New Zealand

Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment The U.S. Dwindling Manufacturing Employment The U.S. Dwindling Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses ...And Households Support Domestic Businesses ...And Households Support Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 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 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 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 continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 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 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Theme 1 - Returning U.S. Animal Spirits: I Want To Break Free Animal spirits are making a comeback in the U.S. The catalyst for this development is the hope that a Trump administration will alleviate the regulatory burden that has been a source of worry for corporate America (Chart I-1). Feeding this impression has been Trump's anti-regulation rhetoric. His deal-maker, take-no-prisoners persona, along with a cabinet packed with businessmen and corporate scions further solidifies this perception. However, Trump's electoral victory was only the match igniting the fuel. The conditions for a resurgence of animal spirits were already in place. Animal spirits are only a Keynesian metaphor for confidence. From late 2014 to 2016, a 16% contraction in profits weighed on business confidence. However, pre-tax profits have bottomed and are set to continue their acceleration (Chart I-2). Chart I-1Hurdle To Animal Spirits bca.fes_sr_2016_12_16_s1_c1 bca.fes_sr_2016_12_16_s1_c1 Chart I-2A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing Since profits have bottomed, business capex intentions have picked up steam. As Chart I-3 illustrates, this development not only tends to presage a rise in business investments, it also is a leading indicator of economic activity at large. This rise in capex intentions is not only a reflection of an ebbing contraction in profits. It also indicates that many companies are starting to worry about hitting their capacity constraints if final demand firms up. After having added to their real capital stocks at the slowest pace in decades, U.S. firms are now facing rising sales, a situation that creates a bottleneck (Chart I-4). Chart I-3CAPEX Intentions And Growth bca.fes_sr_2016_12_16_s1_c3 bca.fes_sr_2016_12_16_s1_c3 Chart I-4Improving Sales Outlook ##br##Meets Supply Constraint bca.fes_sr_2016_12_16_s1_c4 bca.fes_sr_2016_12_16_s1_c4 Moreover, the labor market is tightening. All the signs are there: at 4.6%, U.S. unemployment is in line with its long-term equilibrium; the number of individuals outside of the labor force is in line with the 1999 to 2007 period, an era where hidden labor-market slack was inexistent; and the difficulty for small businesses to find qualified labor is growing (Chart I-5). As is the case today, companies are not concerned by a lack of demand, but by the quality of labor - a combination pointing to decreasing slack - wage growth tends to accelerate. Coincidentally, this is also an environment in which companies increase their allocation to corporate investments (Chart I-6). A few factors explain why companies are more willing to invest when slack narrows and wages grow. Obviously, rising labor costs incentivize businesses to skew their production function toward capital instead of labor. Additionally, rising wages support household consumption. Capex is a form of derived demand. A stronger household sector leads to more perceived certainty regarding the robustness of the expected final demand faced by corporations. Thus, when the share of wages and salaries in the national income grows, so do investments (Chart I-7). Chart I-5The Labor Market Is Tight The Labor Market Is Tight The Labor Market Is Tight Chart I-6When Demand Is Solid And Labor Is Tight... bca.fes_sr_2016_12_16_s1_c6 bca.fes_sr_2016_12_16_s1_c6 Chart I-7Animal Spirits At Work bca.fes_sr_2016_12_16_s1_c7 bca.fes_sr_2016_12_16_s1_c7 This means that while we had already expected the consumer to be a key engine of growth next year, we expect the corporate sector to join the fray.1 To us, this combination represents the main reason to expect our Combined Capacity Utilization Gauge to move into "no slack" territory, an environment where the Fed can hike rates durably. Bottom Line: U.S. animal spirits are breaking free. Trump is the catalyst, but conditions for improving business confidence and higher capex have been in place for a period of time. Profits have troughed, capex intentions are on the rise, and capacity constraints are being hit. This will give the Fed plenty of ammo to increase rates in 2017 and 2018. Theme 2 - Monetary Divergences: Pretty Tied Up Monetary policy divergences will continue to be one of the running themes for 2017. As we have argued, the Fed is in a better position to increase interest rates. However, the European Central Bank and the Bank of Japan are firmly pressing on the gas pedal. Last week, the ECB unveiled a new leg to its asset purchase program. True, bond buying will decrease from EUR 80 billion to EUR 60 billion starting April 2017, but the program is now open-ended. Also, the ECB can now buy securities with a maturity of 1-year, as well as securities yielding less than the deposit facility rates. This gives the ECB more flexibility to increase its purchases if need be to placate any potential economic shock in the future. Most crucially, the ECB does not regard its 2019 inflation forecast of 1.7% as in line with its target. Draghi has stressed that this requires the ECB to persist in maintaining its monetary accommodation. This makes sense. While the European economy has surprised to the upside, the recent roll-over in core CPI highlights the continued deflationary forces in the euro area (Chart I-8). These deflationary forces are present because the European output gap remains wide at around 4% of potential GDP.2 While the OECD pegs the Eurozone's natural rate of unemployment at 9%, it is probably lower. Despite a 2.3-percentage-point fall in the Eurozone's unemployment to 9.8% since 2013, euro area wages continue to decelerate, in sharp contrast with the U.S. situation (Chart I-9). This portends to excess capacity in the European labor market. It also limits European household income growth, which has lagged the U.S. by 14% since 2003. (Chart I-9, bottom panel). As a result, European consumption should continue lagging the U.S. Chart I-8Europe's Deflation Problem bca.fes_sr_2016_12_16_s1_c8 bca.fes_sr_2016_12_16_s1_c8 Chart I-9Signs Of Slack In Europe Signs Of Slack In Europe Signs Of Slack In Europe Additionally, European domestic demand has been supported by a rise in the credit impulse - the change in credit flows (Chart I-10). Between 2011 and 2014, to meet the EBA stress test and Basel III criteria, European banks raised capital and limited asset growth, boosting their capital ratios from 7.1% to more than 11% today. Once this adjustment was over, European banks normalized credit flows, boosting the credit impulse. This process is behind us. To keep the credit impulse in positive territory, credit flows would have to keep on expanding, implying that the stock of credit would have to grow at an ever-accelerating pace. However, the poor performance of European bank equities suggests that credit growth will slow (Chart I-11). While this may be too pessimistic a forecast, it is now unlikely that credit growth will accelerate. As a result, the credit impulse will roll over, hurting domestic demand and keeping deflationary pressures in place. Chart I-10Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Chart I-11Another Dark Omen Another Dark Omen Another Dark Omen This should translate into a very easy monetary policy in Europe for 2017 and most likely 2018. European rates, both at the short- and long-end of the curve will not rise as much as U.S. rates. In Japan, economic slack has dissipated and the labor market is at full employment (Chart I-12). The unemployment rate stands at 3% and the job-openings-to-applicants ratio sits at 1991 levels. What has prevented the Japanese output gap from moving into positive territory has been fiscal belt-tightening. Between 2011 and today, the Japanese cyclically-adjusted deficit has fallen from 7.5% to 4.5% of GDP, inflicting a large drag on growth. Going forward, we expect Japan's GDP to actually move above trend. Based on the IMF's forecast, fiscal austerity is behind us, suggesting that the force that has hampered growth is now being lifted. This is a conservative assessment. Abe has sounded increasingly willing to expand the government's deficit following his July upper-house election victory. Japanese military spending should be a key source of stimulus. In 2004, Japan and China both spent US$50 billion in that arena. Today, Japanese defense spending is unchanged but China's has grown to US$200 billion (Chart I-13). Therefore, Japan is ever more exposed to an increasingly assertive China in the region. Moreover, a potential rapprochement between the U.S. and Russia - a country formally still at war with Japan - also increases the need for a more self-sufficient Japanese defense strategy. Chart I-12Little Slack In Japan bca.fes_sr_2016_12_16_s1_c12 bca.fes_sr_2016_12_16_s1_c12 Chart I-13A Catch Up Is Needed bca.fes_sr_2016_12_16_s1_c13 bca.fes_sr_2016_12_16_s1_c13 Outside of the fiscal realm, there is cause for tempered optimism regarding Japan. Payroll growth remains strong despite full employment, pointing toward potentially higher wages. Also, the Business Activity Index, machinery orders, and the shipments-to-inventory ratio are all firming. Encapsulating these forces, our model forecasts further improvement in industrial production (Chart I-14). While these would point toward a monetary tightening, such is not the case in Japan. The Japanese central bank has committed to let inflation significantly overshoot before removing any accommodation. Hence, as growth improves, inflation expectations can rise, dampening real rates, depressing the yen, and further supporting growth (Chart I-15). This new BoJ policy is a game changer. Chart I-14Some Glimmer Of Hope bca.fes_sr_2016_12_16_s1_c14 bca.fes_sr_2016_12_16_s1_c14 Chart I-15The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ Moreover, this policy becomes supercharged when global bond yields rise, a central view for BCA's U.S. Bond Strategy service in 2017.3 Due to their low beta, JGB yields tend to not rise as much as global yields in a bond selloff. With the BoJ targeting near-zero rates at the long-end of the curve, JGB yields have even less upside. Rising global bond yields result in even-wider-than-before global-Japan rate differentials, which hurts the yen. This will stimulate Japanese growth even further, additionally easing monetary policy. Bottom Line: While the U.S. is on the path toward tighter policy, the ECB and the BoJ, by design, are loosening their policy. In Europe, the economy continues to suffer from underlying deflationary forces, forcing the ECB to stand pat for now. In Japan, the BoJ has elected to let inflation overshoot significantly even as the economy strengthens. This is putting downward pressure on Japanese real rates, a de facto further easing of monetary policy. Theme 3 - China And EM Slow-Down: Livin' On A Prayer After a year of respite, in 2017, emerging markets and China will once again be a source of deflationary shocks for the global economy. EM as a whole remains in a structurally precarious position. Since 2008, EM economies have accumulated too much debt and built too much capacity (Chart I-16). Most worrying has been the pace of debt accumulation. In the past five years, debt-to-GDP has risen by 51 percentage points to 146% of GDP. The debt has been backed up with new investments, but such a quick pace of asset accumulation raises the prospects of capital misallocation. When a large economic block like EM spends more than 25% of its GDP for 13 years on investment, the likelihood that many poor investments have been made is high. EM economies show all the hallmarks that capital has been miss-allocated, threatening future debt-servicing capacity. Labor productivity growth has collapsed from 3.5% to 1.5%, despite rising capital-to-labor ratios, while return on equity has collapsed despite surging leverage ratios, a sure sign of falling return on capital (Chart I-17). Chart I-16EM Structural Handicaps EM Structural Handicaps EM Structural Handicaps Chart I-17Symptoms Of A Malaise bca.fes_sr_2016_12_16_s1_c17 bca.fes_sr_2016_12_16_s1_c17 With this backdrop in mind, what happened in 2016 is key to understanding potential 2017 developments. Excess debt and excess capacity are deflationary anchors that raise the vulnerability of EM to shocks, both positive and negative. In 2016, the shock was positive. In the second half of 2015 and early 2016, China engaged in large scale fiscal stimulus (Chart I-18). Government spending grew and US$1.2 trillion of public-private infrastructure projects were rolled out in a mere six months. This lifted Chinese imports from their funk, used up some of the EM's excess capacity, dampened EM deflationary forces, and raised EM return on capital for a period. Additionally, faced with volatile markets, Western central banks eased monetary policy. The ECB and BoJ cut rates, and the Fed backed away from its hawkish rhetoric. The resultant falls in DM real rates and the dollar boosted commodity prices, further dampening EM deflationary forces and boosting EM profitability. Capital flows into EM ensued, easing financial conditions there and brightening the economic outlook (Chart I-19). Chart I-18China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad Chart I-19EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating This process is moving into reverse, the positive shock is morphing into a negative one. The structural handicaps plaguing EM have only marginally improved. Precisely because the Chinese industrial sector has regained composure, the already-fading Chinese stimulus will fully move into reverse (Chart I-20). With credit appetite remaining low and interbank rates already rising as the PBoC slows liquidity injections, the Chinese economy should soon rollover. Moreover, the dollar and global real rates are on the rise. Paradoxically, the return of U.S. animal spirits could endanger the EM recovery. As Chart I-21 shows, an upturn in DM leading economic indicators presages a fall EM LEIs. This simply reflects relative liquidity and financials conditions. Chart I-20China: As Good As It Gets China: As Good As It Gets China: As Good As It Gets Chart I-21DM Hurting EM DM Hurting EM DM Hurting EM Strong advanced economies, especially the U.S., lifts DM real rates and the dollar. This process sucks liquidity away from EM and tightens their financial conditions exogenously (Chart I-22). This hurts EM risk assets, currencies, and their economies. Moreover, since trade with the U.S. and other DM economies only account for 15% and 13% of EM exports, respectively, a fall in EM currencies does little to boost growth there. The fall in EM growth to be seen in 2017 will lay bare their structural weaknesses. As a result, EM assets are likely to suffer considerable downside. EM economies will limit the rise in global inflation by exerting downward pressures on globally traded goods prices as well as many commodities. Moreover, with Europe and Japan more exposed to EM growth than the U.S. (Chart I-23), EM weaknesses would further contribute to monetary divergences between the Fed and the ECB/BoJ. Chart I-22Rising DM Rates Equal Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Chart I-23U.S. Is The Least Sensitive To EM Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Bottom Line: 2016 was a great year for EM plays as Chinese fiscal stimulus and easier-than-anticipated DM policy contributed to large inflows of liquidity into EM assets, supporting EM economies in the process. However, as Chinese fiscal stimulus moves into reverse and as DM rates and the dollar are set to continue rising, liquidity and financial conditions in EM will once again deteriorate. Theme 4 - Oil Vs. Metals: Good Times Bad Times From the previous three themes, a logical conclusion would be to aggressively short commodities. After all, a strong dollar, rising rates, and weak EM are a poisonous cocktail for natural resources. However, the picture is more nuanced. In the early 1980s, from 1999 to 2001, and in 2005, commodity prices did rise along with the dollar (Chart I-24). In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan's and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar. In both the 1999-to-2001 and 2005 episodes, the share of U.S. and Japanese commodity consumption had already fallen. Most crucially, in both episodes, the rise in overall commodity price indexes only reflected strong energy prices. Outside of this complex, natural resource prices were lackluster (Chart I-25). Chart I-24Commodities And ##br##The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Chart I-25When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally In these two instances, oil prices were able to escape the gravitational pull of a strong dollar because of supply disruptions. In 1999, following an agreement to reduce oil production by OPEC and non-OPEC states, output fell by around 4 million barrels per day, causing the market to re-equilibrate itself. In 2005, as EM growth was already creating a supportive demand backdrop, a devastating hurricane season in the Gulf of Mexico curtailed global production by around 1 million bbl/day. Today, the situation is a hybrid of 1999 and 2005. While EM economies are in a much weaker position than in 2005, the U.S. economy is gathering strength. Hence, close to 50% of global oil consumption - U.S. and DM oil demand - will stay firm (Chart I-26). But, most vitally, the supply picture once again dominates. Not only did OPEC agree to a deal to curtail production by 1.2 million bbl/day, but Russia agreed to share the burden, cutting its own output by 300 thousand bbl/day. Shortly after this agreement was reached, Saudi Arabia threw in an olive branch by pledging to further cut its production if necessary to reduce global oil inventories. This means that the oil market will firmly be in deficit in 2017 (Chart I-26, bottom panel). Our Commodity & Energy Service, which forecasted the OPEC move, believes WTI oil prices could occasionally peak toward US$65 /bbl in 2017.4 The picture for metals is more complex. The output of iron and copper continues to grow. On the demand side of the ledger, the U.S. only contributes 4% and 8% of global demand for each metal, respectively. Thus even if Trump were able to implement a large infrastructure program in 2017 - a big if for next year - the effect on global demand would be low. Instead, what matters for metal demand is the outlook for EM in general and China in particular (Chart I-27). On this front, our negative take on China and EM is a big hurdle for metals to overcome. Chart I-26Supportive Oil Back Drop Supportive Oil Back Drop Supportive Oil Back Drop Chart I-27Metals Are About China, Not The U.S. Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Yet, all is not dark. Metal and oil prices have historically been co-integrated. In fact, during the previous episodes where oil strengthened as the dollar rallied, metals have more or less been flat. This pattern is likely to repeat itself, especially if as we expect, EM experience a growth slowdown and not an outright recession. Altogether, expectations of strong oil prices and flat metal prices suggest that any EM slowdown should be more discriminating than in 2015 and early 2016. Countries like Russia and Colombia should fare better than Brazil or Peru. This reality is also true for DM economies. Canada and Norway are likely to outperform Australia. Bottom Line: Despite a bullish view on the dollar and a negative EM outlook, overall commodity indices are likely to rise in 2017. This move will mostly reflect a rally in oil - the benchmark heavyweight - a market where supply is being voluntarily constrained. The performance of metals is likely to be much more tepid, with prices mostly moving sideways next year. Theme 5 - Dirigisme: Sympathy For The Devil In 2017, a new word will need to enter the lexicon of investors: dirigisme. This was the economic policy of France after the Second World War. Dirigisme does not disavow the key support systems of capitalism: the rule of law, private property, the sacrosanct nature of contracts, or representative governments. Instead, dirigisme is a system of free enterprise where, to a certain degree, the state directs the economy, setting broad guidelines for what is admissible from the corporate sector. Donald Trump fully fits this mold. He wants business to be conducted a certain way and will try his hardest to ensure this will be the case. What will be the path chosen by Trump? Globalization and laissez-faire capitalism have been great friends of corporate profit margins and the richest echelons of U.S. society (Chart I-28). While it has also greatly benefited the EM middle class, the biggest losers under this regime have been the middle class in advanced economies (Chart I-29). As long as U.S. consumers had access to easy credit, the pain of stagnating incomes was easily alleviated. Without easy credit the pain of globalization became more evident. Chart I-28The (Really) Rich Got Richer Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Chart I-29Globalization: No Friend To DM Middle Class Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Trump has courted the disaffected middle class. While he is likely to cut regulation, he will also put in place potentially erratic policies that may destabilize markets. The key will be for investors to appreciate his ultimate goal: to boost, even if only temporarily, the income of the American middle class. As such, his bullying of Carrier - the U.S. air-conditioner manufacturer that wanted to shift production to Mexico - is only the opening salvo. Tax policy is likely to move in this direction. A proposed tax reform that would cut tax for exporters or companies moving production back to the U.S. towards 0 - that's zero - and punish importers is already in the pipeline. The implications of such policies on U.S. employment are unclear. While U.S. businesses may repatriate production, they may do so while minimizing the labor component of their operations and maximizing the capital component in their production function. In any case, more production at home will support the domestic economy for a time period. However, the global impact is clearer. These policies are likely to be deflationary for the global economy outside the United States. A switch away from production outside of U.S. jurisdiction will raise non-U.S. output gaps. This should weigh on global wages and globally traded goods prices. Additionally, this deflationary impact will cause global monetary policy to remain easy relative to the U.S., particularly hurting the currencies of nations most exposed to global trade. Compounding this effect, nations that currently export heavily to the U.S. - which will lose competitiveness due to tax policy shifts and/or potential tariffs - are likely to let their currencies fall to regain their lost competitiveness. The currencies of Asian nations, countries that have benefited the most from globalization, are likely to get hit the hardest (Chart I-30). Chart I-30Former Winners Become Losers Under Trump's Dirigisme Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Moreover, along with a shift toward dirigisme, the U.S.'s geopolitical stance could harden further, a troubling prospect in an increasingly multipolar world. Tensions in East Asia are likely to become a recurrent theme over the next few years. Ultimately, the rise of dirigisme means two things: First, the influence of politics over markets and economic developments will continue to grow. Economics is moving closer to its ancestor: political-economy. Second, while Trump's dirigisme can be understood as a vehicle to implement his populist, pro-middle class policies, they will add an extra dose of uncertainty to the global economy. Volatility is likely to be on a structural upswing. Interestingly, the risk of rising dirigisme is more pronounced in the U.S. and the U.K. than in continental Europe. Not only are economic outcomes more evenly distributed among the general population in the euro area, recent elections in Spain or Austria have seen centrist parties beat the populists. While Italy still represents a risk on this front, the likelihood of a victory by the right-wing Thatcherite reformist Francois Fillon for the French presidential election in May is very high.Germany will remain controlled by a grand coalition after its own 2017 elections.5 Bottom Line: The U.S. economy is moving toward a more state-led model as Trump aims to redress the plight of the U.S. middle class. These policies are likely to prove deflationary for the global economy outside of the U.S. and could support the U.S. dollar over the next 12-18 months. On a longer-term basis, the legacy of this development will be to lift economic and financial market volatility. Theme 6 - Inflation: It's A Long Way To The Top Our final theme for the upcoming year is that the inflationary outcome of a Trump presidency will take time to emerge and inflation is unlikely to become a big risk in 2017. Much ink has been spilled predicting that Trump's promises to inject fiscal stimulus exactly when the economy hits full employment will be a harbinger of elevated inflation. After all, this is exactly the kind of policies put in place in the late 1960s. Back then, due to the Great Society program and the deepening U.S. involvement in the Vietnam War, President Johnson increased fiscal stimulus when the output gap was in positive territory. Inflation ensued. This parallel is misleading. True, in the long-term, Trump's fiscal stimulus and dirigisme bent could have stagflationary consequences. However, it could take a few years before the dreaded stagflation emerges. To begin with, the structure of the labor market has changed. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart I-31). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. Likewise, cost-of-living-adjustment clauses have vanished from U.S. labor contracts. Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Additionally, today, capacity utilization - a series that remains well correlated with secular inflation trend - remains much lower than in the 1960s and 1970s (Chart I-32). This means that one of the key ingredients to generate a sharp tick up in inflation is still missing. Chart I-31Labor: From Giant To Midget Labor: From Giant To Midget Labor: From Giant To Midget Chart I-32Capacity Utilization: Not Johnson Nor Nixon bca.fes_sr_2016_12_16_s1_c32 bca.fes_sr_2016_12_16_s1_c32 Chart I-33Today's Slack Is Not Where It Once Was bca.fes_sr_2016_12_16_s1_c33 bca.fes_sr_2016_12_16_s1_c33 Also, when looking at the output gap, the 1960s and 1970s once again paint a markedly different picture versus the present. Today, we are only in the process of closing the output and unemployment gaps. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966. Unemployment had been below its equilibrium rate since 1963, and by 1968 it was 2.5% below NAIRU (Chart I-33). Together the aforementioned factors suggest that inflation should remain quite benign in 2017. We probably still have a significant amount of time before raising the stagflationary alarm bells. Finally, the Fed currently seems relatively unwilling to stay behind the curve for a prolonged period and let inflation significantly overshoot its target. Wednesday, the Fed surprised markets by forecasting three rate hikes in 2017, resulting in a much more hawkish communique than was anticipated. Therefore, the FOMC's tolerance for a "high pressure" economy now seems much more limited than was assumed by markets not long ago. This further limits the inflationary potential of Trump's stimulus. Instead, it highlights the dollar-bullish nature of the current economic environment. Bottom Line: Trump fiscal stimulus at full employment evokes the inflationary policies of the late 1960s and early 1970s. However, back then it took years of economic overutilization before inflation reared its ugly head. Additionally, the structure of the labor market was much friendlier to inflation back then than it is today. Thus, while Trump's policy may raise inflation in the long term, it will take a prolonged period of time before such effects become evident. Instead, in 2017, inflation should remain well contained, especially as the Fed seems unwilling to remain significantly behind the curve. Investment Implications USD The U.S. dollar is in the midst of a powerful bull market. While the USD is already 10% overvalued, the greenback has historically hit its cyclical zenith when it traded with more than a 20% premium to its long-term fair value. This time should be no exception. Beyond our positive view on households, resurging animal spirits are beginning to support the economy. This combination is likely to prompt the Fed to move toward a more aggressive stance than was expected a few months ago (Chart I-34). With monetary divergences fully alive and backed up by economic fundamentals, interest-rate spreads between the U.S. and the rest of the G10 will only grow wider. Factors like a move toward dirigisme and an absence of blow-out inflation will only feed these trends. Chart I-34Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Tactically, the dollar is overbought, but clearly momentum has taken over. There is so much uncertainty floating in terms of economic and policy outcomes that evaluating the fair-value path for interest rates and the dollar is an even trickier exercise than normal for investors. This lack of clarity tends to be a fertile ground for momentum trading. Investors are likely to continue to chase the Fed. This process could last until market pricing for 2017 has overshot the Fed's own prognostications. Chart I-35EUR/USD: Technical Picture EUR/USD: Technical Picture EUR/USD: Technical Picture EUR At this point in time, the euro suffers from two flaws. First, as the anti-dollar, shorting the euro is a liquid way to chase the dollar's strength. Second, monetary divergences are currently in full swing between the ECB and the Fed: the U.S. central bank just increased interest rates and upgraded its rate forecast for 2017; meanwhile, the ECB just eased policy by increasing the total size of its asset purchase program. Investors are in the process of pricing these two trends and EUR/USD has broken down as a result (Chart I-35). The recent breakdown could bring EUR/USD to parity before finding a temporary floor. That being said, a EUR/USD ultimate bottom could still trade substantially below these levels. The U.S. economy is slowly escaping secular stagnation while Europe remains mired in its embrace. The euro is likely to end up playing the role of the growth redistributor between the two. JPY The Bank of Japan has received the gift it wanted. Global bond yields and oil prices are rising. This process is supercharging the potency of its new set of policies. Higher oil prices contribute to lifting inflation expectations, and rising global rates are widening interest-rate differentials between the world and Japan. With the BoJ standing as a guarantor of low Japanese yields, real-rate differentials are surging in favor of USD/JPY. USD/JPY has broken above its 100-week moving average, historically a confirming signal that the bull market has more leg. Additionally, as Chart I-36 shows, USD/JPY is a function of global GDP growth. By virtue of its size, accelerating economic activity in the U.S. will lift average global growth, further hurting the yen. Tactically, USD/JPY is massively overbought but may still move toward 120 before taking a significant pause in its ascent. We were stopped out of our short USD/JPY position. Before re-opening this position, we would want to see a roll-over in momentum as currently, the trend is too strong to stand against. GBP While political developments remain the key immediate driver of the pound, GBP is weathering the dollar's strength better than most other currencies. This is a testament to its incredible cheapness (Chart I-37), suggesting that many negatives have been priced into sterling. Chart I-36USD/JPY: A Play On Global Growth bca.fes_sr_2016_12_16_s1_c36 bca.fes_sr_2016_12_16_s1_c36 Chart I-37Basement-Bargain Pound bca.fes_sr_2016_12_16_s1_c37 bca.fes_sr_2016_12_16_s1_c37 For the first half of 2017, the pound will be victim to the beginning of the Brexit negotiations between the EU and the U.K. The EU has an incentive to play hardball, which could weigh on the pound. In aggregate, while the short-term outlook for the pound remains clouded in much uncertainty, the pounds valuations make it an attractive long-term buy against both the USD and EUR. Chart I-38CAD: More Rates Than Oil bca.fes_sr_2016_12_16_s1_c38 bca.fes_sr_2016_12_16_s1_c38 CAD The Bank of Canada will find it very difficult to increase rates in 2017 or to communicate a rate hike for 2018. The Canadian economy remains mired with excess capacity, massive private-sector debt loads, and a disappointing export performance. This suggests that rate differentials between the U.S. and Canada will continue to point toward a higher USD/CAD (Chart I-38). On the more positive front, our upbeat view on the oil market will dampen some of the negatives affecting the Canadian dollar. Most specifically, with our less positive view on metals, shorting AUD/CAD is still a clean way to express theme 4. AUD & NZD While recent Australian employment numbers have been positive, the tight link between the Australian economy and Asia as well as metals will continue to represent hurdles for the AUD. In fact, the AUD is very affected by theme 3, theme 4, and theme 5. If a move towards dirigisme is a problem for Asia and Asian currencies, the historical link between the latter and the AUD represents a great cyclical risk for the Aussie (Chart I-39). Tactically, the outlook is also murky. A pullback in the USD would be a marginal positive for the AUD. However, if the USD does correct, we have to remember what would be the context: it would be because the recent tightening in U.S. financial conditions is hurting growth prospects, which is not a great outlook for the AUD. Thus, we prefer shorting the AUD on its crosses. We are already short AUD/CAD and tried to go long EUR/AUD. We may revisit this trade in coming weeks. Finally, we have a negative bias against AUD/NZD, reflecting New Zealand's absence of exposure to metals - the commodity group most exposed to EM liquidity conditions, as well as the outperformance of the kiwi economy relative to Australia (Chart I-40). However, on a tactical basis, AUD/NZD is beginning to form a reverse head-and-shoulder pattern supported by rising momentum. Buying this cross as a short-term, uncorrelated bet could be interesting. Chart I-39Dirigisme Is A Problem For The Aussie bca.fes_sr_2016_12_16_s1_c39 bca.fes_sr_2016_12_16_s1_c39 Chart I-40New Zealand Is Perkier Than Australia bca.fes_sr_2016_12_16_s1_c40 bca.fes_sr_2016_12_16_s1_c40 NOK & SEK The NOK is potentially the most attractive European currency right now. It is supported by solid valuations, a current account surplus of 5% of GDP and a net international investment position of nearly 200% of GDP. Moreover, Norwegian core inflation stands at 3.3%, which limits any dovish bias from the Norges Bank. Additionally, NOK is exposed to oil prices, making it a play on theme 4. We like to express our positive stance on the NOK by buying it against the EUR or the SEK. The SEK is more complex. It too is cheap and underpinned by a positive current account surplus. Moreover, the inflation weaknesses that have kept the Riksbank on a super dovish bias mostly reflected lower energy prices, a passing phenomenon. However, being a small open economy heavily geared to the global manufacturing cycle, Sweden is very exposed to a pullback from globalization, limiting the attractiveness of the krona. Moreover, the krona is extremely sensitive to the USD. CHF The SNB is keeping its unofficial floor under EUR/CHF in place. Therefore, USD/CHF will continue to be a direct mirror image of EUR/USD. On a longer-term basis, Switzerland net international investment position of 120% of GDP and its current-account surplus of 11% of GDP will continue to lift its fair value (Chart I-41). Hence, once the SNB breaks the floor and lets CHF float - an event we expect to materialize once Swiss inflation and wages move back toward 1% - the CHF could appreciate violently, especially against the euro. Chart I-41The Swiss Balance Of Payment Position Will Support CHF bca.fes_sr_2016_12_16_s1_c41 bca.fes_sr_2016_12_16_s1_c41 Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the consumer and the dollar, please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy", dated December 8, 2016, available at ces.bcaresearch.com. 5 For a more detailed discussion of dirigisme, multipolarity, and rising tensions in East Asia, please see Geopolitical Strategy Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1 bca.fes_sr_2016_12_16_s2_c1 bca.fes_sr_2016_12_16_s2_c1 Chart II-2 bca.fes_sr_2016_12_16_s2_c2 bca.fes_sr_2016_12_16_s2_c2 The Fed hiked rates to 0.75% as expected. The dollar began to rally soon after the updated dot-plot suggested a faster pace of tightening than previously expected. Data from Thursday morning displayed a strengthening labor market, with expectations consistently beaten: Initial Jobless Claims came in at 254 thousand, beating expectations of 255 thousand. Continuing Jobless Claims were recorded at 2.018 million, outperforming by 7 thousand. Additionally, the NY Empire State Manufacturing Index also outperformed expectations of 4, coming in at 9. These figures provided an additional lift to the dollar with the DXY nearing the 103 mark. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 The Euro Chart II-3 bca.fes_sr_2016_12_16_s2_c3 bca.fes_sr_2016_12_16_s2_c3 Chart II-4 bca.fes_sr_2016_12_16_s2_c4 bca.fes_sr_2016_12_16_s2_c4 The Euro Area's data releases seem to be a mixed bag. Industrial production failed to meet expectations, and even contracted 0.1% on a monthly basis. The Markit Composite PMI remained steady at 53.9, and was in line with expectations, while the Services PMI fell and underperformed expectations, whereas the Manufacturing PMI rose and beat expectations. The increase in the dollar has also forced down Euro, where it has broken the crucial support level of around 1.055, and traded as low as 1.04. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5 bca.fes_sr_2016_12_16_s2_c5 bca.fes_sr_2016_12_16_s2_c5 Chart II-6 JPY Technicals 2 JPY Technicals 2 Despite the recent collapse in the Yen, Japan continues to be plagued by strong deflationary pressures. The BoJ will have no choice but to continue to implement radical monetary measures and thus the yen will continue to fall as some of the data lacks vigor: The decline in machinery orders accelerated to 5.6% YoY, underperforming expectations. Japanese industrial production is also contracting, at a pace of 1.4%. Particularly, most measures in the Tankan Survey (for both manufacturers and non-manufacturers) also underperformed expectations. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 British Pound Chart II-7 bca.fes_sr_2016_12_16_s2_c7 bca.fes_sr_2016_12_16_s2_c7 Chart II-8 bca.fes_sr_2016_12_16_s2_c8 bca.fes_sr_2016_12_16_s2_c8 Both the BoE and the market continue to be very bearish on the U.K. economy, causing the pound to be very cheap. However, the cable has remained resilient amid the recent dollar surge, in part because U.K. data, as we have mentioned many times, keeps outperforming expectations. The recent set of data confirms this view: Retail sales ex-fuel grew by 6.6% YoY, beating expectations of 6.1% YoY growth. Average earnings (both including and excluding bonus) also outperformed. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9 bca.fes_sr_2016_12_16_s2_c9 bca.fes_sr_2016_12_16_s2_c9 Chart II-10 bca.fes_sr_2016_12_16_s2_c10 bca.fes_sr_2016_12_16_s2_c10 Australian new motor vehicle sales are still quite weak: They are contracting 0.6% on a monthly basis, albeit at a slower pace from October's 2.4%; On an annual basis, they are now contracting 1.1%. Labor market data was also released, with unemployment increasing to 5.7%. However, the change in employment was better than expected, with 39,100 new total jobs being added to the economy. The Consumer Inflation Expectation measure for December also highlighted an upbeat outlook on inflation, reading at 3.4%, up from 3.2%. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11 bca.fes_sr_2016_12_16_s2_c11 bca.fes_sr_2016_12_16_s2_c11 Chart II-12 bca.fes_sr_2016_12_16_s2_c12 bca.fes_sr_2016_12_16_s2_c12 The recent dollar rally has been very damaging for the kiwi, as it has fallen by 3% since the Fed policy decision. Recent data has also been negative: Manufacturing Sales slowed down to 2.1% in Q3 from 2.2% in Q2 (this number was also revised down from 2.8%). Additionally Business PMI slowed down slightly from 55.1 to 54.4. The NZD has also shown weakness in spite of the surge in dairy price, which now stand at their highest point since June 2014. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13 bca.fes_sr_2016_12_16_s2_c13 bca.fes_sr_2016_12_16_s2_c13 Chart II-14 bca.fes_sr_2016_12_16_s2_c14 bca.fes_sr_2016_12_16_s2_c14 The outlook for Canada's economy remains murky. Although the Financial Stability Report concluded that Canada's financial system remains mostly unchanged from six months ago, the BoC highlighted three key vulnerabilities that remain in the financial system: household debt, for which the debt-to-disposable income is approaching 170%; imbalances in the housing market, where the prices have reached just under 6 times average household income - their highest recorded level; and fragile fixed-income market liquidity. Therefore, underlying weaknesses are apparent and data is reflective of a weak economy. Pressure from a rising dollar will continue to place additional pressure on the CAD going forward. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15 bca.fes_sr_2016_12_16_s2_c15 bca.fes_sr_2016_12_16_s2_c15 Chart II-16 bca.fes_sr_2016_12_16_s2_c16 bca.fes_sr_2016_12_16_s2_c16 The SNB decided to stay put and leave rates unchanged at -0.75%. In addition, the SNB slightly decreased its forecast for inflation for the coming years. However the central bank remains optimistic on the Swiss economy, as improved sentiment in other advanced economies should help the Swiss export sector. Additionally, the labor market remains solid, with only 3.3% of unemployment. Although the franc should continue to mirror the Euro, all these factors will eventually put upward pressure on this currency. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17 bca.fes_sr_2016_12_16_s2_c17 bca.fes_sr_2016_12_16_s2_c17 Chart II-18 bca.fes_sr_2016_12_16_s2_c18 bca.fes_sr_2016_12_16_s2_c18 The Norges Bank decided to stay put and leave rates at 0.5%. In their Executive Board Assessment the Norges Bank project that rates will remain around their current level in the coming years. They also project that inflation should slowdown given a somewhat slower expected path for growth. However, worries about household debt persist: House prices rose by 11.6% YoY in November, while household debt grew by 6.3%. Additionally household credit is rising faster than household income. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19 bca.fes_sr_2016_12_16_s2_c19 bca.fes_sr_2016_12_16_s2_c19 Chart II-20 bca.fes_sr_2016_12_16_s2_c20 bca.fes_sr_2016_12_16_s2_c20 The Swedish economy has picked up a bit, as annual inflation figures came out at 1.4%, closer to the Riksbank's target. The labor market also displayed resilience as the unemployment rate dropped by 0.2% to 6.2%. Despite the upbeat data, the SEK failed to perform. With the dollar trading at new highs, USD/SEK also reached a new 13-year high, trading above 9.4 for a moment. Additionally, the SEK is trading poorly on its crosses as well, down against most of the G10 currencies. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global Duration: Global bond yields, pushed higher since July on the back of improving global growth and rising inflation, have now overshot to the upside on excessive expectations of U.S. fiscal stimulus. Take profits on bearish bond positions and increase portfolio duration exposure to at-benchmark on a tactical basis until the oversold conditions unwind. 2017 Global Yield Curve Expectations: The recent steepening of government bond yield curves across the developed markets should soon begin to fade, leading to a more diverse evolution of curves during the course of 2017: steeper in the U.S., core Europe and in Japan (at the long end), flatter in the U.K., Canada, Australia and New Zealand. U.K. Inflation Protection: Take profits on our recommended U.K. inflation trades (overweight inflation-linked bonds and CPI swaps), in response to the recent stability of the Pound and signs that the Bank of England is shifting in a more hawkish direction. Feature Time To Tactically Take Profits On Short Duration Positions Investors have been reminded over the past few months that boring old bonds, just like equities, can generate painful losses when prices disconnect from fundamentals. Back on July 19, we moved to a below-benchmark stance on overall portfolio duration, as we noted that government bonds across the developed markets had reached an overbought extreme despite improving trends in global growth and inflation (Chart of the Week).1 Bonds have sold off smartly since, with benchmark 10-year government yields in the U.S., U.K., Germany and Japan rising +88bps, +60bps, +36bps, +27bps respectively. The popular market narrative is that the latest leg of the bond selloff is a direct result of Donald Trump winning the White House. This raised investor awareness to the bond-bearish implications of a protectionist U.S. president looking to provide a fiscal kick to an economy already at full employment. The reality, however, is that global bond yields troughed a full four months before the U.S. elections on the back of a better global growth picture. It is quite possible that the latest bump in yields would have happened even if Trump did not win the election. Rising industrial commodity prices, happening in the face of a strengthening U.S. dollar that typically dampens prices, also suggest that bond yields have been responding more to faster realized growth and inflation and less to future expected fiscal stimulus (Chart 2). Chart of the WeekGlobal Bonds##br## Are Oversold Global Bonds Are Oversold Global Bonds Are Oversold Chart 2Stronger Growth Has ##br## Pushed Yields Higher bca.gfis_wr_2016_12_06_c2 bca.gfis_wr_2016_12_06_c2 Looking ahead, if the global economy evolves as we expect, with growth continuing to look relatively robust and inflation continuing to grind higher, then yields have even more upside in 2017. However, bonds now appear deeply oversold amid highly bearish sentiment. U.S. Treasury yields, in particular, have overshot the fair value estimates from our models (Chart 3). Also, this week's ECB meeting is unlikely to provide any bearish surprises for bond investors, as the ECB will likely extend the current QE program (at the current pace of buying) until at least next September. This should act to cap the recent widening of global bond term premia (Chart 4) and prevent a "Fifth Tantrum" from unfolding in global bond markets, as we discussed last week.2 Therefore, we are taking profits today on our bearish bond call and moving back to a tactical at-benchmark portfolio duration stance. However, we still expect yields to rise over the next year to levels beyond current forward rates.3 Thus, we would look to reinstate a below-benchmark duration posture if the 10-year U.S. Treasury yield were to fall to the 2-2.2% range. We will also look for signs of oversold momentum fading and a reduction in short positioning in U.S. Treasuries before re-establishing a below-benchmark duration tilt (Chart 5). The next leg of pressure on global bond yields should come from the U.S., given our optimistic view on U.S. growth and inflation for next year (see below). Chart 3UST Yields Are##br## A Bit Too High bca.gfis_wr_2016_12_06_c3 bca.gfis_wr_2016_12_06_c3 Chart 4A Big Adjustment In##br## Term Premia & Expectations bca.gfis_wr_2016_12_06_c4 bca.gfis_wr_2016_12_06_c4 Chart 5Taking Profits On##br## Our Bearish Bond Call bca.gfis_wr_2016_12_06_c5 bca.gfis_wr_2016_12_06_c5 Bottom Line: Global bond yields, pushed higher since July on the back of improving global growth and rising inflation, have now overshot to the upside on excessive expectations of U.S. fiscal stimulus. Take profits on bearish bond positions and increase portfolio duration exposure to at-benchmark on a tactical basis until the oversold conditions unwind. Some Initial Thoughts On Developed Market Yield Curves In 2017 With only a handful of trading days remaining in 2016, it is time to peer ahead to how markets could perform in the New Year. We will be publishing our full 2017 Outlook report on December 20th, but this week we are presenting some preliminary ideas on how government bond yield curves could evolve over the course of next year. United States - Eventual Bear Steepening In Excess Of The Forwards We see U.S. growth accelerating to a 2.8% pace next year, an above-potential pace that is stronger than current consensus forecasts.4 Combined with a steady grind higher in realized inflation (both headline and core), this will generate a nominal growth outcome over 5% in 2017. This will help push the 10-year U.S. Treasury yield to the 2.8-3.0% area by the end of 2017 as the Fed will likely continue to raise rates but not as fast as nominal growth will accelerate (i.e. will remain accommodative). This move will be led by rising inflation expectations, which we see rising to a level consistent with the Fed's inflation target.5 This will put steepening pressure on the U.S. Treasury curve, at a pace that will easily exceed the flattening currently priced into the forwards (Chart 6, top panel). We see the potential for curve steepening pressure to come both from growth, which will push up longer-dated real yields and steepen the "real" yield curve, and from inflation, with a tight labor market putting upward pressure on wage and price inflation even with a stronger U.S. dollar (Chart 7). Chart 6A Steeper UST Curve,##br## Led By Rising Real Yields bca.gfis_wr_2016_12_06_c6 bca.gfis_wr_2016_12_06_c6 Chart 7Will UST Yields Pause##br## After A Rate Hike Next Week? bca.gfis_wr_2016_12_06_c7 bca.gfis_wr_2016_12_06_c7 For now, however, we are keeping a "neutral" stance on U.S. yield curve exposure until we see signs that oversold conditions in the Treasury market have corrected. One final point: the Treasury market likely moved too quickly in recent weeks to discount a fiscal ease under the new Trump administration. However, any impetus to growth from the government sector, coming at a time when the U.S. economy is running near full employment, will be another structural factor putting steepening pressure on the yield curve in the next year through more Treasury issuance and stronger inflation pressures. Core Euro Area - Very Modest Steepening In Line With The Forwards As we discussed in a recent Weekly Report, the ECB will most likely continue with its current bond-buying program, with no tapering of the size of the purchases, until at least September 2017.6 European inflation remains too low relative to the ECB's target (Chart 8) and the central bank will be wary about reducing monetary stimulus anytime soon. The overriding presence of ECB buying will act to limit the upside in longer-dated European bond yields, even in an environment where U.S. Treasury yields rise over the course of 2017. The core European government bond yield curves (Germany, France) will likely still see some modest steepening pressure, led by upward pressure on real yields, as global growth continues to improve. Combined with the lagged impact of the weakening Euro and the rise in commodity prices, there should be some mild additional steepening pressure coming from inflation expectations, as well. The forward curves are currently pricing in a very modest steepening over the next year, and we do not see a case for the curve to steepen much beyond the forwards (Chart 9). We continue to favor core Europe as a recommended overweight in our global Developed Market bond allocation. Favoring the longer-end of the curve (10 years and longer) in Germany and France - the higher yielding parts of these low-yielding bond markets - makes the most sense against the backdrop of subdued Euro Area inflation. Chart 8No Threat To Global Bonds##br## From The ECB This Week bca.gfis_wr_2016_12_06_c8 bca.gfis_wr_2016_12_06_c8 Chart 9ECB QE Will Limit##br## Any Curve Moves In Europe bca.gfis_wr_2016_12_06_c9 bca.gfis_wr_2016_12_06_c9 Japan - Expect Long-End Steepening, Even With Bank Of Japan Curve Targeting The Japanese yield curve is now fairly straightforward to predict, with the Bank of Japan (BoJ) now explicitly targeting the level of JGB yields. The BoJ has committed to keep the 10yr JGB yield at 0% until Japanese inflation expectations overshoot the 2% BoJ target. With inflation expectations currently sitting just above 0%, that goal is now far from being realized. We see very little movement in the 2-10 year part of the JGB curve next year, but we expect the curve beyond 10 years to be more influenced by trends in global bond yields, with the BoJ providing no guidance on the desired level of longer-dated JGB yields. Given our views on a potential bear-steepening of the U.S. Treasury curve in 2017, we expect that the 10/30 JGB curve will also steepen (Chart 10). Focusing Japanese