe Past The Worst Europe Past The Worst Europe Past The Worst In China too we have seen important progress. Curtailment to excess capacity in the steel and coal sectors as well as across a wide swath of industries are bearing fruit (Chart I-7). China is not the source of deflation that it was as recently as 2015. Industrial profits have stopped contracting, industrial price deflation is over, and even core consumer prices are showing signs of vigor, growing at a 2.28% pace, the highest since the 2010 to 2011 period (Chart I-8). Thanks to these developments, global export prices have stopped deflating and are now growing at a 4.64% annual pace. With the three deflationary anchors having been slain, global growth is now able to escape its lethargy, with industrial activity at its strongest since 2003, while global capacity utilization has improved (Chart I-9). This is giving global central banks room to remove their easing. The Fed has already hiked rates four times and is embarking on decreasing its balance sheet; the Bank of Canada has followed suit two times, and the BoE, one time. Even the ECB is now beginning to taper its own asset purchases. We do anticipate this trend to continue with more and more central banks, with potentially the exception of the BoJ, joining the fray as the global environment remains clement. Even the People's Bank of China is likely to keep tightening policy due to the increasingly inflationary environment being experienced. Chart I-7Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chart I-8China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore Chart I-9Central Banks Can Normalize Central Banks Can Normalize Central Banks Can Normalize Bottom Line: The three anchors of global deflation have been slain. Private sector deleveraging in the U.S. is over, the euro area has healed and Chinese excess capacity has declined. As a result, global economic activity is at its strongest level in 14 years, and deflationary forces are becoming more muted. This is giving global central banks an opportunity to normalize policy without yet killing the business cycle. Implications For Gold Gold is likely to fare very poorly in this environment. Gold can be thought of as a zero coupon, extremely long-maturity inflation-indexed bond. This means that gold is a function of both inflation and real rates. Currently, gold offers little protection against outright inflation, having moved out of line with prices by a very large margin (Chart I-10). This leaves gold extremely vulnerable to development in real rates and liquidity. Saying that central banks can begin to normalize policy is akin to saying that central banks are in a position where letting real rate rise is feasible. As Chart I-11 illustrates, there has been a strong negative relationship between TIPS yields and gold prices. Moreover, when one looks beyond the price of gold in U.S. dollars, one can see that gold has been negatively affected by higher bond yields (Chart I-11, bottom panel). BCA currently recommends an underweight stance on duration, one that is synonymous with lower gold prices.1 Chart I-10Gold Is Expensive Gold Is Expensive Gold Is Expensive Chart I-11Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Moreover, the Fed's own research suggests that its asset purchases have curtailed the term premium by 85 basis points. The balance sheet run-off that the U.S. central bank is engineering will weaken that impact to a more meager 60 basis points by 2024. This also points to lower gold prices, as gold prices have displayed a negative relationship with the term premium (Chart I-12). An outperformance of financials in general but banks in particular is also associated with poor returns for gold (Chart I-13). Strong financials are associated with growing loan volumes, which mean a lesser need for policy easing, which puts upward pressure on the cost of money. Anastasios Avgeriou, who heads BCA's sectoral research, has an overweight on banks both globally and in the U.S. on the basis of the stronger loan growth we are beginning to see around the world.2 This represents a dangerous environment for gold. Chart I-12Normalizing Term Premium ##br##Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Chart I-13Bullish Banks Equals ##br##Bearish Gold Bullish Banks Equals Bearish Gold Bullish Banks Equals Bearish Gold Finally, there is an interesting relationship between real stock prices and real gold prices. When stocks are in a secular bull market, gold prices are typically in a secular bear market (Chart I-14). A secular bull market in stocks tends to happen in an environment where there is more confidence that growth is becoming more durable, where there is less fear that currencies will have to be debased to support economic activity, or where inflation is not a destructive force like it was in the 1970s. These are environments where real rates tend to have upside. The continued strength in global equity prices, which are again in a secular bull market, would thus contribute to an increase in currently still-depressed global real yields, and thus, create downside in gold. One key risk to our view is that the Fed falls meaningfully behind the curve and lets inflation rise violently, which would put downward pressure on real rates and cause a violent correction in global equity prices - prompting investors to price in an easing in monetary policy. Geopolitics are another key risk, particularly a ratcheting up in North Korea tensions. With our bullish stance on the dollar, we are inclined to short the yellow metal versus the greenback. Moreover, for the past eight years, when net speculative positions in gold have been as elevated as they are today relative to net wagers on the DXY, gold in U.S. dollar terms has tended to weaken (Chart I-15). However, the analysis above suggests that gold could weaken against G10 currencies in aggregate. Thus investors with a more negative dollar view than ours could elect to sell gold against the euro. Agnostic players should short gold equally against the USD and the EUR. Chart