bond exposure on the 10-year point makes the most sense in this environment, although at a yield of 0% the return prospects are hardly inviting. U.K. - Steepening Will Turn To Flattening The Bank of England (BoE) took out a very large insurance policy on the U.K. economy by cutting interest rates and re-starting quantitative easing (QE) after the shocking Brexit vote. This has appeared to work, as U.K. economic growth has been surprisingly strong in the months since the June referendum. But the ramifications of the BoE's aggressive easing was a massive depreciation of the Pound and a subsequent rise in U.K. inflation (Chart 11). Chart 10BoJ Is Not Worrying About##br## The Long End For JGBs BoJ Is Not Worrying About The Long End For JGBs BoJ Is Not Worrying About The Long End For JGBs Chart 11The Post-Brexit ##br## Adjustment Is Nearly Complete The Post-Brexit Adjustment Is Nearly Complete The Post-Brexit Adjustment Is Nearly Complete This has set up a situation where the Gilt market is behaving much like the U.S. Treasury market did after the Fed introduced its own QE programs between 2008 & 2012. The result was as rise in nominal bond yields led by rising inflation expectations and stronger economic growth, both of which were a function of a weaker currency. In the case of the U.K. now, the rise in inflation has been strong enough to force the BoE to back off its promise to deliver an additional rate cut before the end of 2016. The BoE will likely not extend the latest QE program beyond the March 2017 expiry, as well. There is even a chance that the BoE could be forced to hike rates sometime in the first half of 2017. Against this backdrop where the BoE has to play a bit of monetary catchup to rising nominal growth, the Gilt curve is likely to see some flattening pressure after the recent steepening. With the forwards pricing in no change in the slope of the curve next year (Chart 12), curve flattening positions that limit exposure to the front-end of the Gilt curve could offer opportunities in 2017 after global bond yields consolidate the recent rise in yields. While we believe it is too early to reposition our Gilt curve allocation this week, we are taking profits on our recommended U.K. inflation protection trades given the recent stability of the Pound and growing evidence that the Bank of England is turning more hawkish (Chart 13). Specifically, we are closing our Overlay Trade favoring index-linked Gilts versus nominals at a profit of +59bps. We also advise closing our "Brexit hedge" trade suggested in June before the referendum, which was a long position in U.K. CPI swaps versus U.S. equivalents. Chart 12Nearing The End Of ##br## Gilt Curve Steepening? Nearing The End Of Gilt Curve Steepening? Nearing The End Of Gilt Curve Steepening? Chart 13Take Profit On U.K.##br## Inflation Protection Trades Take Profit On U.K. Inflation Protection Trades Take Profit On U.K. Inflation Protection Trades Canada - The Steepening Is Over A modest steepening of the Canadian government bond yield curve in 2017 is currently priced into the forwards. We think even this small move is unlikely to be realized. The short-end of the yield curve should stay well-anchored around current levels. Probabilities extracted from the Canadian Overnight Index Swap (OIS) curve currently show a 4% market-implied chance of a rate cut, and 40% odds of a rate hike, by December 6th 2017. Of the two, the probability of a rate hike looks too high. The Bank of Canada (BoC) has rarely increased policy rates when our BCA Canadian Central Bank Monitor was in "easy money required" territory (Chart 14). More likely, the Bank of Canada will stay on hold throughout 2017 due to a lack of inflationary pressures. The Canadian unemployment rate remains far higher than the full employment level, while a wide gap has developed between the growth rates of core CPI and weekly earnings; low wage inflation usually drags core CPI inflation lower. Already, the Canadian CPI less the most volatile components - one of the core inflation measures monitored by the BoC - has rolled over. In the longer part of the curve, the weakening economic cycle will keep yields well contained. While the rebound in energy prices seen this year is a positive for the beaten-up Alberta economy, even higher prices will be needed for Canadian energy producers to rekindle investments in that sector given the high cost of oil extraction in Western Canada. Without a meaningful recovery in Alberta, the Canadian economy will be unable to expand at an above-trend pace; growth will be slower than the general consensus forecast of 2.0% in 2017.7 To profit from that view, we are opening a new butterfly spread trade on the Canadian curve: going long the 2-year/10-year barbell versus a short position in the 5-year bullet. This trade should generate positive excess returns if the 2-year/10-year slope of the Canadian curve flattens, as we expect (Chart 15). Chart 14Canadian Short Rates##br## To Remain Well-Anchored Canadian Short Rates To Remain Well-Anchored Canadian Short Rates To Remain Well-Anchored Chart 15Go Long A Canadian 2/10 ##br## Barbell Vs. The 5yr Bullet Go Long A Canadian 2/10 Barbell Vs. The 5yr Bullet Go Long A Canadian 2/10 Barbell Vs. The 5yr Bullet Australia - Flattening Phase Ahead A small flattening of the Australian yield curve over the next 12 months is currently priced into the forwards. This expectation seems reasonable to us, but the bulk of the flattening should come from the short end where yields will drift higher over the course of the year. Australian inflation prospects are improving, with the Melbourne Institute Inflation Gauge having stabilized of late. As the negative impact of imported goods price deflation recedes going forward, domestic inflation should rise. In addition, our model is calling for core CPI inflation to grind higher in 2017 (Chart 16). Chart 16Australian Inflation Is Bottoming... Australian Inflation Is Bottoming... Australian Inflation Is Bottoming... Chart 17...Even As Australian Growth Is Starting To Cool ...Even As Australian Growth Is Starting To Cool ...Even As Australian Growth Is Starting To Cool Because of this, the Reserve Bank of Australia (RBA) will progressively become less dovish and greater odds of a rate hike will be priced into the yield curve. This is already starting to happen, on the margin; since October, the probability of a rate cut by December 5th, 2017 has decreased substantially, from 65% to 5%. As we have been pointing out over the past several months, the Australian economy has been humming along. China's policy reflation seen earlier in 2016 had a direct positive impact on Australian export demand, while a rising terms of trade fueled by higher base metals prices has provided a boost to domestic income. However, the upward pressure on yields from accelerating domestic growth has become milder of late. Employment growth, motor vehicle sales and aggregate private sector credit growth are now all trending to the downside (Chart 17). This might be an indication that the boom from the first half of this year is starting to dissipate. This tames, to some extent, our optimism over the Australian economy. If economic activity continues to slow modestly, corporate bond supply, i.e. demand for credit and liquidity, should ease. In turn, this should also alleviate the recent upside pressure on the longer part of the Australian government bond yield curve. Chart 18The NZ Curve Will Follow##br## The Forwards In 2017 The Bond Vigilantes Take A Break For The Holidays The Bond Vigilantes Take A Break For The Holidays In sum, on a 3-6 month horizon, the short end of the Aussie curve could edge higher as the market prices in a less dovish RBA that will need to begin worrying about rising inflation once again. While at the same time, longer-term bond yields might have seen their highs given some cooling of economic growth. We already have a recommended position on the Australian curve to benefit from these trends, as we are short the 4-year government bond bullet versus a long position in the 2-year/6-year barbell. This trade was initiated earlier this year, has generated +13bps of profits so far, and remains valid.8 As an exit strategy, we will re-evaluate this trade if high-frequency cyclical Australian data disappoint further or the current expansion of Australia's terms of trade starts to reverse. New Zealand - Following The Forwards The New Zealand forward yield curve is currently pricing a 12bps flattening over the next 12 months, with the 2-year/10-year slope expected to move from 107bps to 95bps (Chart 18). This move seems reasonable to us. As we discussed in a recent report, inflation will re-surface in New Zealand in 2017.9 The upside surprise will be due to those factors: Narrowing global output gaps that will bring about a more inflationary global backdrop. A boost from China, most notably through higher producer prices. A weakening of the Kiwi dollar in response to a more hawkish Fed. A stronger dairy sector, which should help New Zealand's exports and reflate domestic wages. A potential reversal of migration inflows, which should shrink the supply of workers and tighten the labor market, boosting wage growth and pressuring price inflation higher. If this view materializes, the Reserve Bank of New Zealand (RBNZ) will become more hawkish. This should push short term yields higher and flatten the New Zealand government bond yield curve. Like everywhere else, the New Zealand yield curve has steepened over the last month as global bond markets have priced in faster growth and the potential impact of Trump-ian fiscal stimulus in the U.S. As this external impact dissipates in the next few months, the main factor driving the shape of the New Zealand curve will swing back to expectations of future RBNZ policy. Bottom Line: The recent consistent steepening of government bond yield curves across the developed markets should soon begin to fade, leading to a more diverse evolution of curves during the course of 2017: steeper in the U.S., core Europe and in the long end in Japan; flatter in the U.K., Canada, Australia and New Zealand. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at gfis.bcaresearch.com & usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at gfis.bcaresearch.com & usbs.bcaresearch.com 3 The current 1-year forward rate for the benchmark 10-year U.S. Treasury is 2.67% 4 Please see BCA Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen", dated October 14, 2016, available at gis.bcaresearch.com 5 The Fed targets headline PCE inflation, while inflation compensation in U.S. TIPS is priced off headline CPI inflation. The historical gap between the two measures is about 40bps, thus a level of breakeven inflation in TIPS that is consistent with the Fed's 2% inflation target is 2.4% (2% PCE inflation + 0.4%). 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com 7 Both the Bank of Canada and the median economist surveyed by Bloomberg forecast 2.0% real GDP growth in 2017. For further details, please http://www.bankofcanada.ca/2016/10/mpr-2016-10-19/ 8 Please see BCA Global Fixed Income Strategy Weekly Report, "Five Yield Curve Trades For The Rest Of The Year", dated May 24, 2016, available at gfis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Weekly Report, "A Post-Trump Update Of Our Overlay Trades", dated November 22, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Bond Vigilantes Take A Break For The Holidays The Bond Vigilantes Take A Break For The Holidays Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Commodity prices and the dollar can occasionally rise together. The 1999-2001 and the 2005 experiences suggest a supply shock is required. If commodities were to rally alongside a strengthening dollar in 2017, this would be an oil-led move. Metals have very little potential upside as improving DM growth drains liquidity from EM economies. Favor petro currencies (CAD and NOK) relative to the antipodeans (AUD and NZD). Stay short AUD/CAD. USD/JPY is in a major bull market. However, near-term risks are to the downside. Feature It has become axiomatic among investors to assume that a dollar bull market is synonymous with a commodity bear market. While the relationships usually holds, there have been episodes where the narrow trade-weighted dollar and natural resource prices moved in tandem, not in opposite directions: 1982 to 1984, 1999 to 2001, and in 2005. The recent surge in base metals raises that possibility, but as DM economies suck in global liquidity away from EM ones, the prospect for a positive correlation between most commodities and the dollar is still remote. When Do Commodities And The Dollar Walk Together? Commodities and the dollar usually move in opposite direction. Since 1980, there has only been three episodes of consistent commodity strength despite dollar appreciation: 1982 to 1984, 1999 to 2001, and in 2005 (Chart I-1). What defines each of these episodes? In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar (Chart I-2). Chart I-1Commodities Can Rise ##br##Alongside The Dollar bca.fes_wr_2016_11_25_s1_c1 bca.fes_wr_2016_11_25_s1_c1 Chart I-2Early 1980s: U.S. Growth Was ##br##Able To Boost Metal Prices bca.fes_wr_2016_11_25_s1_c2 bca.fes_wr_2016_11_25_s1_c2 From 1999 to 2000, the rally in commodity was not broad based. In fact, it was concentrated in the energy sector (Chart I-3). It reflected three factors: After being decimated in 1997 and 1998, EM stock prices managed to stage a temporary rebound; one that mostly reflected bombed out equity and currency valuations. However, the muted response of non-oil commodities suggests that this rebound had little economic impact. Energy was buoyed by the vigorous growth in DM, with OECD oil consumption growing 1% annually between 1998 and 2001. Finally, as oil prices fell below US$10/bbl in late 1998 global oil production contracted sharply, plummeting by more than 4 million barrels, or 5% of total production. Not only could Saudi Arabia and Russia not withstand the pain of lower oil prices, but the latter was in the midst of a massive economic crisis that disrupted the local oil industry's ability to finance its operations. While most commodities in the 2005 episode experienced subtle upward drift, once again, energy was the true winner (Chart I-4). Supply disruptions in the Gulf of Mexico following the record-breaking 2004 and 2005 hurricane seasons contributed to removing slightly more than one million barrels from the market. Additionally, oil had captured investors' imagination, with the peak-oil theory being all the rage. This combination explains why oil was the primary beneficiary of Chinese and EM economic strength while base metals could not overcome the dollar's hurdle. Chart I-31999-2001: Commodity##br## Rally Was An Oil Rally bca.fes_wr_2016_11_25_s1_c3 bca.fes_wr_2016_11_25_s1_c3 Chart I-42005: Commodity##br## Rally Was An Oil Rally bca.fes_wr_2016_11_25_s1_c4 bca.fes_wr_2016_11_25_s1_c4 Bringing it all together, the dollar and commodities where able to rise as one in the 1980s because they responded to the same positive U.S. growth shock. However, during the 1999-2001 and 2005 commodity rallies in the face of strong dollar, the supply/demand imbalance in oil was paramount. Bottom Line: The dollar and commodity prices can occasionally move together. This happens when a supply shock affects a natural resource as important as oil, lifting its price despite the greenback hurdle. Outside of energy, in general prices still displayed little upside through these episodes. Giant Sucking Sound Our bullishness on the dollar is built on our positive outlook for U.S. growth and rates, a view only reinforced by Trump's electoral victory.1 This does not mean we expect the same boost to metal consumption that we saw in the early 1980s. Today, combined Japanese and U.S. copper consumption only accounts for 11% of global consumption. For iron ore, the U.S. represents only 4% of global consumption. Even if the U.S. were to spend $1trillion over five years on infrastructure (an extremely optimistic assumption), it will not constitute the same relative boost to global demand as the U.S. expansion during the 1980s did (Chart I-5). Additionally, metals will remain slightly oversupplied. In fact, inventories have been rising and more supply of iron ore is coming upstream in 2017, as additional Pilbara iron ore deposits are being unleashed on the markets. In the case of copper, our commodity specialists expect supply to continue to grow in the years ahead. But still, could EM lift the demand for metals enough to play the same role as the U.S. did in the early 1980s? We doubt it. When it comes to China, the current growth improvement is likely as good as it gets. The Keqiang index - a measure of industrial activity in the Middle Kingdom - is approaching post-2011 highs, but the demand for loans remains very depressed (Chart I-6). Moreover, the Chinese fiscal impulse - which has buoyed the country's economy for much of 2016 - has rolled over and is now in negative territory, suggesting that the Keqiang index will weaken in 2017. This will weigh on Chinese imports of machinery and raw materials, representing a deflationary shock for other EM. Chart I-5Metals Are About China, Not The U.S. Party Like It's 1999 Party Like It's 1999 Chart I-6China: The Best Is Behind Us China: The Best Is Behind Us China: The Best Is Behind Us At the current juncture, additional deflationary forces on EM would be an unwelcomed development. The structural headwinds plaguing EM economies are still in place. EM remain burdened by too much capacity, too much debt, and too little productivity (Chart I-7). More worryingly, strong DM growth will do very little to lift EM economies and assets out of their structural funk. Instead, DM strength is likely to hurt EM. As Chart I-8 shows, since 2009 improvements in DM leading economic indicators (LEIs) have led to falling EM LEIs. Chart I-7EM Structural Headwinds bca.fes_wr_2016_11_25_s1_c7 bca.fes_wr_2016_11_25_s1_c7 Chart I-8DM Hurting EM bca.fes_wr_2016_11_25_s1_c8 