I-14Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Chart I-15Tactical Risk To Gold Tactical Risk To Gold Tactical Risk To Gold Bottom Line: The outlook for gold is negative. As the global economy escapes its deflationary funk and global central banks begin abandoning emergency easing measures, real interest rates will rise and term premia will normalize, which will put downward pressure on gold prices. Additionally, BCA's positive stance on banks is corollary with a negative outlook on gold. The continued bull market in stocks is an additional hurdle for gold. New Zealand: A New Hot Spot Of Populism The formation of the Labour/NZ First/Green coalition has sent ripples through the kiwi. The reaction of investors is fully rational, as the Adern government is carrying a very populist torch, sporting a program of limiting foreign investments in housing, limiting immigration, increasing the minimum wage and creating a dual mandate for the Reserve Bank of New Zealand. The key question is whether this is a fad, or whether something more profound is at play in New Zealand. We worry it is the latter. New Zealand has suffered from a profound increase in inequality since pro-market reforms were implemented in the 1980s. New Zealand's gini coefficient is very elevated, but even more worrisome has been the deteriorating trend. As Chart I-16 illustrates, the ratio of income of the top 20% of households relative to the bottom 20% has been in a steady uptrend. Additionally, this trend is sharper once the cost of housing is incorporated into the equation. Moreover, as Chart I-17 shows, New Zealand has experienced one of the most pronounced increases in housing costs among the G10. Chart I-16Growing Inequalities In New Zealand Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-17Kiwi Housing Is Expensive Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead It is undeniable that the impact of immigration has been real. Net migration has averaged 24 thousand a year since 2000, on a population of 4.8 million. Moreover, the labor participation rate of immigrants has been higher than that of the general population, reinforcing the perception that immigration has contributed to keeping wage growth low (Chart I-18). The effect of low wage growth - whether caused or not caused by the increase in the foreign-born population - has been to boost household credit demand, pushing the national savings rate into negative territory, something that was required if households were to keep spending. These developments suggest that kiwi populism is not a fad, and is in fact a factor that will remain present in New Zealand politics. It also implies that policies designed to limit foreign investments into housing as well as immigration are indeed popular and will be implemented. What are the economic implications of these developments? Immigration was a key source of growth for New Zealand. As Chart I-19 shows, the growth of the kiwi economy since 1985 has been driven by an increase in the labor force. In fact, over the past five years, 86% of growth has been caused by labor force growth, with a very limited contribution from productivity gains. More concerning, as Chart I-20 shows, 44% of the increase in the population growth since 2012 has been related to immigration. Chart I-18The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs Chart I-19Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Chart I-20Labor Force Growth Could Halve Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Additionally, according to the IMF's Article IV consultation for New Zealand, immigration has boosted output significantly, contributing to total hours worked as well as forcing an increase in the capital stock, which has boosted capex (Table I-1). Hence, lower intakes of foreign-born workers is likely to push down the country's potential growth rate. Limiting immigration in New Zealand could therefore have a significantly negative impact on the country’s neutral rate. As Chart 21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential growth rate would push down the equilibrium policy rate in New Zealand, limiting how high the RBNZ's terminal policy rate will rise in the future. This points toward downward pressure on the NZD on a long-term basis. Shorting NZD/CAD structurally makes sense at current levels, especially as Canada remains open to immigration and immune to populism, as income inequalities are much more controlled there (Chart I-22). Table I-1Impact Of Immigration On Growth Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-21Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Chart I-22NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy Limiting immigration in New Zealand could therefore have a significantly negative impact on the country's neutral rate. As Chart I-21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential Shorter-term, the picture is slightly brighter for the NZD. Credit growth is strong, and is pointing toward an increase in the cash rate next year. Additionally, consumer confidence is high, and the labor market is showing signs of tightness, especially as the output gap stands at 0.87% of GDP (Chart I-23). This tightness in the labor market could easily be catalyzed into higher wage growth, especially as the new government is tabulating a 4.76% increase in the minimum wage in the coming quarters. Thus, BCA continues to expect an uptick in kiwi inflation and higher kiwi rates, even if a dual mandate for the RBNZ is implemented. Our favored way to play this strength in the kiwi remains going short the AUD/NZD. Our valuation model points to a strong sell signal in this cross (Chart I-24). Moreover, speculators are very long the AUD relative to the NZD, which historically has provided a contrarian signal to short it. Additionally, the concentration of power around Chinese President Xi Jinping points towards more reform implementations in China - reforms that we estimate will be targeted at decreasing the reliance of growth on debt-fueled investment while increasing the welfare of households, which should help Chinese