bca.fes_wr_2016_11_25_s1_c8 EM nations are not very dependent on DM as a source of growth. Intra EM trade has been responsible for most of the growth in EM exports as shipments to the DM economies and the U.S. now account for only 28% and 15% of EM total exports, respectively. While this explains why DM growth cannot lift EM growth, it still does not explain why DM growth leads to deteriorating EM activity. The glue binding this paradox is global liquidity. In a nutshell, when DM growth improves, DM economies suck in global liquidity, which results in a tightening of EM monetary and financial conditions. This combined constriction acts as a large brake on EM growth. Underpinning the relationship between liquidity and growth are a few relationships: First, DM real rates are a relatively clean measure of growth expectations. As Chart I-9 shows, U.S. real yields and the growth expectations embedded in U.S. stocks prices correlate closely with each other. Second, when DM real yields rise, EM reserve accumulation - a measure of high-powered liquidity - moves into reverse (Chart I-10). This suggests that rising DM real yields prompt investors to abandon EM markets, attracted by improving risk-adjusted returns in DM. Chart I-9Real Interest Rates: ##br##A Read On Expected Growth bca.fes_wr_2016_11_25_s1_c9 bca.fes_wr_2016_11_25_s1_c9 Chart I-10The Liquidity ##br##Channel bca.fes_wr_2016_11_25_s1_c10 bca.fes_wr_2016_11_25_s1_c10 Third, rising DM rates puts downward pressure on EM FX (Chart 10, bottom panel). Being associated with a reversal of carry trades this is another indication that capital is leaving EM economies. Additionally, falling EM exchange rates tighten EM financial conditions by hampering the financial viability of EM borrowers with foreign currency debt. Fourth, given that the exogenously-driven fall in liquidity already hurts EM growth, rising EM borrowing costs in response to increasing DM real rates amplify the economic drag. By causing the return on EM bonds to fall (Chart I-11), this generates further outflows from EM, and also tightens EM financial conditions. Finally, rising DM yields have been associated with underperforming EM equities relative to DM equities (Chart I-12), giving investors another reason to pull money out of EM. These dynamics have implications for commodity currencies. BCA's view is that DM real yields have upside from here, and therefore EM liquidity and financial conditions are set to tighten. Not only will this hurt EM assets, but a flattening BRICs yield curve should also lead to falling commodity currencies (Chart I-13). Chart I-11The Financial ##br##Channel bca.fes_wr_2016_11_25_s1_c11 bca.fes_wr_2016_11_25_s1_c11 Chart I-12EM/DM Stocks: A Function ##br##Of DM Real Rates bca.fes_wr_2016_11_25_s1_c12 bca.fes_wr_2016_11_25_s1_c12 Chart I-13Tightening EM Liquidity Conditions##br## Hurt Commodity Currencies bca.fes_wr_2016_11_25_s1_c13 bca.fes_wr_2016_11_25_s1_c13 However, differentiation is needed. Tightening EM liquidity and financial conditions are likely to hurt the metal market where there is no broad-based supply deficit. However, like in the late 1990s, oil could actually do well under a strong dollar scenario. For one, the OECD and the U.S. represent much larger shares of oil demand than they do for industrial metals (Chart I-14). In the context of robust U.S. economic growth and consumer spending, we could see continued upward momentum in global oil demand. This is crucial as the oil market is already in a deficit following the collapse in oil capex in 2015 and 2016 (Chart I-15). Additionally, our Commodity and Energy Strategy team argues that OPEC and Russia are very likely to cut production next week. Economic strains and the desire for asset sales in Saudi Arabia and Russia are creating the needed incentives.2 In this environment, oil currencies (CAD and NOK) should outperform antipodeans (AUD and NZD). The outlook for the AUD is the poorest. It is the currency most exposed to metals, the segment of the commodity market most aligned with EM growth. NZD could be at risk too. While it is not exposed to metals like the AUD, the kiwi is very exposed to EM spreads, a variable that is likely to suffer if DM yields continue to rise.3 Buying a basket of CAD and NOK relative to AUD and NZD makes sense here. In terms of our trades, we shorted AUD/CAD too early. However, the economic backdrop described above suggests that the economic rationale for this trade is growing ever more potent. In fact, from late December 1998 to January 2000, CAD rallied against the USD, while the AUD was flat. Additionally, technicals and positioning point to a favorable entry point at the current juncture (Chart I-16). Chart I-14Oil Is Still About The U.S. bca.fes_wr_2016_11_25_s1_c14 bca.fes_wr_2016_11_25_s1_c14 Chart I-15Favorable Supply/Demand Backdrop For Oil bca.fes_wr_2016_11_25_s1_c15 bca.fes_wr_2016_11_25_s1_c15 Chart I-16A Good Entry Point For Shorting AUD/CAD bca.fes_wr_2016_11_25_s1_c16 bca.fes_wr_2016_11_25_s1_c16 Bottom Line: In 2017, the relationship between commodity prices and the dollar is likely to resemble the 1999-2001 outcome. While tightening EM liquidity conditions could weigh on metals, supply concerns and a strong U.S. economy could lift oil prices. This environment would favor the CAD and the NOK relative to the AUD and the NZD. A Countertrend Bounce In The Yen? As we discussed last week, the move in USD/JPY makes sense based on the BoJ policy dynamics we analyzed in our September 23 report titled "How Do You Say "Whatever It Takes" In Japanese?". However, despite our bearish disposition toward the yen, we worry that a countertrend correction in USD/JPY is in the offing. USD/JPY is approaching a formidable resistance. The tell-tale sign of a USD/JPY bull market has been when the pair moves above its 100-week moving average (Chart I-17). We do expect such a move to ultimately materialize. However, with the 100-week MA currently at 114.8, this key indicator is a stone throw away from the present exchange rate of 113.39 and might prove to be a temporary resistance. Additionally, a congestion zone exists between 113 and 114.5, reinforcing this risk. Increasing the danger at the 114 level is the recent high degree of groupthink behavior displayed by this pair. As was the case for the U.S. bonds, the fractal dimension measure for USD/JPY is now below 1.25, highlighting the risk of a countertrend move (Chart I-18). Chart I-17USD/JPY: Key Resistance In Sight bca.fes_wr_2016_11_25_s1_c17 bca.fes_wr_2016_11_25_s1_c17 Chart I-18A Countertrend Move In USD/JPY bca.fes_wr_2016_11_25_s1_c18 bca.fes_wr_2016_11_25_s1_c18 Moreover, we agree with our U.S. Bond Strategy service and expect a pause in the U.S. bond sell-off.4 With the tight relationship between USD/JPY and 10-year Treasury yields fully alive, any rebound in bond prices would imply a rebound in the yen. Finally, our intermediate-term timing indicator shows that USD/JPY is 5% overvalued on a tactical time frame, a level where the likelihood of a temporary reversal is heightened. Based on the above observations, today we are opening a tactical short USD/JPY position at 113.39, with a target of 107 and a stop at 115.2. We are also closing our long NOK/JPY trade at a profit of 5.3%. Bottom Line: While the cyclical outlook for USD/JPY continues to point upward, tactically, USD/JPY is facing some downside risk. We are implementing a tactical short USD/JPY trade with a target at 107 and closing our long NOK/JPY trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, and Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, "The OPEC Debate", dated November 24, 2016, available atces.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_11_25_s2_c1 bca.fes_wr_2016_11_25_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_11_25_s2_c2 bca.fes_wr_2016_11_25_s2_c2 The dollar has crossed a crucial resistance level, and the DXY is now trading close to 102. Positive data this month have contributed to this rally. Durable goods orders came in at 4.8% for October, up from 0.4% in September. This has lifted manufacturing PMI for November to 53.9, showing strength in the supply side of the U.S. economy. Minutes from the November 1-2 FOMC meeting indicate a clear hawkish consensus for December's meeting. A probability of a hike is now fully priced in and is reflected in the almost 14-year high reached by the DXY following the release of the minutes. We should see some stability in the DXY coming up to the December meeting. Otherwise, the U.S. economy seems strong. Upcoming data should ultimately buoy the strength in the dollar, but short-term movements will be limited. Report Links: One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_11_25_s2_c3 bca.fes_wr_2016_11_25_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_25_s2_c4 bca.fes_wr_2016_11_25_s2_c4 Draghi remains resolute in his commitment to reach the inflation target. Easy monetary policy has helped support recent growth in the euro area. Low policy rates have increased credit supply, leading to higher lending volumes to households, NFCs and SMEs. Key indicators, such as this month's composite PMI which went up to 53.7, from 53.3, highlight continued decent growth in Europe. Nevertheless, core inflation remains weak at 0.75%, which entails a high likelihood for easy policy going forward. Persistently low rates and structural weaknesses will continue to weigh on bank profitability. Banks may eventually respond by limiting credit growth in the future and hampering overall activity. The short-run outlook for the Euro still remains solid against crosses. EUR/USD has hit a support level, but momentum indicates strong downward pressure against the dollar, so attention to this resistance level is warranted. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_25_s2_c5 bca.fes_wr_2016_11_25_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_25_s2_c6 bca.fes_wr_2016_11_25_s2_c6 USD/JPY has appreciated by more than 7% since the day Donald Trump was elected president. From 1990 up until the day Trump got elected, the yen depreciated at such a high rate in such a short time frame in only 4 occasions. We are taking a tactical short position in USD/JPY, because although we continue to be yen bears on a cyclical basis, the current sell-off seems overdone. USD/JPY has reached highly overbought technical levels and it is near its 100-week moving average of 114.8, which should act as a temporary resistance. More importantly, the sell-off in U.S. bond yields, a major driver of the recent plunge in the yen is likely to pause for the time being. USD/JPY will once again become an attractive buy at around 107. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_25_s2_c7 bca.fes_wr_2016_11_25_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_25_s2_c8 bca.fes_wr_2016_11_25_s2_c8 On Wednesday the Treasury released its Autumn Statement, outlining fiscal policy for the coming year. Philip Hammond, Chancellor of the Exchequer, offered no surprises as he vouched to continue to rebalance the budget, albeit at a slower pace. The fiscal impulse looks to increase slightly, yet stay negative for the next 4 years. Such a hawkish fiscal stance should be a drag on growth in an economy that cannot afford any setbacks as it prepares to exit the European Union. However, despite this grim outlook we are still monitoring the pound as an attractive buy, given that it is very cheap. In fact GBP/USD had very little movement after the announcement, which suggests that much of the risks for the U.K's economic outlook are already priced into the cable. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_25_s2_c9 bca.fes_wr_2016_11_25_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_11_25_s2_c10 bca.fes_wr_2016_11_25_s2_c10 The Australian economy continues to encounter structural weaknesses from a deteriorating mining sector, for which the outlook remains pessimistic. An interesting observation is that the mining investment-cut is considerably mature, as RBA Assistant Governor Christopher Kent states "about 80% of the adjustment" is done. However, weak Asian EM fundamentals and a questionable outlook for China imply impending demand-side problems, which will weigh, not only on Australian terms of trade, but also the Australian economy, as emerging Asia represents 66% of Australia's total exports. An additional hurdle for the terms of trade is a rising USD, which could drag down commodity prices and the AUD. In the short run, the MACD line for AUD/USD also points to downside in the near future, as the currency approaches a possible resistance level at 0.72. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_11_25_s2_c11 bca.fes_wr_2016_11_25_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_11_25_s2_c12 bca.fes_wr_2016_11_25_s2_c12 We continue to hold a bearish stance towards NZD/USD, as the dollar bull market and weakness in Asian currencies will ultimately weigh on the kiwi. However, the outlook for the NZD against other commodity producers is not as clear. Prices for dairy products, which constitute over 30% of New Zealand exports, have skyrocketed and are now growing at 46% YoY. This trend is set to continue in the short term, as Chinese dairy imports continue to rebound, recording a 9.7% growth rate compared to last year. Furthermore, real GDP is growing at a 3.5% pace, the highest in the G10. That being said, we are reticent to be too bullish on this currency, as inflation remains very low and increasing migration is putting a lid on wages. However if inflation picks up, the NZD could become attractive relative to its commodity peers. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_11_25_s2_c13 bca.fes_wr_2016_11_25_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_11_25_s2_c14 bca.fes_wr_2016_11_25_s2_c14 Recent data has come out below expectations: Core CPI came in at 1.7%. Wholesale sales are contracting at -1.2%. Retail sales excluding autos are at 0%. These figures support the view that there is an underlying weakness in the Canadian economy which will keep the BoC from reaching its inflation target. However, as the U.S. continues to be the largest consumer of oil in the world, with around 20% of global consumption, stronger U.S. growth will support oil demand, which in conjunction with tighter supply, will support oil prices. This will support the CAD against other commodity producing currencies. Structural weaknesses and an upward trend in USD/CAD since May suggest that the CAD could experience more downside momentum against USD. Nevertheless, it is important to monitor next week's OPEC meeting, the outcome of which will dictate the CAD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_11_25_s2_c15 bca.fes_wr_2016_11_25_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_11_25_s2_c16 bca.fes_wr_2016_11_25_s2_c16 The decline in EUR/CHF appears to have subsided for the time being. Last week we mentioned that the SNB would not tolerate much more downside on this cross, and would not be shy to intervene if necessary. This view has shown to be valid, as EUR/CHF has found support around 1.07. This floor imposed by the SNB means that the performance of the franc against the dollar should mirror EUR/USD for the time being. This implies that USD/CHF should have limited upside in the short term, as EUR/USD has hit a major support level around 1.05 that has been in place for the last 2 years. On a cyclical basis, monetary divergences should continue to weigh against the euro, which makes us bullish on USD/CHF on this time frame. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_11_25_s2_c17 bca.fes_wr_2016_11_25_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_11_25_s2_c18 bca.fes_wr_2016_11_25_s2_c18 The U.S. continues to be world's largest consumer of crude oil, with 20% of total consumption, while China leads in both the copper and nickel markets, accounting for nearly half of global consumption and consuming over 5 times as much as the U.S. in both markets. This divergence implies that if U.S. outperforms the rest of the world, and if the rising dollar continues to weigh on EM economies, oil should outperform base metals in the commodity space and consequently petro currencies like the NOK should outperform other commodity currencies. Additionally the NOK is supported by a current account surplus of 6%, and high inflation is prompting Norges Bank to back off from its dovish stance. While we like the NOK on its crosses, we are more bearish on the NOK versus the USD, as USD/NOK remains very sensitive to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_11_25_s2_c19 bca.fes_wr_2016_11_25_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_11_25_s2_c20 bca.fes_wr_2016_11_25_s2_c20 The Swedish economy continues to show signs of strength. Recent data supports this view: Consumer confidence for November is at 105.8, compared to 104.8 for October. Producer Price Index came in at 2.2% annually for October. A strong consumer sector has lifted inflation expectations in Sweden. Strong PPI numbers validate this, as they foretell a potential rise in CPI as producers pass on their costs to consumers. Despite this strength, SEK may see limited upside. As mentioned last week, most of the movement in the SEK can be attributed to the USD. Rate hike expectations have now been fully priced in for the Fed, so it is likely that movements in the USD will be muted, and hence the SEK could find some support, at least for now. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature Happy Thanksgiving to all our U.S. clients. We wish you the best the holiday has to offer, as you share blessings with friends and family. In this holiday-shortened week, we are publishing a joint report with our colleagues at BCA's Energy Sector Strategy (NRG) service. We succinctly examine the pros and cons of the debate over whether OPEC will or will not agree to and uphold a *real* production cut, as it has promised, at its much-anticipated meeting on November 30. Disagreement on the likely outcome of the meeting runs high. In late September, OPEC announced an agreement in principle to cut oil production at the formal November meeting to a level of 32.5-33.0 MMb/d. This would represent a 500,000-750,000 b/d reduction from August production levels, and an 830,000-1,330,000 b/d reduction from the IEA's latest OPEC production estimate for October of 33.83 MMb/d. In addition, non-OPEC behemoth Russia has signaled a potential willingness to contribute its own production freeze or cut to the agreement in an effort to support higher oil prices. Chart 1With A 1 MMb/d Cut, ##br##Draws Would Be Greater bca.ces_wr_2016_11_24_c1 bca.ces_wr_2016_11_24_c1 There are compelling arguments to be made both supporting the likelihood of a production cut as well as for being skeptical that such an agreement will be reached and adhered to. Even within BCA, there is disagreement. This service, the Commodity & Energy Strategy (CES), which sets the BCA house view on oil prices, pegs the odds at greater than 50% that there will be a meaningful cut of 1 MMb/d+, anchored by large cut pledges from OPEC's leader, the Kingdom of Saudi Arabia (KSA), and Russia. The NRG team, dissents; they think it is more likely that no deal is reached, and if a deal is announced, it will not be adhered to. Regardless of whether there is an announced agreement to cut production or not, both CES and NRG expect KSA's production to decline by 400,000-500,000 b/d between August and December according to KSA's normal seasonal management of production levels; we would not include this expected seasonal reduction in the calculation of a *real* cut. In our analysis on Chart 1, we include a *real* cut of 1MMB/d below the normal seasonality of KSA's production, which lasts for six months. In H2 2017, we assume the cut is dissolved and the market also receives an extra 200,000 b/d of price-incentivized production from the U.S. shales. How To Bet On A Cut, The Out-Of-Consensus Call Chart 2Without A Cut,##br## Inventories Still Will Be Drawn In 2017 bca.ces_wr_2016_11_24_c2 bca.ces_wr_2016_11_24_c2 CES's view for a cut (established November 3) was significantly out-of-consensus until recent chatter from OPEC increased the perception that an agreement could be reached. Still, there remains significant doubt a freeze or cut can be accomplished. Without a cut, NRG and CES share a constructive outlook for oil markets heading towards steepening deficits during 2017 (Chart 2). Note: BCA's estimates show a tighter oil market than the EIA's estimates: Our Q3 2016 production estimates are lower than the EIA's by ~300,000 b/d due to differences in our assessments in Brazilian, Russian and Chinese production; our Q3 2016 consumption estimate is higher than the EIA due to our higher assessment of U.S. summer-time demand (the EIA has consistently underestimated U.S. demand over the past few years). A production cut coupled with a natural tightening in the market brought about by the price-induced supply destruction over the past 18 months would make 2017 inventory draws even greater, lifting oil prices higher, and providing even greater upward support to our favorite investment recommendations (Chart 1). Below we outline the investment recommendations that would benefit from an OPEC cut, spanning individual equities, ETFs, and commodity calls: Direct Commodity Investment: CES recommends two pair trades on oil contracts and call options. Long February 2017 $50/bbl Brent Calls vs. short February 2017 $55/bbl Brent Calls to play the spike in oil prices that would come from a successful OPEC cut, which was recommended November 3 and was up 50.41% as of Tuesday's close. Long August 2017 WTI contract vs. short November 2017 WTI contract to play an expected flattening of the forward curve, which also was recommended November 3 and it up 48.61% as of Tuesday's close. Oil Producers: NRG recommends overweight-rated Permian oil producers EOG, PXD, FANG and PE, which will be leaders in expanding production into an improving oil price market. Service Companies: NRG recommends overweight-rated completion-oriented services companies HAL, SLB and SLCA, which will benefit most from increased U.S. shale spending. Equity-Backed ETFs: NRG recommends overweight-rated ETFs XLE, FRAK, and OIH as vehicles that provide more diversified investment exposure to higher oil prices and oilfield service activity than individual equities. Oil-Backed ETF. Tactically buying the U.S. Oil Fund ETF (USO) would provide good direct exposure to a quick oil price surge. However, USO should not be held as a longer-term investment because the inherent cost of continually rolling contracts consistently erodes USO's value versus the equity-backed ETFs XLE and OIH. This longer-term underperformance informs NRG's underweight rating on USO. Risks To Our Views: Oil and natural gas prices that differ materially from our forecasts, possibly due to slower-than-expected global economic growth and/or greater than expected supply growth. Poor operational execution and/or changes to regulatory restrictions could negatively impact the financial and stock performance of our recommendations. A week ahead of the OPEC meeting, in the wake of recently recovering production in Libya and Nigeria, and amid campaigning by Iran and Iraq to be excluded from participation in the cuts, it is impossible to know for certain how the complicated politics of OPEC and Russia will play out. Below we outline the competing objectives and risks that will be in play. Case Against A Cut Undeniably, a cut in production, particularly a coordinated cut where several countries share the burden of restricting production, would raise oil prices and enhance 2017 oil export revenues for all OPEC producers. However, that near-term benefit for pricing and revenue has been obvious for the past two years, and yet neither KSA nor Russia has been willing to cut production, feeling the potential to lose longer-term market share outweighed the immediate revenue benefits of a cut. The hazard of a price-increasing production cut, is that the higher oil price would essentially subsidize non-OPEC competitors with higher cash flows, and would simultaneously bolster the confidence of capital markets that OPEC will support prices at a floor of $50, reducing the risk of future investments. These two effects would jointly encourage increased capital investment into establishing new production, especially by the fast-acting U.S. shale producers, whose rampant investment and production growth from 2010-2015 was, by far, the leading contributor to the 2015-2016 oversupply of oil. Encouraging a resurgence of drilling and production would certainly lead to faster production growth from the U.S. shales in 2017-2018, allowing those producers to grow market share under the umbrella of OPEC's production sacrifices that created the higher prices. OPEC has just endured a lot of economic pain through the oil price decline. The economic purpose of this pain was to starve global producers of operational cash flow and dissuade the inflow of new capital, thus choking off the reinvestment required to continue to grow oil production. By and large, this goal has been achieved, with U.S. shale producers slashing capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cutting capital expenditures by 40% over the same period. As a result, after the substantial surge in global oil production in 2014-2015 that created the current over-supply, the capital starvation caused by low oil prices will result in essentially no global production growth in either 2017 or 2018, allowing for demand growth to erode the oversupply of production during 2016, and to eat into the overstocked inventories of crude during 2017-2018. KSA has created fear and uncertainty throughout global producers and capital markets by steadfastly refusing to use its production-management powers to support a floor under oil prices. We are skeptical that KSA will ultimately agree to reverse this strategy, by now establishing a price floor. Such a reversal would undermine the profound market-share message KSA has delivered to competitors (at the cost of great financial pain), and weaken its perceived resolve to allow oil prices to be set by the market. As such, the NRG team believes KSA will not agree to cut production beyond the already-expected seasonal reduction in production, and that this position will scuttle September's tacit agreement to cut production at the official meeting next week. Such a scenario would be fairly similar to how KSA undermined the production-freeze discussions in Doha in April, by insisting other OPEC members - Iran, in particular - share in the production limitations in order to engender KSA's support; a condition that other members were unwilling to accept. The Case For A Cut The case to expect a cut agreement acknowledges that such a cut would subsidize competitors and diminish the impression of KSA's resolve and/or ability to out-last competitors through an oil price down-cycle. The case for a cut concludes that the benefits of higher 2017 oil prices simply outweigh these market share and reputational costs. The benefits that OPEC and Russia would receive are: Critical Need For Higher Revenue. If KSA and Russia each cut 2017 production by 500,000 below current expectations, and oil prices jumped $10/bbl as a result, KSA's 2017 oil export revenues would increase by close to $17.5 billion, and Russia's would increase by almost $8.25 billion. If the financial pain endured by these countries is substantially greater than NRG has estimated, this near-term revenue lift could be more critical than we appreciate, overwhelming the reputational and longer-term market-share losses resulting from the reversal of policy. Borrowing capacity for each country also would increase, as a result of higher revenues. With both states seeking to tap international debt and equity markets, this increased revenue would increase their borrowing capacity. Higher Value For Asset Sales. KSA is preparing to IPO Saudi Aramco. Bolstering the spirits of capital markets with higher oil prices would be expected to increase the proceeds received from this equity sale, increase the market value of the company, reduce debt-service costs, and improve access to debt markets, which KSA and Saudi Aramco are both likely to tap more frequently in the future as the country tries to diversify the economy away from oil. Similarly, two weeks ago, Russia signed a decree to sell a 19.5% stake in Rosneft by the end of 2016. An immediate oil price strengthening and messaging that KSA and Russia would support a pricing floor would inflate the value of this sale, given the high correlation between Brent crude oil prices and Rosneft's equity price. Production Stability Not As Strong As It Seems. Russia's production levels in 2016 have been surprisingly strong, exceeding our expectations. The collapse of the Russian Ruble has allowed for continued internal investment despite the substantial reduction to dollar-denominated oil revenues. Still, it is likely that Russian producers are pulling very hard on their fields, over-producing the optimal level in an effort to scratch out higher revenues. Such over-production is not sustainable ad infinitum, and Russia may know that its fields need a rest in 2017 anyhow, so a 4-5% production cut is ultimately not much of a sacrifice. Make Room For Libya & Nigeria. Both Libya and Nigeria are trying to overcome substantial civil obstacles to allow production to increase back towards oilfield capabilities. If these problems were solved, we estimate Libya could increase production by 400,000-600,000 b/d while Nigeria could add 200,000-300,000 b/d. If KSA, OPEC, and Russia believe these countries will be able to re-establish shut-in production, they may conclude a production cut is necessary to make room for the growth, and to keep prices from collapsing. Entrenching U.S. Shale As The Marginal Barrel: If KSA and Russia can agree to a 1 MMb/d cut, U.S. shale-oil producers would be the first to take advantage of expected higher prices, given the fast-response nature of this production. This actually would work to the advantage of KSA and Russia and other low-cost producers in and outside OPEC, by firmly entrenching U.S. shale oil as the marginal barrel for the world market. On the global cost curve, shale sits in the middle some $30 to $40/bbl above KSA and Russia, which means that, as long as the global market is pricing to shale economics at the margin, these mega-producers earn economic rents on their production. In order to retain those rents, KSA and Russia will have to find a way to keep shale on the margin - i.e., regulate their production so that prices do not rise too quickly and encourage more expensive output to come on line. For KSA and Russia, it is better to climb the shale cost curve than to encourage the next tranche of production - such as Canadian oil sands - to come on to the market too quickly, or to further incentivize electric vehicles and conservation with run-away price increases, with too-sharp a production cut. Allowing prices to trade through a $65 - $75/bbl range or higher would no doubt produce a short-term revenue jump for cash-strapped producers - particularly those OPEC members outside the GCC. But it also would make most of the U.S. shales economic to develop, and incentivize other "lumpy," expensive production that does not turn off quickly once it is developed (e.g., oil sands and deepwater). This ultimately would crash prices over the longer term, making it difficult for the industry to attract capital. This is not an ideal outcome for KSA's planned IPO of Aramco, or Russia's sale of 19.5% of Rosneft, or their investors. Global Reinvestment Needs To Be Re-Stimulated. Stimulating non-OPEC reinvestment with higher oil prices and increased price-floor confidence may actually be needed in the not-too-distant future. IOCs have barely started to show the negative production ramifications of their 40% cuts to capex; cuts which will grow deeper in 2018. We expect these production declines to show up increasingly over the next four years, and there is not much the IOCs can do to stop it, since their mega-project investments generally require 3-5 years from the time that spending decisions are made until first oil is produced. With such huge cuts to future expenditures, and enormous amounts of debt incurred by the IOCs to pay for the completion of legacy mega-projects that will need to be repaid ($130B in debt added in the past two years), OPEC could see a looming shortage of oil developing later this decade if IOC-sponsored offshore production falls into steep declines, as we think is likely. To orchestrate a softer landing, to prevent oil prices from spiking too high due to a shortage of production, to head-off an acceleration in the pursuit of alternative fuels and/or the recessionary impact of an oil price spike, KSA may actually want to accelerate the re-start of global investment. Bottom Line: There are strongly credible and well-reasoned arguments that support the expectations for a successful establishment of a production cut from OPEC and Russia, as well as to doubt that such an agreement will be achieved (and adhered to) amid the political and economic competition between OPEC members and against non-OPEC producers. A successful agreement to cut production in excess of 1 MMb/d, as CES believes is likely, would be the more out-of-consensus call, with substantially bullish implications for oil prices and for our oil-levered investment strategy and stock recommendations. Even without a production cut, the NRG service remains strongly constructive on the investment strengths of high-quality Permian oil producers and the completion-oriented service companies that will benefit from increased U.S. shale spending. If a production cut is achieved, our investment cases become even stronger, as the U.S. shale producers and service companies would be the greatest beneficiaries of an upward step-change in oil prices. Matt Conlan, Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com SOFTS Dairy: Moderate Upside In 2017H1 Dairy prices may have another 5%-10% upside over next three to six months, based on tightening supply in the global dairy market. China will become more important in the global dairy market. The country's dairy imports will continue heading north. Downside risks include elevated global dairy product inventory, a supply boost from major exporters, and a continuing strengthening dollar. We have been cautiously bullish on global dairy market since last October.1 Since then, the Global Dairy Trade (GDT) All-Products Price Index, which is widely used as a benchmark price for the market, has rallied over 50% in the past seven months off its November - March lows (Chart 3, panel 1). Chart 3Dairy: Tactically Bullish bca.ces_wr_2016_11_24_c3 bca.ces_wr_2016_11_24_c3 Now the question is: will the rally continue? A review of what had happened in 2015 and so far this year may be a good start of our analysis. A Terrible 2015 The GDT index tumbled to the lowest level on record in early August 2015. A sharply drop in Chinese dairy imports; the Russian import ban on dairy products; robust supply growth across major dairy producing countries; and the EU's decision to scrap its production quotas created a perfect storm for the global dairy market last year - resulting in an extremely oversupplied market, stock builds and depressed dairy prices (Chart 3, panels 2, 3 and 4). An Improving 2016 Fundamentals have improved since April, as major dairy exporting countries responded to low dairy prices, while Chinese dairy imports revived. Fonterra, the world's biggest dairy exporter, and Murray Goulburn, Australian's biggest dairy company, both announced retrospective price cuts in April to dairy farmers in New Zealand and Australia, which hit both countries' dairy industries hard. Many farmers exited the dairy business, given their production costs were well above farm-gate milk prices. As a result, dairy farmers In New Zealand have cut the national dairy cow herd size by 3.3% yoy in 2015 and