consumption. As a result, metals could suffer relative to consumer goods. With New Zealand being a big exporter of foodstuffs and dairy products, this should represent a positive terms-of-trade shock for the kiwi relative to the Aussie. Chart I-23Short-Term Positives In New Zealand Short-Term Positives In New Zealand Short-Term Positives In New Zealand Chart I-24Downside Risk To AUD/NZD Downside Risk To AUD/NZD Downside Risk To AUD/NZD Bottom Line: The increase in populism in New Zealand is being fueled by a sharp increase in inequalities and rising housing costs. Immigration, rightly or wrongly, has been blamed in the public narrative for these ills. The measures announced by the Adern government target these issues head on, and we expect they will be implemented. This hurts New Zealand's long-term growth profile, and thus the terminal rate hit by the RBNZ this cycle. This could hurt the NZD on a structural basis. Tactically, it still makes sense to be short AUD/NZD. A Word On The BoE The BoE increased rates this week for the first time in a decade, but now acknowledges that current SONIA pricing is correct, removing its mention that risks are skewed toward higher rates than anticipated by the market. The pound sold off sharply on the news. Consumer confidence and retailer orders point to further slowdown in consumption. Thus, we think the British OIS curve is currently well priced, limiting any potential rebound in the GBP. Brexit continues to spook markets, rightfully. The political theater is far from over, and the continued uncertainty is likely to weigh further on the U.K. economy. This is likely to generate additional downside risk in the pound over the coming months. Thus, on balance, our current assessment is that the risks are too high to make a bullish bet on the GBP for now. A progress in the negotiations between the U.K. and the EU is needed before investors can buy the GBP, a currency that is cheap on a long-term basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Global Fixed Income Strategy Weekly Report, titled "Follow The Fed, Ignore The Bank Of England" dated September 19, 2017, available at gfis.bcaresearch.com 2 Please see Global Alpha Sector Strategy Weekly Report, titled "Buy The Breakout" dated May 5, 2017, available at gss.bcaresearch.com and U.S. Equity Strategy Weekly Report, titled "Girding For A Breakout?" dated May 1, 2017, available at uses.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 U.S. data was mixed: Core PCE was unchanged at 1.3%, and in line with expectations; Headline PCE was also unchanged at 1.6%; ISM Prices Paid came in at 68.5, beating expectations of 68; ISM Manufacturing came in weaker than expected. In other news, Jerome Powell is President Trump's pick as the next Fed chairman to replace Janet Yellen. Market reaction was muted as Powell is expected to continue in Yellen's footsteps and hike rates at a similar pace. While the Fed decided to leave rates unchanged this month, the probability of a December rate hike went up to 98%. We expect the USD bull market to strengthen next year when inflation re-emerges. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 Data out of Europe was mixed: German and Italian inflation underperformed expectations and weakened compared to last month, while French inflation beat expectations; Overall European headline and core inflation also mixed expectations, coming in at 1.4% and 1.1% respectively; European preliminary GDP, however, beat expectations of 2.4%, coming in at 2.5%; The unemployment rate dropped to 8.9% for the euro area; The euro was up on Thursday after the nomination of Jerome Powell as Fed chair. His nomination represents a continuity of monetary policy. Despite this, we believe the re-emergence of inflation will cause the Fed to continue hiking after the December hike, deepening downward pressure on the euro next year. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 Japanese data has been mixed: Housing starts yearly growth came above expectations, coming in at -2.9%. However, housing starts did accelerate their contraction from August, when they were falling by 2% year-on-year. Industrial Production yearly growth came in above expectations, at 2.5%. However the jobs-to-applicants ratio came below expectations, staying put at 1.52. On Tuesday the BoJ left rates unchanged. Additionally the committee vowed to keep 10-year government bond yield around 0% and to continue their ETF purchases. More importantly, however, was the Bank of Japan's change to its outlook for inflation, which was decreased for this year. We continue to believe that deflation is too entrenched in Japan for the BoJ to change its policy stand. Thus, we expect USD/JPY to keep grinding higher, as U.S. monetary policy becomes more hawkish vis-à-vis Japan. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 surprised to the upside: Mortgage Approvals also outperformed expectations, coming in at 66.232 thousand. Moreover Nationwide house price yearly growth also outperformed, coming at 2.5% Both Markit Manufacturing PMI and Construction PMI outperformed, coming in at 56.3 and 50.8 respectively. The BoE hiked rates yesterday by 25 basis points as expected. Moreover, the committee also voted unanimously to maintain the stock of UK government bond purchases. However, the committee also acknowledged that inflation was not be the only effect of Brexit on the economy. They highlighted that uncertainty about the exit from the European Union was hurting activity despite a positive global growth backdrop. Overall, we think that the BoE will not deviate from the interest rate path priced into the OIS curve. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 Australian data was mixed: HIA New Home Sales contracted by 6.1%; AiG Performance of Manufacturing Index came in at 51.1, less than the previous 54.2; Exports increased by 3%, while imports stayed flat at 0%; The trade balance increased to AUD 1.745 bn, compared to the expected AUD 1.2 bn, and above the previous AUD 873 mn. The AUD was up on the release of the trade balance. But underlying slack in the economy, which worries RBA officials, points to a low fair value for the AUD. The AUD will be the poorest performer out of the commodity currencies, due to the relative strength of those economies and of oil relative to metals. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 positive: The unemployment rate came below expectations at 4.6%, it also decreased from last quarter's 4.8% reading. The participation rate came above expectations, at 71.1%. It also increased from 70% on the previous quarter. The Labour cost Index came in line with expectations at 1.9% yearly growth. However it increased from 1.6% in the previous quarter. Overall the New Zealand economy looks very strong. This should warrant a hike by the RBNZ. However the new government create a new set of long-term risks. The elected government is a response to the high inequality and high migration that the country had experienced in the recent years. Overall the plans to reduce immigration and install a double mandate to the RBNZ are bearish for the NZD, as the neutral rate of New Zealand would be structurally lowered. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 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 Canadian data has been weak recently: The raw material price index contracted by 0.1%; Industrial product prices contracted at a 0.3% monthly rate; GDP also contracted at a 0.1% monthly pace; Manufacturing PMI came out at 54.3, lower than the previous 55. In addition to this, Poloz identified several issues with the Canadian economy in his speech on Tuesday. These included the deflationary effects of e-commerce, slack in the labor market, subdued wage growth, and the elevated level of household debt. The probability of a rate hike has fallen to 22% for December, and it only rises above 50% in March next year. The CAD has lost a lot of its value since the BoC began hiking, but we believe it will resume hiking next year. Increasing oil prices will also mean that that CAD will outperform other G10 currencies. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 positive: The SVME Purchasing Manager's Index came above expectations at 62 in October. It also increased from the September reading. The KOF leading indicator also outperformed expectations significantly, coming at 109.1. EUR/CHF continues to climb unabated and is now only 3% from where it was before the SNB let the franc appreciate in January of 2015. Overall we see little indication that the SNB would let the franc appreciate again in the near future. On Wednesday, SNB Vice President Zurbruegg continued to talk down the franc by stating that a stronger CHF would cause a growth slowdown and that the CHF is still highly valued. Thus we expect downside in EUR/CHF to be limited for the time being. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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 Recent data in Norway has been mixed: Retail sales growth underperformed expectations, as they contracted by 0.8% in September. However Norway's credit indicator surprised to the upside, coming in at 5.8%. Since September USD/NOK has appreciated by nearly 6%. This has been in an environment where oil has rallied by nearly 20%. Although this divergence might seem counterintuitive, it confirms our previous findings: USD/NOK is much more sensitive to real rate differentials than to oil prices. Inflationary pressures are still very tepid in Norway, while inflation is set to go higher in the U.S. These factors will further amplify the monetary policy divergences between these 2 countries, and consequently propel USD/NOK higher. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 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 Swedish Manufacturing PMI decreased to 59.3 from 63.7, below the expected 62. EUR/SEK has appreciated to June levels, implying that markets have priced out any potential hawkishness by the Riksbank. Similarly, USD/SEK has risen by 6.2% from September lows. This is due to the re-chairing of Stefan Ingves, known for negative rates and quantitative easing. On the opposite side of the trade, President Trump elected Jerome Powell as the next Fed chair who will most likely continue the rate hike path highlighted by Janet Yellen. This will add further upward pressure on USD/SEK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights This week, we are reviewing all our current active trades in our Tactical Overlay. As a reminder, these positions (Table 1) are meant to complement our strategic GFIS Model Fixed Income Portfolio, typically with shorter holding periods and occasionally in smaller or less liquid markets outside our usual core bond market coverage (i.e. U.S. TIPS or Swedish interest rate swaps). This report includes a short summary of the rationale behind each position, as well as a decision on whether to continue holding the trade, close it out or switch to a new position that may more efficiently express our view. The trades are grouped together by the country/region that is most relevant for the performance of each trade. Table 1GFIS Tactical Overlay Trades Updating Our Tactical Overlay Trades Updating Our Tactical Overlay Trades Feature U.S. Short July 2018 Fed Funds futures (HOLD). Long 5-year U.S. Treasury (UST) bullet vs. 2-year/10-year duration-matched UST barbell (HOLD). Long U.S. TIPS vs. nominal USTs (HOLD). Short 10-year USTs vs. 10-year German Bunds (HOLD). The tactical trades that we have been recommending within U.S. markets all have a common theme - positioning for an expected rebound in U.S. inflation that will push up U.S. bond yields. We are maintaining all of them. The drift lower in realized inflation rates since the spring has been a surprise given the backdrop of above-potential growth, low unemployment and a weakening U.S. dollar. On the back of this, markets have priced out several of the Fed rates hikes that had been expected over the next year, leaving U.S. Treasury yields at overly-depressed levels. Back on July 11th, we initiated a recommendation to short the July 2018 fed funds futures contract (Chart 1). This was a position that would turn a profit if the market moved to once again discount multiple Fed rate hikes by mid-2018. The trade has a modest profit of 9bps, but with scope for additional gains if the market moves to discount 2-3 hikes by the middle of next year. Our base case scenario is that the Fed will lift rates again this December, and deliver additional increases next year amid healthy growth and with inflation likely to grind higher towards the Fed's 2% target. With the market discounting 46bps of rate hikes over the next year, there is scope for additional profits in our fed funds futures trade. Another tactical position that we've been recommending is a butterfly trade within the U.S. Treasury (UST) curve, long a 5-year UST bullet versus a duration-matched 2-year/10-year UST barbell. This is a position that would benefit from a bearish steepening of the UST curve as the market priced in higher longer-term inflation expectations (Chart 2). We have held that trade for a much longer period than a typical tactical trade, going back nearly a full year to December 20th, 2016. Yet while the UST curve has flattened since that date, our trade has delivered a return of +18bps. This outperformance can be attributed to the undervalued level of the 5-year bullet at the initiation of the trade. Chart 1Stay Short July 2018##BR##Fed Funds Futures Stay Short July 2018 Fed Funds Futures Stay Short July 2018 Fed Funds Futures Chart 2Stay Long The 5yr UST Bullet Vs.##BR##The 2yr/10yr UST Barbell Stay Long The 5yr UST Bullet Vs The 2yr/10yr UST Barbell Stay Long The 5yr UST Bullet Vs The 2yr/10yr UST Barbell While that valuation cushion no longer exists (bottom panel), longer-term TIPS breakevens are back to the levels seen last December (middle panel), thanks in no small part to much higher energy prices (top panel). This leaves the UST curve at risk of a bearish re-steepening on the back of rising inflation expectations. Add in a U.S. dollar that is -2.5% weaker from year-ago levels (Chart 3, middle panel), and a solid U.S. economic expansion that should eventually translate into rising core inflation momentum (bottom panel), and the case for a steeper UST curve over the next 3-6 months is a strong one. The above logic also supports our trade recommendation to go long U.S. TIPS vs. nominal USTs, which is up +248bps since inception on August 23, 2016. We have been holding this trade for much longer than our usual tactical recommendations, but we will not look to take profits until we see the 10-year breakeven (now at 186bps) return back to levels consistent with the Fed's 2% PCE inflation target (i.e. headline U.S. CPI inflation back to 2.5%). One final tactical trade that will benefit from higher UST yields is our recommendation to position for a wider spread between 10-year USTs and 10-year German Bunds. This trade was initiated on August 9th of this year, and has delivered a profit of +9bps. Yet the UST-Bund spread still looks too low relative to shorter-term interest rate differentials that favor the U.S. (Chart 4, top panel). With U.S. data starting to surprise more on the upside than Euro Area data (middle panel), and with UST positioning still quite long (bottom panel), there is potential for additional near-term UST-Bund spread widening. The upcoming decision by the European Central Bank (ECB) on potential tapering of its asset purchases next year represents a potential risk for the long Bund leg of our recommended trade. Any hawkish surprises on that front would be a likely catalyst for us to close out this position. Chart 3Stay Long U.S. TIPS Vs. Nominal USTs Stay Long U.S. TIPS Vs. Nominal USTs Stay Long U.S. TIPS Vs. Nominal USTs Chart 4Stay Short 10yr USTs Vs. German Bunds Stay Short 10yr USTs vs German Bunds Stay Short 10yr USTs vs German Bunds Euro Area Long 10yr Euro Area CPI swaps (HOLD). Long 5-year Spain vs. 5-year Italy in government bonds (HOLD). We have two recommended tactical trades that are specifically focused on developments in the Euro Area. We are maintaining both of them. As a way to position for an eventual pickup in European inflation, we entered a long position in 10-year Euro Area CPI swaps back on December 20th, 2016. That trade is now estimated to have a profit of +29bps, as market-based inflation expectations have drifted higher in the Euro Area. The simple reason for that increase is that realized inflation has moved higher on the back of rising energy costs, as there is a very robust correlation between the annual growth rate of oil prices (denominated in euros) and headline Euro Area inflation (Chart 5). More importantly, the booming Euro Area economy, which has eaten up much of the spare capacity in the Europe, has boosted wage growth and core inflation to levels seen prior to the disinflation shock from the 2014/15 collapse in oil prices (bottom panel). With no signs of any imminent slowing of Euro Area growth that could raise unemployment and slow underlying inflation pressures, the trend for inflation expectations in Europe is still upward. The current 10-year Euro Area CPI swap at 1.5% is still well beneath the ECB's inflation target of "just below" 2% on headline CPI, so there is room for inflation expectations to continue drifting higher. ECB tapering of asset purchases is not an immediate threat to this trade, as the central bank is still likely to keep buying bonds next year (at a slower pace), while holding off on any interest rate increases until late 2019. In other words, the ECB will not be looking to act to slow economic growth to bring down Euro Area inflation anytime soon. Our other tactical trade recommendation in Europe is a relative value spread trade, long 5-year Spanish government debt versus 5-year Italian bonds. This trade was initiated on December 13th, 2016 and currently has only a modest gain of +9bps, although the profits were much larger earlier this year. Italian bonds have been outperforming on the back of improving Italian economic growth (Chart 6, top panel) and, recently, a generalized sell-off in Spanish financial assets on the back of the political uncertainty in Catalonia. Chart 5Stay Long 10yr##BR##Euro Area CPI Swaps Stay Long 10yr Euro Area CPI Swaps Stay Long 10yr Euro Area CPI Swaps Chart 6Stay Long 5yr Spanish Government Bonds Vs.##BR##5-Year Italian Debt Stay Long 5yr Spanish Government Bonds Vs 5-Year Italian Debt Stay Long 5yr Spanish Government Bonds Vs 5-Year Italian Debt Our colleagues at BCA Geopolitical Strategy have been downplaying the threat to Spanish political stability from the Catalonian independence movement, given that the polling data shows only 35% for outright independence from Spain. At the same time, the poll numbers in Italy for the upcoming parliamentary elections are much closer, with parties favoring less integration with Europe holding a slight lead over more "establishment" parties (bottom two panels). With the bulk of the cyclical convergence between Italian and Spanish growth now largely completed, and with a greater potential for future political instability in Italy compared to Spain, we expect that Spain-Italy spreads will tighten further back to the lows seen at the beginning of 2017 (-64bps on the 5-year spread). That is a level we are targeting on our current tactical trade recommendation. Canada Short 10-year Canadian government bonds vs. 10-year USTs (TAKE PROFITS). Long Canada/U.K. 2-year/10-year government bond yield curve box, positioning for a relatively flatter Canadian curve (TAKE PROFITS). Short 5-year Canada government bond versus a duration-matched 2-year/10-year barbell (TAKE PROFITS). We have three different Canadian fixed income trades in our Tactical Overlay, all of which were biased towards tighter monetary policy in Canada: a Canada-U.S. bond spread widener, a yield curve box trade versus the U.K. and a curve flattener expressed as a barbell trade (Chart 7) All three positions are in the money, but we now recommend taking profits. We had initiated these recommendations in a very timely fashion earlier in the year at a time when the Bank of Canada (BoC) was sending a relative dovish message. In our view, the Canadian economy was building significant upward momentum that would eventually force the central bank to shift its policy bias. This would especially be true with the Fed also in a tightening cycle, given the typical tendency for the BoC to follow the Fed's policy actions. Several members of the BoC monetary policy committee began to sing a more hawkish tune over the summer, particularly after the release of the Q2 BoC Business Outlook Survey. That robust report, which was confirmed by a 2nd quarter GDP growth rate of nearly 4% (Chart 8), led the BoC to deliver not one by two unexpected interest rate hikes in July and September. Markets reacted accordingly, driving Canadian bond yields higher and flattening the yield curve. Chart 7Take Profits On Bearish Canadian Bond Trades Take Profits On Bearish Canadian Bond Trades Take Profits On Bearish Canadian Bond Trades Chart 8Canadian Growth Set To Cool Off A Bit Canadian Growth Set To Cool Off A Bit Canadian Growth Set To Cool Off A Bit Now, we see the market pricing as having gone a bit too far, too quickly. The Q3 Business Outlook Survey, released yesterday, was still positive but with readings softer than the booming Q2 report. Meanwhile, the commentary from the BoC has become more balanced, with BoC Governor (and BCA alumnus) Stephen Poloz describing the central bank as being more "data dependent" after the recent rate hikes. Markets are now pricing in another 72bps of rate hikes over the next year, even with our own BoC Monitor off the peak (Chart 9). Chart 9Our BoC Monitor Is Peaking Our BoC Monitor Is Peaking Our BoC Monitor Is Peaking From a tactical perspective, the repricing of the BoC that we expected earlier this year is now largely complete. Thus, we are taking profits on all three Canadian trades: Canada-U.S. spread trade: initiated on January 17th, profit of +43bps. Canada/U.K. box trade: initiated on May 16th, profit of +67bps. Canada 2yr/5yr/10yr butterfly trade: initiated on December 6th, 2016, profit of +95bps. From a strategic perspective, we still see a case where the BoC can deliver additional rate hikes and keep upward pressure on Canadian bond yields. The output gap in Canada is now closed, according to BoC estimates, and additional strength in the economy now has a greater chance in translating to higher inflation. Strong global growth, especially in the U.S., will also support Canadian export growth and feed into rising capital spending. While the rate hikes have help boost the value of the Canadian dollar (CAD), the exchange rate (on a trade-weighted basis) also largely reflects a rising value of energy prices and is, therefore, should provide an additional boost to growth via stronger terms-of-trade (bottom panel). In other words, the rising CAD will not prevent additional BoC rate hikes if oil prices remain strong. Thus, we are maintaining our underweight recommendation on Canadian government bonds in our strategic model bond portfolio, even as we take profits on our bearish Canadian tactical trades. Australia Long a 2-year/10-year Australia government bond curve flattener (SELL AND SWITCH TO NEW TRADE). On July 25th of this year, we entered into a 2-year/10-year curve flattener trade for Australia. Though employment was improving and house prices were booming in Australia, the wide output gap, high level of consumer indebtedness and lack of real wage growth was keeping the Reserve Bank of Australia (RBA) inactive. In our view, nothing has changed since then; the RBA remains in a very difficult position. While the yield curve flattened substantially following the initiation of our trade, the global rise in long-term yields since mid-September lifted Australian longer-maturity yields, and the yield curve with it (Chart 10). Now, Australian long-term yields are not reflecting domestic fundamentals but are instead driven by improving global growth. As such, we are closing the trade and initiating a new position - long Dec 2018 Australian Bank Bill futures - as a more focused way to express