then a further 1.5% in 2016, based on USDA data. In Australia, dairy farmers have sent more cows into slaughterhouse as well. According to Dairy Australia, in the past 12 months to August 2016, 109,102 head were sold, an increase of 33% on the previous year. New Zealand and Australia are the world's largest and the fourth largest dairy exporters, respectively. In June, one month before the start of the new season (July 2016 to June 2017), farm-gate milk prices set by major dairy processors in Australia were still much lower than most dairy farmers' production costs, further damaging the country's dairy production outlook for the 2016/17 season. In July, August and September, Australian milk production fell sharply for three consecutive months, with a yoy contraction of 10.3%, 9.3%, and 10.2%, respectively. In July, the European Commission funded a €150 million program to pay farmers to cut their milk production. At the same time, the region also intervened with a stock purchase program and a private-storage aid scheme to help remove excess supply from the market. The EU region is the world's second biggest exporter. Its production increase due to the removal of its quota system was one main reason for last year's price drop. The recent supportive policy has worked well - the region's milk volumes decreased in September for the third consecutive month. In the meantime, Chinese dairy imports have rebounded 9.7% yoy for the first nine months of this year, a significant improvement from last year's 44.4% contraction over the same period. China is the world biggest dairy importer, accounting for 51% of global fluid milk imports, and 40% of dry, whole-milk powder imports (Chart 4, panel 1). Chart 4China Needs More Dairy Imports bca.ces_wr_2016_11_24_c4 bca.ces_wr_2016_11_24_c4 In comparison, the number of Chinese cow herds only accounts for 6% of global total cows for milk production, which is clearly far from meeting its domestic demand (Chart 4, panel 2). Early this year the country loosened up the "one-child" policy, and now allows "two-kids" in a family, starting this year. This will increase the country's baby formula's demand. The country's dairy product intake per capita is still far below Asian peers like Japan and Korea. Growing family wealth and increasing demand for healthy dairy food will continue boosting the dairy consumption in China. Due to the limited pasture land in the country for raising cows, we expect China's dairy imports will continue heading north. What about the price outlook in the remainder of 2016 and 2017? Most of the positive factors aforementioned are still in place. In the near term, we do not see significant supply increase. Despite the 61% price rally in the GDT price index over the past seven months, most of the price increase still has not passed to farm-gate milk prices in major producing countries (except New Zealand). Hence, for the remainder of 2016 and 2017H1, we expect prices will be prone to the upside. Pullbacks are always possible. But overall we still expect another 5% to 10% upside over next three to six months for the GDT price index. Beyond 2017H1, the price outlook is less clear. If prices either go sideways or up, milk production in major producing countries should eventually recover. For now, we hold a neutral view for dairy prices in 2017H2. Downside Risks Chart 5Downside Risks bca.ces_wr_2016_11_24_c5 bca.ces_wr_2016_11_24_c5 First, global dairy stockpiles are much higher than previous years (Chart 5, panel 1). According to the European Commission, at the end of September, around 428 thousand metric tons (kt) of skimmed-milk powder (SMP) was in public intervention stocks, while another 73 kt SMP was in private storage. In addition, there also is about 90 kt butter and 19 kt cheese stored privately. As the EU still is aiming to cut milk production to boost dairy prices, we believe the odds of an unexpected release from storage in a fast and massive manner is low. The release will likely be gradual. Second, much of New Zealand's milk production is dependent on weather conditions, which have improved from mid-August. Moreover, Fonterra increased its farm-gate milk price to $6 per kgMS (kilogram milk solid) from $5.25 per kgMS last week, which was the third increase over the past four months. Since August, farm-gate milk price in New Zealand has already been up 41% and well above the country's production cost. A combination of both factors may boost the country's milk production more than the market expected. In this case, prices could decline in 2017H1. Third, if the U.S. dollar continues strengthening versus the RMB and other major exporters' currencies, this will tend to discourage purchases from China and encourage sales from New Zealand, the EU and Australia, which will be negative to dairy prices (Chart 5, panel 2). We will monitor these risks closely. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 please see Commodity & Energy Strategy Weekly Report for softs section "Oil Markets Pricing In $20/Bbl Downside," dated October 1, 2015, available at ces.bcaresearch.com Investment Views And Themes Recommendations Tactical Trades Commodity Prices And Plays Reference Table Closed Trades

Highlights Sweden Yield Curve: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. Swedish Rates: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. NZ Rates: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Korea vs. Japan: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Feature The surprising U.S. election victory of President-elect Trump, on a policy platform that is both reflationary and protectionist, has shaken up the global macro landscape. The shock has been even more acute for small, open and export-oriented economies like Sweden, New Zealand and Korea. This triggers a necessary re-assessment of our positions. In this Weekly Report, we revisit three previously recommended trades included in our "Overlay Trades Portfolio" that are most exposed to the changing global backdrop. Sweden: Closing Our Flattener Trade... Last year, we were of the view that the Riksbank would shift to a more hawkish policy stance during 2016.1 Fast forward to today, and this has not panned out as we expected with the Riksbank persistently sticking with its dovish bias. We are no longer comfortable facing the stiff resolve of the Riksbank and, therefore, we are closing our recommended Swedish 5-year/10-year yield curve flattener trade (Chart 1). Chart 1Closing Our Sweden Flattener Closing Our Sweden Flattener Closing Our Sweden Flattener Chart 2The Dovish Rhetoric Is Paying Off The Dovish Rhetoric Is Paying Off The Dovish Rhetoric Is Paying Off The message has been clear - Sweden's central bank will stay accommodative as long as it takes to get inflation back on a sustainable upward trajectory. In a unified fashion, the most senior Riksbank officials have communicated the following: 2 Monetary policy is set to escape low inflation as fast as possible. Currency intervention to weaken the Krona cannot be ruled out. There is no problem in extending the Riksbank's asset purchase program, since it has worked well so far in keeping government bond yields at accommodative levels and helping depress the Krona. The exchange rate is now notably weaker throughout the entire Riksbank forecast period than previously assumed, but this has not been sufficient to counteract the lower underlying inflationary pressures in Sweden.3 In a nutshell, the Riksbank wants to bring about higher inflation through a depreciation of the currency. The strategy has started to work of late (Chart 2). A very accommodative monetary policy, combined with rising inflation pressures from a cheapening Krona, now points to a prolonged period of low real policy rates that will keep the Swedish yield curve under steepening pressure. Aside from the monetary policy rhetoric, the global political landscape is no longer favorable for a yield curve flattening trade either, even in Sweden. In June, when Brexit surprised the planet, our Sweden flattener trade performed well, as global uncertainty spiked and a risk-off environment supported lower longer-term bond yields. Donald Trump's upset election earlier this month had the exact opposite effect, however, triggering a massive curve steepening in most bond markets, including Sweden (Chart 3).4 Going forward, if the effects of Trump's proposed policies - such as a decent fiscal impulse and protectionist trade measures - linger, as we expect, a Swedish flattener will likely underperform. Global bond markets will continue to be heavily influenced by a steepening U.S. Treasury curve. Moreover, our optimism on Swedish growth has dimmed recently, with certain parts of the economy slowing down. At the business level, weakening new orders data signal lower industrial production growth ahead. In addition, exporter order books have rolled over, resulting in a build-up of inventories (Chart 4). Chart 3Same Populism, Different Outcome A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades Chart 4Dimming Optimism Dimming Optimism Dimming Optimism In turn, Swedish households are feeling the pinch. Slower wages and employment growth are reducing consumption. Growth in retail sales and car registrations has decelerated and private bankruptcies have started to rise (Chart 5). Since household consumption is a vital part of Sweden's economy, the recent robust expansion will moderate in the next few quarters. Consequently, the gap between the Riksbank's dovish monetary stance and the economic backdrop can no longer be deemed unsustainable, as we have described it in the past. This reality has been well depicted in the latest Riksbank Monetary Policy Report (MPR), where 2016 GDP growth is now forecasted to be only 1.8%. This seems reasonable considering the decline in actual demand - observable through the slowing growth of Swedish imports - and the Riksbank's own forward-looking economic activity index (Chart 6). The Riksbank is now projecting only a modest growth rebound to 2.5% in 2017, but this implies a meaningful reacceleration in growth to an above-trend pace later on in the year. Chart 5Swedish Households: Feeling The Pinch Swedish Households: Feeling The Pinch Swedish Households: Feeling The Pinch Chart 6Swedish GDP Growth Will Slow Further Swedish GDP Growth Will Slow Further Swedish GDP Growth Will Slow Further Bottom Line: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. ...And Placing A New Bet On Rising Swedish Inflation Currently, the Swedish Overnight Index Swap (OIS) curve is expecting monetary policy stability in the first half of next year, pricing in only a 10% probability of a rate cut and a mere 2% chance of a rate hike by July 2017. Of the two, a rate hike is most likely, in our view, given the growing risks of upside inflation surprises stemming from a weaker Krona and rising energy prices. With such a low probability of a hike currently priced into the curve, the risk/reward potential for a trade is compelling. Today, we enter into a new position: paying 18-month Swedish OIS rates (Chart 7). Chart 7Pay 18-Month Sweden OIS Rates Pay 18-Month Sweden OIS Rates Pay 18-Month Sweden OIS Rates Chart 8Energy Prices Are Crucial For Swedish Inflation A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades In the Riksbank's October MPR, the first rate increase was pushed forward from the second quarter of 2017 to the first quarter of 2018.5 At that point, the central bank's forecast becomes slightly lower than the interest rate expectation now priced in the OIS market. Even with our more sober view of the Swedish economy, the next rate hike is now expected to occur too far into the future. It will likely happen beforehand as upside surprises on inflation will force the Riksbank to begin tightening sooner than planned. Sweden's inflation path is mainly influenced by two factors: the Krona and energy prices. If the Krona's weakness accelerates and energy prices resume their uptrend, inflation will jump. In turn, if inflation reaches its target earlier, the central bank will start normalizing rates sooner than expected. Chart 9Can Sweden Still Overheat? Can Sweden Still Overheat? Can Sweden Still Overheat? As stated above, the Riksbank members' dovish rhetoric has been successful in pushing the Krona lower. Much to our astonishment, they seem ready to continue moving in that direction, despite the potential negative spillovers. The bubbly Swedish housing market - fueled by low interest rates and lacking the macro-prudential measures to stop its expansion - does not appear to be a major concern of the Riskbank for the time being. In addition to the exchange rate, the path of energy prices is crucial for inflation; it represents the bulk of the deflationary pressure over the last few years (Chart 8). Although this situation has changed recently, with a positive contribution to inflation in the last four months, energy prices will need to appreciate again to keep consumer price advances on track. This is likely to happen. Our Commodity strategists believe that the markets are understating the odds of Brent exceeding $50/bbl by the end of this year, given their expectation that Saudi Arabia and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30th in Vienna.6 If such meaningful production cuts come to fruition, energy prices will rise and add to Sweden's inflationary pressure. Moreover, the bigger structural picture in Sweden remains very inflationary, despite the short term cyclical weakness stated earlier. GDP, employment and hours worked are all expanding faster than the Riksbank's assessment of the long-run trend growth rates. Plus, according to the Economic Tendency Survey, companies are reporting labor shortages in all major business sectors.7 In sum, with resource utilization already stretched, keeping real interest rates low for longer can only prolong the steadfast Swedish credit expansion, potentially overheating the economy and creating additional inflation surprises (Chart 9). This will set the stage for an eventual shift by the Riksbank to a more hawkish posture. Bottom Line: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. New Zealand: Inflation To Re-Surface Here, As Well Chart 10Global Output Gaps Have Narrowed Global Output Gaps Have Narrowed Global Output Gaps Have Narrowed On November 9th, the Reserve Bank of New Zealand (RBNZ) cut its overnight rate to 1.75% and signaled that it would probably be on hold for the foreseeable future. From here, things could go both ways; another rate cut is not inconceivable in 2017. Yet the market is expecting a stable rate backdrop, pricing in only a 5% chance of a rate cut and a 6% probability of a rate hike by June 2017. Such an "undecided" market is not surprising. On one hand, inflation remains below target. On the other hand, the economy has been humming along with no signs of any major slowdown on the horizon. In our view, monetary policy risks are tilted towards rate hikes. Similar to Sweden's case, inflation has the potential to surprise on the upside in 2017. Several factors have contributed to the current stubbornly low inflation environment. However, going forward, those forces will abate and push inflation and, eventually, short term interest rates higher. 1.A more inflationary global backdrop New Zealand's low inflation problem comes from the tradable components. Simply put, because of the global deflationary environment of the last few years, and because of the Kiwi's strength, New Zealand has imported lower prices from abroad. But this phenomenon will move in the other direction going forward. The global inflationary backdrop has slowly changed. As noted by our Chief Global Investment Strategist, Peter Berezin, spare capacity within the developed economies has shrunk substantially over the last few years (Chart 10).8 Unemployment rates are lower than the non-accelerating inflation rates of unemployment (NAIRU) in most major countries, with the exception of France and Italy. Looking ahead, the current cyclical upswing in global growth, coming at a time of narrowing output gaps and increasing supply-side constraints, will put upward pressure on global inflation. This will eventually trigger a rise in New Zealand's import price inflation, although the impact might not be felt in the very short term. 2.A continued boost from China Closer to home for New Zealand, China's backdrop has become less deflationary. As we pointed out in a recent Special Report, China has turned into a cyclical tailwind for the global economy, putting upward pressure on inflation and bond yields in the near-term.9 Our "GFIS China Check List", composed of our favored indicators, highlights that China is in the expansionary phase of its economic cycle (Table 1). Table 1The GFIS China Checklist A Post-Trump Update Of Our Overlay Trades A Post-Trump Update Of Our Overlay Trades Most striking is that Chinese final goods producer prices have turned positive. This could prove to be a major development for New Zealand tradable goods prices, if it lasts; the correlation between Chinese PPI inflation and the tradable goods contribution to New Zealand's headline CPI has historically been elevated (Chart 11). 3.A weaker kiwi dollar Donald Trump's U.S. election victory could help raise New Zealand inflation through the exchange rate. If his ambitious fiscal plan and protectionist inclinations gain traction, the Fed might have to raise rates more aggressively than expected, putting upward pressure on the U.S. dollar. Under such a scenario, the Kiwi will re-price lower, potentially reversing the prior dampening effect on import prices from a strengthening currency. This would relieve policymakers on the RBNZ, who have consistently pointed to the currency's strength as the main reason inflation has missed the target (Chart 12). Chart 11China: A New Tailwind For Prices China: A New Tailwind For Prices China: A New Tailwind For Prices Chart 12The Kiwi Is Problematic The Kiwi Is Problematic The Kiwi Is Problematic 4.A stronger dairy sector Over the past couple of years, the Achilles heel for New Zealand has been its dairy sector, with plunging prices eroding confidence throughout the economy. Fortunately, this bad predicament is about to change as well. The exogenous factors depressing dairy prices are abating and prices are surging anew (Chart 13). The Global Dairy Trade price index has advanced in seven out of the last eight dairy auctions.10 If this impulse is prolonged, both New Zealand's export prices and domestic wages will begin to reflate. 