the view that the RBA will stay on hold for longer than markets expect. Markets are currently pricing in 30bps of RBA rate hikes over the next twelve months. We believe this will be unlikely, for several reasons. Macroprudential measures on the Australian housing market will continue to dampen credit growth. Core inflation is slowly rising but still far below the central bank's target. Additionally, there is plenty of slack in the labor market despite the spike in employment growth. This is evidenced in anemic real wage growth, stubbornly high underemployment rate, low hours worked and high percentage of part-time to full-time workers (Chart 11). Chart 10Close Australian Government##BR##Bond 2yr/10yr Flattener Close Australian Government Bond 2yr/10yr Flattener Close Australian Government Bond 2yr/10yr Flattener Chart 11RBA Unlikely To Deliver##BR##Discounted Rate Hikes RBA Unlikely To Deliver Discounted Rate Hikes RBA Unlikely To Deliver Discounted Rate Hikes The biggest risk to our new trade would if signs of a tighter Australian labor market started to feed through into faster wage growth, which would likely coincide with faster underlying price inflation and a more hawkish turn by the RBA. New Zealand Long 5-year NZ government bonds vs. 5-year USTs (currency hedged). Long 5-year NZ government bonds vs. 5-year Germany (currency unhedged). Chart 12Stay Long 5yr NZ Government Bonds##BR##Vs. U.S, & Germany Stay Long 5yr NZ Government Bonds Vs U.S, & Germany Stay Long 5yr NZ Government Bonds Vs U.S, & Germany We entered two New Zealand (NZ) tactical bond trades on May 30th, going long 5-year government bonds vs. U.S. and Germany (Chart 12). We expected NZ spreads to tighten faster than the forwards based on our more hawkish views on the Fed and, to a lesser extent, the ECB relative to the more dovish view on the Reserve Bank of New Zealand (RBNZ). The outright bond spreads have tightened and, on a currency-hedged basis, both trades are in the money. Our dovish view on the RBNZ came from the central bank's own forecasts, which called for slowing headline inflation on the back of softer "tradeables" inflation and a sharp cooling of domestic "non-tradeables" inflation through a slowing housing market (Chart 13, bottom two panels). Our own RBNZ Monitor has been calling for the need for higher interest rates in NZ, mostly from the strength in the labor market. Yet we have been ignoring that signal, as has the market which has priced out one full expected RBNZ rate hike since the beginning of the year. With business confidence rolling over, and with the trade-weighted NZ dollar still staying at stubbornly strong levels, the case for the RBNZ to deliver even a single rate hike is not a strong one - especially given the soft inflation forecasts of the central bank. Thus, we are sticking with our tactical spread trades for NZ versus the U.S. and Germany. We are maintaining the currency hedge on the U.S. version of the trade, as we typically do for the vast majority of our cross-country spread trade recommendations. Occasionally, however, we will make an active decision to do a spread trade UN-hedged if we felt very strongly about a currency move. We did that for our NZ-Germany spread trade and this has cost us in the performance of the trade, which is down -3.4%. This is because of a surprisingly large decline in the New Zealand dollar (NZD) versus the euro since the inception of our trade. Yet a review of the technical indicators on the NZD/EUR currency cross shows that the currency pair is now very stretched versus its medium-term trend (the 40-week moving average), with price momentum also at some of the most negative levels of the past decade (Chart 14). These measures suggest that the worst of the downturn in the currency is likely over. The relative positioning on the two individual currencies is now neutral, as long positions on the NZD have been reduced (bottom panel). Chart 13RBNZ Dovishness Is Justified RBNZ Dovishness Is Justified RBNZ Dovishness Is Justified Chart 14Keep NZ/Germany Position Currency Unhedged Keep NZ/Germany Position Currency Unhedged Keep NZ/Germany Position Currency Unhedged Given these technical indicators, and from these current levels, we see greater upside potential for NZD/EUR in the months ahead. This leads us to maintain our unhedged currency position on the NZ-Germany spread trade so as not to realize the current mark-to-market losses on the trade. Sweden Pay 18-month Sweden Overnight Index Swap (OIS) rate (TAKE PROFITS). We entered into a bearish Swedish rates position back on November 22nd, 2016, paying Sweden 18-month Overnight Index swap rates (Chart 15). At the time, we expected the Riksbank to begin hiking interest rates earlier than what was priced in the markets IF inflation reached the central bank target faster due to a weaker Swedish krona. We also believed that the economy would continue to expand at a robust pace when the economy had no spare capacity, creating additional upside inflation surprises. According to the Riksbank's latest Monetary Policy Statement (MPS), the central bank will likely keep the repo rate at -0.5% until mid-2018, while continuing its asset purchase program until the end of this year - even with an overheating economy. This is because realized inflation has remained below the Riksbank target for a long period of time and, although current inflation is above target, it was not necessary to immediately tighten conditions. More likely, the Riskbank is worried about the potential for the krona to appreciate - especially versus the euro - if rate hikes are delivered. It will only be a matter of time before the central bank is forced to tighten policy with the economy likely to strengthen further, led by solid domestic demand, strong productivity growth, and improving exports. Consumption is also expected to increase as households have scope to cut back their high level of savings. Combining the Riksbank's easing policy with the current strength of the economy and the tightness of the labor market, inflation is very likely to return to the 