5.A reversal of migration inflows The massive flow of migration into New Zealand since 2013 has been the main factor capping wage growth by increasing the supply of labor (Chart 14). The bulk of this inflow has been composed of young workers, aged between 15 & 29 years old.11 It is unclear if this migration will become permanent or prove to be transitory. Chart 13NZ Dairy Prices Have Rebounded NZ Dairy Prices Have Rebounded NZ Dairy Prices Have Rebounded Chart 14NZ Inward Migration To Stabilize... NZ Inward Migration To Stabilize... NZ Inward Migration To Stabilize... Much of this inflow can be explained by the weakness in the Australian economy, which has triggered migration back into New Zealand from those who left for work in Australia. As such, if the Aussie economy improves, the migration flow could conceivably reverse, at least to some extent. As a result, the domestic supply of workers would recede and the invisible ceiling on New Zealand wages would progressively disappear. This scenario is highly plausible. The latest surge in Australia's terms of trade could be an early signal of a commodity sector revival. Much of this is due to China's growth upturn this year. However, the wave of optimism towards a potential fiscal stimulus in the U.S. - especially through longer-term infrastructure projects - is a possible boost to demand that could support higher global commodity prices higher over the next few years.12 If this proves correct, New Zealand migration towards Australia could be renewed, shrinking the domestic pool of skilled labor, and pushing wages higher (Chart 15). An unwind of these disinflationary forces would coincide with improving cyclical growth prospects. A mix of strong credit growth, decent construction sector activity and robust corporate earnings should support job creation and wages in the short term (Chart 16). In this environment, consumption will accelerate. Since the output gap is already closed, faster spending will cause inflationary pressures to build (Chart 17). Chart 15...If Australian Mining Revives ...If Australian Mining Revives ...If Australian Mining Revives Chart 16An Inflationary Backdrop An Inflationary Backdrop An Inflationary Backdrop Chart 17Inflation Surprises Ahead Inflation Surprises Ahead Inflation Surprises Ahead Traders can benefit from a turnaround in New Zealand inflation prospects by playing the Overnight Index Swap market. Since April 12th of this year, we have recommended payer positions in 6-month New Zealand Overnight Index Swap (OIS) rates.13 This trade has not worked as planned, due to the stubbornly low trend of New Zealand inflation, and today we are closing that trade recommendation at a loss of -30bps. The market is currently pricing in a 23% chance of a rate hike by the September 28, 2017 RBNZ meeting. Due to the inflation risks cited above, the probability should be higher than that, in our view. As such, we are entering a 12-month OIS payer. This trade offers modest downside risk versus for a decent potential gain, i.e. a risk/reward ratio of about 3:1. Bottom Line: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Closing Our Japan/Korea Relative Value Trade This week, we are unwinding our Japan/Korea relative value trade, where we were long 5-year Korean government bonds versus 5-year Japanese Government Bonds (JGBs) on a currency-unhedged basis. While the currency leg did allow for a profitable trade, the Korea/Japan yield differential widened by +52bps. Several unpredictable events have negatively impacted Korean bonds since the trade was initiated. Chart 18Political Scandal = Higher Risk Premium Political Scandal = Higher Risk Premium Political Scandal = Higher Risk Premium Chart 19Trump: Catastrophic For Korean Bonds Too Trump: Catastrophic For Korean Bonds Too Trump: Catastrophic For Korean Bonds Too First, a scandal surrounding the Korean president, a.k.a. Choi-Gate, has erupted. As more details of the affair have been revealed, the president's approval rating has plunged - standing now at 5% - and the Government has become dysfunctional (Chart 18). In the near future, the geopolitical risks surrounding Korean assets should remain elevated as the prosecutors will continue the process of investigating the president and her associates; the risk premium on Korean bond yields might increase further. Chart 20The Korea 5-Year Bond Model The Korea 5-Year Bond Model The Korea 5-Year Bond Model Second, Trump's victory has been catastrophic for bond markets across the globe, including those related to open and export-oriented economies linked to the emerging markets, like Korea (Chart 19). Yet the impact on JGBs has been more contained since the Bank of Japan (BoJ) moved to a yield curve targeting framework back in September. The BoJ surprised many by adopting that policy of anchoring longer-term JGB yields. This has substantially reduced the volatility of JGBs, even during the recent backup in global yields. In turn, this has lowered the payoff potential of shorting JGBs, both in absolute terms and versus Korean bonds. Finally, the appeal of our Korea vs Japan trade has decreased from a valuation perspective. A simple model that we have developed for the Korean 5-year government bond yield now points towards rising yields in 2017 (Chart 20).14 With all of these factors now working against our trade, we are choosing to close it out. The trade has generated a profit from the currency exposure, which we decided not to hedge. However, when events move against the original reasons for putting on a trade, the prudent strategy is to unwind that position and look for other opportunities. Bottom Line: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 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 Special Report, "Riksbank: Close To An Inflection Point", dated September 22, 2015, available at gfis.bcaresearch.com 2 Source: Bloomberg Finance L.P. NSN OG2NHA6JIJUO GO. NSN OGD9GRSYF01S GO. NSN OGFQO26S972O GO 3 http://www.riksbank.se/Documents/Protokoll/Penningpolitiskt/2016/pro_penningpolitiskt_161026_eng.pdf 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 For details, please see http://www.riksbank.se/en/Press-and-published/Published-from-the-Riksbank/Monetary-policy/Monetary-Policy-Report/ 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut", dated November 3, 2016, available at ces.bcaresearch.com 7 Private services, retail trade, construction and manufacturing 8 Please see BCA Global Investment Strategy Weekly Report, "Slack Around The World", dated November 4, 2016, available at gis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Special Report, "How To Assess The 'China Factor' For Global Bonds", dated November 8, 2016, available at gfis.bcaresearch.com 10 https://www.globaldairytrade.info/en/product-results/ 11 For details, please see "Understanding low inflation in New Zealand", Dr, John McDermott, October 11, 2016 available at http://www.rbnz.govt.nz/news/2016/10/understanding-low-inflation-in-new-zealand 12 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2017, available at gps.bcaresearch.com 13 Please see BCA Global Fixed Income Strategy Special Report, "New Zealand: More Than Just Dairy", dated April 12, 2016, available at gfis.bcaresearch.com 14 This model is based upon a regression of Korean yields on U.S. 5-year treasury yield, Korean Trade-weighted currency, Brent crude price in USD, and Korea's headline CPI. Forecasts are based on financial market futures data and the ministry of finance's inflation forecast. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer Reaganomics 2.0? Reaganomics 2.0? In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Room To Increase Infrastructure Spending Room To Increase Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them bca.fes_wr_2016_11_11_s1_c3 bca.fes_wr_2016_11_11_s1_c3 Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Populism Can Boost Growth Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too bca.fes_wr_2016_11_11_s1_c5 bca.fes_wr_2016_11_11_s1_c5 Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Reaganomics 2.0? Reaganomics 2.0? Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Household Debt Load Can Grow Again Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates bca.fes_wr_2016_11_11_s1_c8 bca.fes_wr_2016_11_11_s1_c8 Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump Reaganomics 2.0? Reaganomics 2.0? We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China Reaganomics 2.0? Reaganomics 2.0? This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall bca.fes_wr_2016_11_11_s1_c11 bca.fes_wr_2016_11_11_s1_c11 Chart I-12China Is The Giant In The Room Reaganomics 2.0? Reaganomics 2.0? The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals bca.fes_wr_2016_11_11_s1_c13 bca.fes_wr_2016_11_11_s1_c13 Chart I-14Better Supply/Demand Backdrop For Oil bca.fes_wr_2016_11_11_s1_c14 bca.fes_wr_2016_11_11_s1_c14 We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump bca.fes_wr_2016_11_11_s1_c15 bca.fes_wr_2016_11_11_s1_c15 Chart I-16European Labor Market##br## Slack Is Evident European Labor Market Slack Is Evident European Labor Market Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally bca.fes_wr_2016_11_11_s1_c17 bca.fes_wr_2016_11_11_s1_c17 Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? bca.fes_wr_2016_11_11_s1_c18 bca.fes_wr_2016_11_11_s1_c18 Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 bca.fes_wr_2016_11_11_s2_c2 bca.fes_wr_2016_11_11_s2_c2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_11_s2_c4 bca.fes_wr_2016_11_11_s2_c4 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_11_s2_c5 bca.fes_wr_2016_11_11_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_11_s2_c6 bca.fes_wr_2016_11_11_s2_c6 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_11_s2_c7 bca.fes_wr_2016_11_11_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_11_s2_c8 bca.fes_wr_2016_11_11_s2_c8 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_11_s2_c9 bca.fes_wr_2016_11_11_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 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 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 bca.fes_wr_2016_11_11_s2_c20 bca.fes_wr_2016_11_11_s2_c20 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights Chart 1Model Weights bca.gis_taami_2016_10_28_c1 bca.gis_taami_2016_10_28_c1 In October, the model outperformed global equities in USD and local-currency terms; it also outperformed the S&P 500 in local-currency terms, while performing in line with the S&P in USD terms. For November, the model trimmed its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). The model increased its weighting in French, Dutch, and Swedish stocks at the expense of the U.S., Japan, Germany, Switzerland, New Zealand, and Emerging Asia. Within the bond portfolio, allocation to New Zealand and the U.K. was increased, while the allocation to U.S., Australian and Spanish paper was reduced. The risk index for stocks deteriorated in October, while the bond risk index improved noticeably. Feature Performance In October, the recommended balanced portfolio gained 0.6% in local-currency terms, and was down 1% in U.S. dollar terms (Chart 2). This compares with a loss of 1.4% for the global equity benchmark, and a 1% loss for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The higher allocation to EM stocks in October was timely, but the boost to bonds was a drag on the model's performance. Weights The model cut its allocation to stocks from 67% to 66% and increased its bond weighting from 21% to 26%. The allocation to cash was decreased from 12% to 8%, while commodities remain excluded from the portfolio (Table 1). The model reduced its allocation to New Zealand equities by 3 points, Emerging Asia by 2 points and U.S., Japan, Germany and Switzerland by 1 point each. Meanwhile, it increased allocation to Dutch, French and Swedish stocks by 4 points, 3 points and 1 point, respectively. In the fixed-income space, the allocation to U.K. and New Zealand paper was increased by 6 points and 5 points respectively, while allocation to Australia, Spain and the U.S. was cut by 3 points, 2 points and 1 point, respectively. Chart 2Portfolio Total Returns bca.gis_taami_2016_10_28_c2 bca.gis_taami_2016_10_28_c2 Table 1Model Weights (As Of October 27, 2016) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated in October and investors should position for additional dollar strength. Our Dollar Capitulation Index seems to be breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation bca.gis_taami_2016_10_28_c3 bca.gis_taami_2016_10_28_c3 Capital Market Indicators Our model continues to exclude commodities from the portfolio. The risk index for this asset class remains at the highest level in over two years (Chart 4). For the first time since June 2014, the risk index for global equities is above the neutral line (Chart 5). The higher overall risk reflects deteriorating liquidity and momentum readings. Our model cut its weighting in equities for the third month in a row. Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk bca.gis_taami_2016_10_28_c5 bca.gis_taami_2016_10_28_c5 The value component of the risk index for U.S. stocks improved in October, but this was overshadowed by worsening liquidity and momentum readings. The model slightly trimmed its allocation to U.S. equities (Chart 6). Even after the latest small uptick in the risk index for Dutch equities, it remains one of the lowest among the model's universe. The allocation to this bourse was increased. (Chart 7). Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_10_28_c6 bca.gis_taami_2016_10_28_c6 Chart 7Netherlands Stock Market And Risk bca.gis_taami_2016_10_28_c7 bca.gis_taami_2016_10_28_c7 The risk index for U.K. stocks declined slightly in October, but remains firmly in high-risk territory both compared to its own history and its global peers. This asset class remains excluded from the portfolio (Chart 8). The model slightly upgraded Swedish equities, despite a worsening risk index. The continued favorable liquidity backdrop remains a boon for Swedish stocks (Chart 9). Chart 8U.K. Stock Market And Risk U.K. Stock Market And Risk U.K. Stock Market And Risk Chart 9Swedish Stock Market And Risk bca.gis_taami_2016_10_28_c9 bca.gis_taami_2016_10_28_c9 After declining for four consecutive months, the overall risk index for bonds is not at extreme high-risk levels anymore. The increase in yields has helped completely unwind overbought conditions, as per our momentum indicator. The model used the latest selloff to increase its allocation to bonds (Chart 10). The risk index for U.S. Treasurys declined markedly in October, but a few other markets also feature improved risk readings. As a result, the model downgraded U.S. Treasurys (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_10_28_c10 bca.gis_taami_2016_10_28_c10 Chart 11U.S. Bond Yields And Risk bca.gis_taami_2016_10_28_c11 bca.gis_taami_2016_10_28_c11 The selloff in New Zealand bonds has pushed the momentum indicator into oversold territory, boosting the allocation to this asset class (Chart 12). The risk index for euro area bonds remains firmly in the high-risk zone even after a notable decline. However, there are select bond markets in the common-currency area that have relatively more favorable risk readings (Chart 13). Chart 12New Zealand Bond Yields And Risk bca.gis_taami_2016_10_28_c12 bca.gis_taami_2016_10_28_c12 Chart 13Euro Area Bond Yields And Risk bca.gis_taami_2016_10_28_c13 bca.gis_taami_2016_10_28_c13 Within the euro area, Italian bonds feature a risk reading that has fallen below the neutral line. While the cyclical indicator continues to move into more bond-negative territory, it is currently being offset by the oversold reading on the momentum indicator (Chart 14). U.K. gilt yields moved up as the post-Brexit inflation backdrop became gilt-unfriendly and growth surprised on the upside. Now, with momentum moving from overbought to oversold over just a couple of months, any negative economic surprises could potentially weigh on gilt yields. The model has added this asset class to the portfolio (Chart 15). Chart 14Italian Bond Yields and Risk bca.gis_taami_2016_10_28_c14 bca.gis_taami_2016_10_28_c14 Chart 15U.K. Bond Yields And Risk bca.gis_taami_2016_10_28_c15 bca.gis_taami_2016_10_28_c15 A more hawkish Fed could push the dollar higher. The 13-week momentum measure for the USD remains above, but close to the neutral line. The recovery of the 40-week rate of change from mildly negative levels which have represented a floor since 2012 would suggest that a new leg in the dollar bull market is in the offing (Chart 16). Both the 13-week and 40-week momentum measures for the euro are below the neutral line (Chart 17). Growing monetary divergences could continue weighing on EUR/USD before the technical indicators are pushed into more oversold territory. Fears of hard Brexit knocked down the pound. The 13-week rate of change is now close to its post-Brexit lows, while the 40-week rate of change measure is at the most oversold level since 2000 (excluding the great recession). At these technical levels the pound seems overdue to find a temporary bottom (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_10_28_c16 bca.gis_taami_2016_10_28_c16 Chart 17Euro Euro Euro Chart 18Sterling Sterling Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

This week, we are reviewing all of our active trades discussed in the last twelve months, which are intended to be an overlay to our recommended fixed income portfolio.

In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.