2% target in the next year or two (Chart 16). Chart 15Close Sweden OIS Trade Close Sweden OIS Trade Close Sweden OIS Trade Chart 16Riksbank More Worried About SEK Than Inflation Riksbank More Worried About SEK Than Inflation Riksbank More Worried About SEK Than Inflation However, if the Riskbank remains too concerned about the currency versus the euro, as we suspect, then this will prevent any shift to a more hawkish stance before any change from the ECB. That is unlikely to happen over the next year, at least, even if the ECB slows the pace of asset purchases as we expect. Thus, we are closing out our Sweden 18-month Overnight Index Swap position at a small profit of 12bps. We have already kept this trade for longer than the typical investment horizon for one of our tactical overlay trades. We will investigate the potential for more profitable trade opportunities in the Swedish fixed income markets in a future report. Korea Long a 2-year/10-year Korean government bond yield curve steepener (HOLD). We recommended entering into a 2-year/10-year steepening trade in the Korean government bond yield curve on May 30th, 2017. Since then, the yield curve has flattened by 7bps, which was mainly caused by an unexpected rise in the 2-year yield, rather than a decline in 10-year yield (Chart 17). Korea is currently enjoying a solid business cycle upturn. Leading economic indicators are rising, the year-over-year growth in exports has risen to a 7-year high and previously sluggish private consumption has also rebounded recently. The Bank of Korea (BoK) is of the view that the recovery will continue and consumer price inflation will stabilize at the target level over the medium-term. This recovery should cause the 2/10 curve to steepen as longer-term inflation expectations rise. Based on South Korean President Moon's aggressive fiscal plans to increase welfare spending and create jobs in the public sector, at a time when the economy is good shape, we still believe that long-end of the curve (10-year) will rise. In addition, as shown in Chart 18, the 26-week rolling beta of changes in the 10-year UST yield and Korean 10-year bond is very high, nearly 1. Given our bearish view on USTs, this implies Korean yields can follow suit. On the other hand, the correlation between the 2-year UST yield and equivalent maturity Korean yields is much lower (4th panel), as Korean rate expectations have not been following those of the U.S. higher - even with a stronger Korean economy. Most likely, this is due to investors downplaying the potential for the BoK to match Fed rate hikes tick-for-tick given the heightened tensions between the U.S. and North Korea. Chart 17Stay In Korea 2yr/10yr##BR##Government Bond Steepener Stay In Korea 2yr/10yr Government Bond Steepener Stay In Korea 2yr/10yr Government Bond Steepener Chart 18Long-Term Korean##BR##Yields Are Too Low Long-Term Korean Yields Are Too Low Long-Term Korean Yields Are Too Low We still believe the Korean curve can steepen as longer-term yields rise, although we will be monitoring the behavior of shorter-dated Korean yield as the situation between D.C. and Pyongyang evolves. If investors begin to demand a higher risk premium on Korean assets, particularly the Korean won, then 2-year Korean yields may rise much faster and our curve trade may not go our way. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Updating Our Tactical Overlay Trades Updating Our Tactical Overlay Trades Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Most Leading Economic Indicators Remain Upbeat Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated Global Growth Has Accelerated Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Productivity Growth Has Slowed Across The Globe Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Who Will The Next Fed Chair Be? Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run This Business Cycle Has Further To Run This Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run This Business Cycle Has Further To Run This Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Global Capex On The Upswing Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chinese H-Shares: A Valuation Snapshot Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Favor Cyclicals And Value Plays Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs U.S. Profit Margins Are Close To All-Time Highs U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 24Market Outlook: Equities Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Our Central Bank Monitors Point To Growing Pressures To Tighten Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth Canada Enjoys Robust Growth Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing U.K. Growth Is Slowing U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy There Is Still Slack In The Australian Economy There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators New Zealand: Upbeat Indicators New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Japan: Fading Deflationary Forces Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed High-Yield Spreads Have Narrowed High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate U.S. Corporate Health Continues To Deteriorate U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 35Market Outlook: Commodities Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Euro: Long Positions Are Getting Stretched Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads The Euro Has Overshot Interest Rate Spreads The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions U.S. Versus Euro Area Diverging Financial Conditions U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Credit To Real Economy And Profit Rebound Bode Well For Capex Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Positive Global Trade Momentum: A Tailwind For Chinese Exports Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued The Chinese Yuan Is Undervalued The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Gold: Waiting For Drivers Of Sustained Price Appreciation Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades