Sweden

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 In November, the model underperformed global equities and the S&P in USD and in local-currency terms. For December, the model reduced its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). Within the equity portfolio, most of the decrease in allocation came at the expense of EM, Sweden, Netherlands, U.S., and New Zealand. The model increased its weighting in Swedish, French, U.K., and Canadian bonds. The risk index for stocks deteriorated in November, while the bond risk index improved significantly. Chart 1Model Weights bca.gis_taami_2016_11_25_c1 bca.gis_taami_2016_11_25_c1 Feature Performance In November, the recommended balanced portfolio lost 1.5% in local-currency terms and was down 3.4% in U.S. dollar terms (Chart 2). This compares with a gain of 1.3% for the global equity benchmark, and a 3.7% gain 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 sharp bond selloff and weakness in EM equity markets both took a toll on the model's performance in November. Weights The model cut its allocation to stocks from 66% to 53%, and increased its bond weighting from 26% to 47%. The allocation to cash was brought down to zero from 8%, while commodities remain excluded from the portfolio (Table 1). The model trimmed its allocation to Latin American equities by 4 points, Sweden by 3 points, and the Netherlands by 3 points. Also, weightings were reduced in U.S., New Zealand, Spanish, and Emerging Asian stocks. In the fixed-income space, the allocation to Swedish paper was boosted by 12 points, France by 7 points, Canada by 5 points, the U.K. by 3 points, and Italy by 1 point. Allocation to New Zealand bonds was decreased by 6 points and U.S. Treasurys by 1 point. Chart 2Portfolio Total Returns bca.gis_taami_2016_11_25_c2 bca.gis_taami_2016_11_25_c2 Table 1Model Weights (As Of November 24, 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 significantly in November following the U.S. presidential election. Our Dollar Capitulation Index spiked and is currently at levels that suggest the rally in the broad trade-weighted dollar could pause (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation bca.gis_taami_2016_11_25_c3 bca.gis_taami_2016_11_25_c3 Capital Market Indicators The momentum indicator for commodities has moved further into overbought territory, pushing up the overall risk index. This asset class remains excluded from the portfolio (Chart 4). The deterioration in the liquidity and momentum indicators has lifted the risk index for global equities to the highest level in over 2 years. Our model cut its weighting in equities for the fourth month in a row (Chart 5). Chart 4Commodity Index And Risk bca.gis_taami_2016_11_25_c4 bca.gis_taami_2016_11_25_c4 Chart 5Global Stock Market And Risk Global Stock Market And Risk Global Stock Market And Risk The risk index for U.S. stocks increased sharply in November. With stocks reaching new highs, the model trimmed its allocation to this bourse. The markets took note of the growth-positive aspects of Trump's policies, but seem complacent about the stronger dollar, higher interest rates, and the potential for trade protectionist policies (Chart 6). The risk index for euro area equities has ticked up slightly in November. However, unlike its U.S. peers, it remains in the low-risk zone. Above-trend growth could provide support for euro area equities. (Chart 7). Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_11_25_c6 bca.gis_taami_2016_11_25_c6 Chart 7Euro Area Stock Market And Risk Euro Area Stock Market And Risk Euro Area Stock Market And Risk The risk index for Dutch equities ticked up slightly and the model has downgraded this asset. That said, the weighting in Dutch equities remains the highest among its euro area counterparts (Chart 8). Improvements in the value and momentum measures for Latin American stocks have been largely offset by a deteriorating liquidity reading. As a result, the risk index did not decline much after the selloff. The model decreased its allocation to this asset (Chart 9). Chart 8Dutch Stock Market And Risk bca.gis_taami_2016_11_25_c8 bca.gis_taami_2016_11_25_c8 Chart 9Latin American Stock Market And Risk bca.gis_taami_2016_11_25_c9 bca.gis_taami_2016_11_25_c9 Over the course of only a few months, the risk index for bonds has swung from an extremely high risk level to the low-risk zone. Momentum has been the primary driving force behind this move and currently suggests that yields could pull back in the near term (Chart 10). The risk index for U.S. Treasurys declined significantly in November. While the model used the latest selloff to boost its allocation to bonds, it preferred to add allocation to bond markets outside of Treasurys. (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_11_25_c10 bca.gis_taami_2016_11_25_c10 Chart 11U.S. Bond Yields And Risk bca.gis_taami_2016_11_25_c11 bca.gis_taami_2016_11_25_c11 After the rise in yields, Canadian bonds are massively oversold based on our momentum measure. The extremely low-risk reading has prompted the model to allocate to this asset (Chart 12). German bonds are oversold, but the reading on the cyclical measure has become considerably more bund-unfriendly. The model opted not to include bunds in the overall boost to its bond allocation. (Chart 13). Chart 12Canadian Bond Yields And Risk bca.gis_taami_2016_11_25_c12 bca.gis_taami_2016_11_25_c12 Chart 13German Bond Yields And Risk bca.gis_taami_2016_11_25_c13 bca.gis_taami_2016_11_25_c13 The risk reading in French bonds is more favorable than for bunds. Apart from oversold momentum, the value reading has also improved. The model increased its allocation to French bonds (Chart 14). The cyclical component of the risk index for Swedish bonds keeps moving in a bond-bearish direction. But that is completely overshadowed by extremely oversold conditions. In fact, the overall risk index for Swedish bonds is the lowest within our bond universe. Much of the increase in overall bond allocation ended up in Swedish paper (Chart 15). Chart 14French Bond Yields And Risk bca.gis_taami_2016_11_25_c14 bca.gis_taami_2016_11_25_c14 Chart 15Swedish Bond Yields And Risk bca.gis_taami_2016_11_25_c15 bca.gis_taami_2016_11_25_c15 Following sharp gains, the 13-week momentum measure for the U.S. dollar has reached levels at which some consolidation may take place. But the recovery in the 40-week rate of change measure indicates that it would probably be a pause in the dollar bull market rather than a trend change. With the December rate hike baked in, the Fed's communication about the policy next year holds the key to the path of the dollar - in addition to the fiscal policy of the next administration (Chart 16). The Japanese yen has been a major victim of the dollar rally. The 13-week momentum measure is approaching levels that halted the yen weakening trend in 2013 and 2015. However, this time around, it is not coupled with the same signal from the 40-week rate of change measure. The BoJ is sticking to its easy monetary policy, and some additional support on the fiscal front could drag the yen lower, notwithstanding a possible hiatus in the short term. Short term the yen could benefit from an EM pullback (Chart 17). After the latest bout of depreciation, the euro seems poised for another attempt to break below 1.05. The 13-week and 40-week momentum measures do not preclude this from happening. However, it would probably take the ECB to reaffirm its dovish message to push EUR/USD technical indicators into more oversold territory (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_11_25_c16 bca.gis_taami_2016_11_25_c16 Chart 17Yen bca.gis_taami_2016_11_25_c17 bca.gis_taami_2016_11_25_c17 Chart 18Euro bca.gis_taami_2016_11_25_c18 bca.gis_taami_2016_11_25_c18 Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

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

Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King The Return Of The King The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Groupthink In The Bond Market Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Bond Sentiment Is Depressed Bond Sentiment Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span Interest Rates Priced In A Lot In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Bond Yields Are Hurting EM Financial Conditions Chart I-7A Dark ##br##Omen A Dark Omen A Dark Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More bca.fes_wr_2016_11_18_s1_c8 bca.fes_wr_2016_11_18_s1_c8 Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex bca.fes_wr_2016_11_18_s1_c9 bca.fes_wr_2016_11_18_s1_c9 Chart I-10Mind The Gap! Mind The Gap! Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Japanese IP Is Picking Up Japanese IP Is Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same USD/JPY And Bond Yields Are One And The Same USD/JPY And Bond Yields Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action The BoJ Policy In Action The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Poor Risk/Reward Tradeoff For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire The Swedish Labor Market Is On Fire The Swedish Labor Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout AUD/SEK: Poised For A Shakeout AUD/SEK: Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. 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 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 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 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_11_18_s2_c3 bca.fes_wr_2016_11_18_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_18_s2_c4 bca.fes_wr_2016_11_18_s2_c4 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. 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_18_s2_c5 bca.fes_wr_2016_11_18_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_18_s2_c6 bca.fes_wr_2016_11_18_s2_c6 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. 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_18_s2_c7 bca.fes_wr_2016_11_18_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_18_s2_c8 bca.fes_wr_2016_11_18_s2_c8 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. 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_18_s2_c9 bca.fes_wr_2016_11_18_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. 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 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. 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 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. 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 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. 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 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. 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 SEK Technicals 2 SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. 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

Highlights Global liquidity conditions are set to tighten in the months ahead. This could add some fire to a dollar rally, especially against EM and commodity currencies. The GBP has become the new anti-dollar, reflected by its strong sensitivity to the greenback. Financing the U.K.'s large current-account deficit is a difficult task when global liquidity tightens, the layer of political uncertainty now makes it a herculean labor. While the pound is now attractive as a long-term play, it still possesses plenty downside risk. A quick look at EUR/SEK, NOK/SEK, GBP/CAD, and AUD/JPY. Feature Global liquidity conditions have begun to tighten. This development is likely to send the dollar higher and inflict serious damage on EM and commodity currencies. The pound's weakness fits nicely into this larger story. Not only is the current political climate in the British Isles prompting investors to think twice about buying British assets, but a tightening in global liquidity makes financing the U.K. current account deficit even more onerous. This adjustment demands a cheaper GBP. Global Yields: A Step Forward, Half A Step Backward The main reason why global liquidity conditions are tightening is the recent back up in global bond yields. In normal circumstances, a 39 basis-point (bp), a 24bp, and a 16bp back-up in 10-year Treasury yields, JGB yields, and bund yields, respectively, would not represent much of a problem. But today is anything but normal. The shift in global monetary policy has been behind the back-up in yields. In aggregate, global central banks are about to begin decreasing their purchases of securities. This will not only lift interest rates on government paper, but it will also raise rates for private-sector borrowing, especially as global risk premia have been depressed by an effect known as TINA - or "There Is No Alternative" (Chart I-1). The Fed too is in the process of lifting global bond yields. For one thing, U.S. labor market slack is dissipating and we are starting to witness rising wage pressures (Chart I-2). As such, we expect the Fed to raise its policy rate in December, and to further push rates higher in 2017 and 2018. Given that only 62 basis points of hike are priced in until the end of 2019, there is scope for U.S. bond yields to rise. Chart I-1Central Banks Are Contributing##br## To Tightening Liquidity Central Banks Are Contributing To Tightening Liquidity Central Banks Are Contributing To Tightening Liquidity Chart I-2U.S. Labor Market Is ##br##Showing Signs Of Tightening U.S. Labor Market Is Showing Signs Of Tightening U.S. Labor Market Is Showing Signs Of Tightening In terms of investor sentiment, despite the recent back-up in long bond yields, investors remain surprisingly upbeat on the outlook for T-bonds (Chart I-3). This, combined with their still-poor valuations, is another reason to be worried about the outlook for U.S. and global bonds for the remainder of the year. Finally, we expect U.S. real rates to have more upside than non-U.S. rates. Why? The U.S. output gap is arguably narrower than that of Europe or Japan. Moreover, the U.S. economy has deleveraged more than the rest of the G10. With U.S households enjoying strong real income growth, strong balance sheet positions, and with banks easing their lending standards to households, U.S. private-sector debt levels can expand vis-à-vis those of other developed economies. This will lift U.S. relative real rates (Chart I-4). Chart I-3Upside For ##br##Yields Upside For Yields Upside For Yields Chart I-4Real Rate Differentials Should ##br##Move In The Dollar's Favor Real Rate Differentials Should Move In The Dollar's Favor Real Rate Differentials Should Move In The Dollar's Favor What does this all mean for currency markets? As we highlighted last week, we expect the U.S. dollar to display more upside, potentially rising by around 10% over the next 18 months. We also expect more tumultuous times to re-emerge in the EM space. Rising real rates have been a bane for EM assets in this cycle. This is because EM growth has been dependent on EM financial conditions, which themselves, have been a function of global liquidity conditions (Chart I-5). Exacerbating our fear, the recent narrowing in EM spreads has not been reflective of EM corporate health. This suggests that EM borrowing costs and financial conditions are at risk of a shakeout (Chart I-6). Chart I-5Global Liquidity Conditions Will Hurt EM Global Liquidity Conditions Will Hurt EM Global Liquidity Conditions Will Hurt EM Chart I-6EM Spreads Are Priced For Perfection EM Spreads Are Priced for Perfection EM Spreads Are Priced for Perfection This obviously leads us to worry about commodity currencies as well. For one, they remain tightly linked with EM equities, displaying a 0.82 correlation with that asset class since 2000. Moreover, as Chart I-7 and Table I-1 illustrate, commodity currencies are tightly linked with the dollar and EM spreads. Thus, a combo of a higher dollar and deteriorating EM financial conditions could do great harm to the AUD, the NZD, and the NOK. Interestingly, SEK and GBP are also two potential big casualties of any such development. Chart I-7The GBP Has Become The Anti-Dollar The Pound Falls To The Conquering Dollar The Pound Falls To The Conquering Dollar Table I-1Currency Sensitivities To Key Factors, Since 2014 The Pound Falls To The Conquering Dollar The Pound Falls To The Conquering Dollar That being said, these dynamics contain the seeds of their own demise. As they are deflationary shocks, EM and commodity sell-offs are likely to elicit a dovish response from global policymakers. This will limit the upside for yields, implying that any tightening in global liquidity conditions is likely to prompt another reflationary push early in 2017. Bottom Line: Global rates still have more upside from here. U.S. real rates could rise the most as the Fed is now confronted with an increasingly tight labor market. Moreover, the U.S. economy possesses the strongest structural fundamentals in the G10. Together, this set of circumstances is likely to boost the dollar, especially at the expense of EM, commodity currencies, and the pound. GBP: Another Arrow In The Eye Nine hundred and fifty years ago to this day, King Harold, the last Anglo-Saxon King of England, died on the battlefield at Hastings from an arrow to the eye.1 The kingship of Norman William the Conqueror ushered a long and complex relationship between the British Isles and the rest of the continent. Over the past two weeks, the fall in the pound has been a dramatic story. The collapse of the nominal effective exchange rate to a nearly 200-year low, is a clear indication that the battle between the U.K. and the rest of the EU is inflicting long-term damage on the kingdom (Chart I-8). The key shock to the pound remains political. PM May made it clear that Brexit means Brexit. Additionally, elements of her discourse, such as wanting firms to list their foreign-born employees, are raising fears among the business community that the Conservatives are taking a very populist, anti-business slant that could weigh on the long-term prospects for British growth. True, these policies may never see the light of day. But across the Channel, the EU partners are taking a hardline approach to Brexit negations. Investors cheered the announcement on Wednesday that PM Theresa May will allow deeper scrutiny from parliament before triggering Brexit. Altogether, this mostly means that the cacophony over the future of the U.K. will only grow louder. Thus, we expect political headline risks to remain a strong source of uncertainty. These political games are poisonous for the pound. The U.K. is highly dependent on FDI inflows to finance it large current account deficit of nearly 6% of GDP (Chart I-9). Not knowing the status of the U.K. vis-à-vis the common market heightens any risk premium on investments in the U.K. Also, any shift of rhetoric toward a more populist discourse increases the risk that regulations could be implemented that either hurt the future profitability of British firms or increase their cost of capital. At the margin, this makes the U.K. less attractive to foreign investors. Chart I-8Something Evil This Way Comes bca.fes_wr_2016_10_14_s1_c8 bca.fes_wr_2016_10_14_s1_c8 Chart I-9The U.K. Needs Capital The U.K. Needs Capital The U.K. Needs Capital This has multiple implications. The pound remains highly sensitive to global liquidity trends, a fact highlighted by its extremely elevated sensitivity to EM spreads. The pound will also remain correlated with EM equity prices. This suggests that if a rising dollar acts as a lever to tighten global liquidity conditions, the pound will continue to be the currency with the largest beta to USD. In other words, investors will continue to express bullish-dollar views through the pound. Domestic dynamics are also problematic. The recent fall in the pound is lifting British inflationary pressures, a reality picked up by our Inflation Pressure Gauge (Chart I-10). In normal times, this could have lifted the pound as investors would have expected a response by the BoE. Today, however, the British credit impulse is very weak, in part reflecting the lack of confidence toward the future of the U.K. (Chart I-10, bottom panel). Hence, the BoE is not responding to these inflationary pressures. This combo is very bearish for the pound. It means that British real rates are falling, especially vis-à-vis the U.S. (Chart I-11). The U.K. is now in a vicious circle where the more the pound falls, the higher British inflation expectations go, which depresses British real rates and puts additional selling pressure on the pound. In other words, the U.K. is in the opposite spot of where Japan was in the spring of 2016. Chart I-10Stagflation Light! Stagflation Light! Stagflation Light! Chart I-11A Vicious Circle For GBP A Vicious Circle For GBP A Vicious Circle For GBP What is the downside for the pound? On a 52-week rate of change basis, the pound is not as oversold as it was at long-term bottoms like in 1985, 1993, or 2009. More concerning, long-term bottoms are also characterized by the 2-year rate of change staying oversold for a prolonged period, which again, has yet to be the case (Chart I-12). On the valuation front, GBP/USD is cheap, trading at a 25% discount to its PPP. However, in 1985, the pound was trading at a 36% discount to PPP (Chart I-13). The uncertainty around the future of the British economy is much higher today than in 1985. A move away from the pro-business Thatcherite policies of the 1980s, could result in a GBP discount similar to that of 1985. The sensitivity of the pound to the dollar amplifies the probability that such a scenario materializes. This could imply a GBP/USD toward 1.1-1.05 at its bottom. Chart I-12GBP/USD: Not Oversold Enough GBP/USD: Not Oversold Enough GBP/USD: Not Oversold Enough Chart I-13GBP/USD Valuation GBP/USD Valuation GBP/USD Valuation When is that bottom likely to emerge? With the strong downward momentum currently weighing on the pound, and the progressive un-anchoring of market based inflation expectations in the U.K., the bottom in the pound is a moving target. Moreover, Dhaval Joshi, who runs our European Investment Strategy service, has written about the fractal dimension as a tool to identify turning points in a trend. When the fractal dimension hits 1.25, a reversal in the trend is likely. Essentially, this metric measures group-think. When both short-term and long-term investors end up uniformly expressing the same views, liquidity dries up as there are fewer and fewer sellers for each buyer (or vice-versa).2 Currently GBP/USD's fractal dimension has not yet hit that stage. While the 3-6 months risk-reward ratio for the pound remains poor, the pound is now attractive as a long-term buy. The recent collapse in real rates and sterling has massively eased monetary conditions in the U.K. (Chart I-14). Also, even if valuations are a poor guide of near term returns, the 25% discount currently experienced by the pound suggests that on a one- to two-year basis, holding the GBP will be a rewarding bet. What about EUR/GBP? EUR/GBP has moved out of line with its historical link to real-rate differentials (Chart I-15). However, the pound's beta to the dollar is twice as high as that of the euro. Moreover, the pound is many times more sensitive to EM spreads than the euro. This suggests that our view of a strong dollar and tightening EM liquidity conditions are likely to weigh on GBP more than on the EUR for the next few months. Thus we believe it is still too early to short EUR/GBP. In fact EUR/GBP could flirt with 0.95. Chart I-14A Glimmer of Hope For The Long-Term A Glimmer of Hope For The Long-Term A Glimmer of Hope For The Long-Term Chart I-15EUR/GBP Has Overshot Fundamentals EUR/GBP Has Overshot Fundamentals EUR/GBP Has Overshot Fundamentals Bottom Line: While the pound is cheap, it can cheapen further. Not only is the pound being hampered by the political quagmire surrounding Brexit, but the strong sensitivity of the pound to the dollar and EM spreads are two additional potent headwinds for the British currency. Altogether, while the pound is most likely a long-term buy at current levels, it could still experience significant downside in the near term. We remain long gold in GBP terms. Four Chart Reviews Four long-term price charts caught our eye this week. First is EUR/SEK. As Chart I-16 shows, despite the valuation, economic momentum, and balance of payments advantages for the SEK, EUR/SEK broke out. We think this reflects the SEK's strong sensitivity to the dollar and brewing EM risks. A move to slightly above 10 on this cross is likely. Second, while we remain positive on NOK/SEK, the next few weeks may prove challenging. As Chart I-17 illustrates, NOK/SEK is about to test a potent downward sloping trend line, exactly as it is becoming overbought. With NOK being slightly more sensitive to the dollar than SEK, punching above this trend line will require much firmer oil prices. While our energy strategists see oil in the mid- to upper-$50s for next year, they worry that the recent rally to $52/bbl may have been too violent and is already eliciting a supply response from U.S. shale producers. Chart I-16EUR/SEK Can Rise Higher EUR/SEK Can Rise Higher EUR/SEK Can Rise Higher Chart I-17Big Ceiling Above Big Ceiling Above Big Ceiling Above Third, since the early 1980s, GBP/CAD has formed long-term bottom in the 1.5 region, a zone we expect to be tested again (Chart I-18). While CAD is more sensitive to commodity prices than the GBP, it is much less sensitive to the USD and EM spreads than the British currency. Also, the loonie does not suffer from a massive political handicap. That being said, each time the 1.5 zone has been hit, GBP/CAD slingshots higher. We recommend buying GBP/CAD at that level. Finally, since 1991, AUD/JPY has been strongly mean-reverting in a trading band between 60 and 110 (Chart I-19). Any blow-up in EM in the next few months is likely to prompt this cross to hit the low end of this band once again. Chart I-18GBP/CAD: Target 1.5 GBP/CAD: Target 1.5 GBP/CAD: Target 1.5 Chart I-19AUD/JPY: A Model Of Mean Reversion AUD/JPY: A Model Of Mean Reversion AUD/JPY: A Model Of Mean Reversion Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This story of his death is now considered more a legend than an historical event, but we like this story. 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.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 Policy Commentary: "We're at a point where the economic expansion has plenty of room to run. Inflation's a little bit below our target, rather than above our target... so, I think we can be quite gentle as we go in terms of gradually removing monetary policy accommodation" - Federal Reserve Bank of New York President William Dudley (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 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 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Policy Commentary: "Due to the role of global inflation, more stimulus is needed than in the past to deliver their domestic mandates; and where, due to the falling equilibrium interest rates, their ability to deliver that stimulus is more constrained" - ECB Executive Board Member Yves Mersch (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Clashing Forces - July 29, 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 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 How Do You Say "Whatever It Takes" In Japanese? - September 23, 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 Policy Commentary: "If the MPC and other monetary authorities hadn't eased policy - if they had failed to accommodate the forces pushing down on the neutral real rate - the performance of the economy and equity markets, and the long-term prospects for pension funds, would probably have been worse" - BoE Deputy Governor Ben Broadbent (October 5, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Messages From Bali - August 5, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_14_s2_c9 bca.fes_wr_2016_10_14_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low. Given very subdued growth in labor costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time" - RBA Monetary Policy Statement (October 3, 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 Messages From Bali - August 5, 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: "Interest rates are at multi-decade lows, and our current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range" - Reserve Bank Assistant Governor John McDermott (October 11, 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: "Policy is having its effects. And obviously we have room to maneuver but its not a great deal of room to maneuver and fortunately we have a different mix of policy today and the fiscal effects we talked about should be showing up in the data any time now" - BoC Governor Stephen Poloz (October 8, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 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 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 feel [negative interest rates and currency market interventions] is actually how we can ensure our mandate, namely by making the Swiss franc less attractive" - SNB Vice President Fritz Zurbruegg (October 12, 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: "Review [of the monetary policy framework] is in order... I would, however, emphasise that our experience of the current framework is positive. This suggests a need for adjustments rather than a regime change" - Norgest Bank Governor Oeystein Olsen (October 11, 2016) Report Links: The Dollar: The Great Redistributor - October 7, 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 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Policy Commentary: "We have all the tools but there are limits since the repo rate and additional bond purchases can produce undesired side-effects... We don't really know for how long future interest rate cuts will work in an effective way." - Riksbank Deputy Governor Cecila Skingsley (October 7, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Grungy Times - A Replay Of The Early 1990s? - June 10, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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.

Investors are overstating the legal and political constraints to "helicopter money"; The BoJ and BoE have few legal hurdles, whereas the ECB would have to get creative to stay within the existing law; Inflation-phobia in Germany will wane if the choice becomes euro survival; The BoJ has already laid the framework for debt monetization with its Sept. 21 decision; The risk is that debt monetization is a difficult policy to restrain once unleashed; Our long-term bet is bullish on an inflation comeback and Japanese risk assets. The helicopters are coming. The global appetite for outright debt monetization, i.e. "helicopter money," appears small today. However, the research philosophy at BCA's Geopolitical Strategy holds that policymakers respond readily to constraints and rarely get to pursue their preferences. As such, we approach every issue from the perspective of what policymakers have to do, not what they want to do. That is why we perked up when the Bank of Japan announced a new monetary policy framework on Sept. 21. The central bank says it will target the yield curve rather than the monetary base in its quest to increase inflation, reduce real interest rates, spur growth, and catapult Japan out of its long-lived liquidity trap. Assuming the policy evolves, as is typically the case, and comes to be accompanied by more ambitious fiscal spending, as we think will happen, it helps clear the way to debt monetization in all but name.1 Our colleague Peter Berezin, Chief Strategist of BCA's Global Investment Strategy, has shown how policymakers may end up dining at the trough of "money printing" (Charts 1 and 2).2 Chart 1As Long As Credit##br## Expands Faster Than Income ... bca.gps_sr_2016_09_26_c1 bca.gps_sr_2016_09_26_c1 Chart 2... Debt Burdens Will Remain High bca.gps_sr_2016_09_26_c2 bca.gps_sr_2016_09_26_c2 To summarize, Peter argues that: The BoJ and the ECB may find themselves in a situation where they have no choice but to implement heterodox monetary policy, and that may happen relatively soon. Negative interest rate policy (NIRP) has failed to increase inflation and demand, leaving intact the global deflationary tail risk and forcing policymakers and investors to ask, "What next?" Japan is stuck in a liquidity trap. Therefore orthodox monetary policy will not increase inflation and demand. Fiscal policy is needed (Charts 3 and 4). There are high political and economic constraints to raising tax rates in Japan. Hence there is little scope for fiscal stimulus that does not increase indebtedness. In the euro area, a return of the sovereign debt crisis cannot be discounted, once the lagged effects of the massive decline in bond yields and credit spreads, a weaker euro, and lower oil prices dissipate in the future. Helicopter money may become politically appealing as a way in which to boost inflation and demand in order to assuage the political costs of painful structural reforms. Chart 3Japan Is In##br## A Liquidity Trap Japan Is In A Liquidity Trap Japan Is In A Liquidity Trap Chart 4Fiscal Stimulus Will Not Drive Up##br## Interest Rates In A Liquidity Trap Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics We agree - and yet the politics can be tricky. In this analysis, we ask, What are the legal and political hurdles to debt monetization, and what are the political risks of pursuing such a policy? We believe that investors may be overstating the constraints to ultra-unorthodox monetary policy. However, we also share the view of our colleague Martin Barnes that debt monetization would entail significant "mischief," including higher political and geopolitical risks.3 Helicopter Shopping Monetary financing (i.e. "helicopter money") can be implemented in various ways.4 Whatever option is chosen, the chief advantage is that "Ricardian Equivalence" does not apply.5 This means that even as the government issues new debt, households and corporates will not restrict their spending and investing on the expectation that taxes will eventually have to go up. Debt monetization avoids this demand-suppressing phenomenon because central bank money is irredeemable, which leads to a permanent increase in the monetary base and should therefore lead to higher inflation and demand. Helicopter money is fiscal stimulus financed by monetary means (hence the term "monetary financing"). Even handing cash directly to households is ultimately a form of fiscal stimulus, equivalent to a tax cut. Critically, and unlike the latter, helicopter money does not involve any increase in government debt levels. There are several forms of monetary financing worth expanding on: Perpetual QE: The government issues government bonds and sells them to financial market participants in order to increase public expenditures or cut taxes. Beforehand, the central bank assures the public that it will buy the same amount of debt in the open market and will never sell it back again. Since bonds are normally redeemable, Ricardian Equivalence is avoided only if the central bank can credibly commit itself never to sell the purchased bonds to the open market. Then it does not matter whether the central bank cancels these bonds or rolls them over when they mature.6 Haircut on existing debt: Central banks could take a haircut on their existing holdings of government bonds, letting a large part of the public debt disappear and giving governments more scope for fiscal stimulus. This would result in a loss on the central bank balance sheet, which it would obviate by creating money out of thin air. Direct lending to government: Governments could issue perpetual zero-coupon bonds and sell them directly to the central bank. This would allow for fiscal stimulus financed by a permanent increase in the monetary base without a balance sheet loss for the central bank. Lending to a public institution: Instead of direct lending, governments could sell perpetual zero-coupon bonds to a public institution (like an infrastructure bank). The central bank would then purchase those bonds from this public institution on the secondary market. This would avoid legal prohibitions, such as those in the euro area, against direct financing of government expenditure. "Trillion dollar coin": Governments could mint a high-value coin and sell it to the central bank. This measure was discussed during the United States fiscal cliff negotiations in 2012 as a way for the president to avoid a debt crisis caused by political brinkmanship with the legislature. "Citizenship credit": Governments could issue "citizenship credits" to all households, which the central bank would then buy for a set price. This fictitious asset swap would result in increased household wealth and could thus have a larger effect on demand than the above measures.7 The evidence from past tax cuts and stimulus measures suggests that households will spend at least 20 cents of every dollar received.8 Pure helicopter drops: The most radical solution would be to print money and distribute it directly to households. In theory, this would lead to a balance sheet loss on part of the central bank because no asset would be received in return. But, in reality, as Peter Berezin points out, from the central bank's point of view "money" is merely a bond which never matures and pays no interest. By definition, such a bond has a present value of zero. From the perspective of the household receiving the money, a one-dollar bill has a present value of $1. The use of actual helicopters to deliver the cash is optional. Legal Constraints One of our guiding principles during the euro area sovereign debt crisis was to ignore any argument that relied purely on the legal architecture at hand. "Laws are meant to be broken," particularly by those who penned them in the first place. Nonetheless, legal architecture is important in so far as it suggests which type of monetary financing is more or less likely in which economy. Table 1 examines the legal constraints that major central banks face when trying to adopt the aforementioned strategies. Based on our subjective read of the "strictness" of the respective institutional constraints, we assign each central bank a number between one and four. The higher the number, the more difficult it is to implement helicopter money legally. Table 1Legal Constraints To Debt Monetization In Developed Markets Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Only direct lending to the government is strictly prohibited by most major central banks. For the Bank of Japan and the Bank of England not even this is the case, resulting in a very low legal constraint index score. In Japan, central bank governor Haruhiko Kuroda has recently said that "directly underwriting government bonds and monetizing fiscal deficits" is either illegal or "should not be done."9 However, the legal constraints seem relatively slight. Article 5 of Japan's Public Finance Law stipulates that "in special circumstances the BoJ shall be able to lend money within the amount approved by the Diet resolution." Articles 38.1 and 43.1 of the Bank of Japan Act allow the BoJ, in effect, to do whatever it deems necessary so long as it obtains the authorization of the prime minister and minister of finance. Hence, it is appropriate to conclude that legal constraints for the BoJ are minimal and that helicopter money could be implemented. This view is supported by the BoJ's Sept. 21 decision. The same conclusion can be drawn for the U.K. The existing "ways and means" facility is nothing other than direct government borrowing from the BoE. Even EU rules allow this facility, so the option remains open even if Brexit should ultimately fail to take place.10 The euro area is a more complicated case. Regarding the prohibition of debt monetization, Article 132.1 of the Treaty of Lisbon is very strict. However, Article 132.2 (the very next paragraph) provides a possible loophole, since it allows lending to a publicly owned credit institution.11 Therefore, a "European infrastructure fund" could be set up that would have access to the ECB's monetary financing and could deploy fiscal stimulus throughout the currency union. The ECB's Emergency Liquidity Assistance (ELA) facility - which provides funding to solvent euro area credit institutions facing liquidity problems - could be another way to avoid prohibitions against direct monetary financing by the ECB.12 The responsibility for the supply of ELA funding lies with national central banks, not the ECB. The ECB can only stop an ELA facility already under way with a two-thirds majority vote in its Governing Council. The ECB has argued in previous opinions that the ELA cannot be used to subvert the Article 123 prohibition against monetary financing, but circumstances may eventually alter those opinions.13 Most critically, national central banks provide liquidity under the ELA in exchange for collateral whose terms they set themselves (such as haircuts based on quality). As such, the national central bank could provide its financial institutions - including, say, a public infrastructure bank - with printed money in exchange for snow globes and comic books. And the ECB could stand aside and watch it all happen, with the Austrian and German members of the ECB Board feigning opposition with token votes against the Governing Council. Another possible loophole for the ECB arises from its Targeted Long Term Refinancing Operations (TLTRO). Under the guise of TLTRO, the ECB could provide perpetual zero-coupon loans to private banks while contractually binding them to extend these loans to any euro area citizen. Economist Eric Lonergan refers to this measure as cash transfers to households intermediated by banks.14 Finally, Article 20 of the Statutes of the ECB allows the Governing Council, by a two-thirds majority, to decide upon other operational methods of monetary control (besides the ones explicitly mentioned) in order to achieve price stability. In other words, if the ECB deems that its price stability mandate is threatened, it could vote itself the power to use helicopters. The alternative to stretching the existing law is to change it.15 Hence we will now assess the ease by which central bank rules can be changed. The possibility to amend the law is what earned the Fed a low legal constraint index in Table 1 above, since the key article has been amended several times in history. Furthermore, the proviso under which the Fed was allowed to purchase bonds directly from the Treasury was only ruled out in 1979.16 Far more difficult to change is the relevant part of the Lisbon Treaty, since that would require unanimity in the European Council and ratification by all member states, which would involve their domestic politics.17 This could be a major obstacle regarding any amendments to Article 132, as we elucidate below. Europeans will likely have to work within the rules available to them, which we think are quite malleable anyway. Finally, Sweden, unlike the United Kingdom, is bound to the Lisbon Treaty and receives no exception for direct lending to the government. Furthermore, the prohibition of monetary financing is also stated in the Sveriges Riksbank Act, making it even more complex to amend the law. The other two options - distributing cash to households and minting a high-value coin - are also of dubious legality in the Swedish case. Therefore, the Riksbank has in our view the highest legal constraints to helicopter money. Bottom Line: Legal constraints to debt monetization are far smaller than one would initially think. This is especially the case for the BoJ and BoE. The ECB would have to get creative in order to work within the law, but its statutes have wide enough holes for any helicopter to fly through. In addition, if one takes into account the raft of controversial, unconventional monetary and fiscal policies undertaken in the euro area in the recent past (Table 2), one is tempted to say, "Where there's a will, there's a way"! Table 2Europe: The Hurdle To Heterodoxy Is Low Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Political Constraints A policy as controversial as debt monetization requires political capital for implementation. In economies where legal and political constraints exist, a crisis will be necessary to overcome them. As such, we agree with our colleague Martin Barnes, who has argued that debt monetization is step three of a process where step two is a deep economic crisis.18 The constraints are not uniform across economies. Countries where households mostly struggle with the twin ills of debt and deflation would welcome higher inflation, but those where households are mostly savers would naturally not. On the other hand, even savers who depend on interest-bearing income for retirement would likely favor unorthodox monetary policy that allows interest rates to rise eventually. We therefore look at three broad factors when assessing the political constraints to monetary financing: Overall trust in monetary institutions; Household savings rate; Financial asset composition of households. Japan The two main factors that led to high saving rates in Japan, i.e. sharply rising incomes and favorable demography, have vanished (Chart 5). Japanese household savings rates have declined dramatically since the 1980s (Chart 6).19 Of course, Charts 7 and 8 show that the financial net worth of households is still massive and hence Japanese households may still prefer low inflation rates.20 But the population's aversion to inflation may not be as great as is assumed by conventional wisdom. Chart 5Japan's Demographic Dividend Is Over ... Japan's Demographic Dividend Is Over ... Japan's Demographic Dividend Is Over ... Chart 6... Leading To A Savings Rate Decline bca.gps_sr_2016_09_26_c6 bca.gps_sr_2016_09_26_c6 Chart 7Japanese Households Are Still Wealthy Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Chart 8Japan: Public Debt Vs. Private Wealth bca.gps_sr_2016_09_26_c8 bca.gps_sr_2016_09_26_c8 After all, Japanese households suffer in a low interest-rate environment because their financial assets are mainly composed of rate-sensitive products (Chart 9). Moreover, high government debt levels risk imperiling future entitlement spending. As such, the public may support policies that inflate away government debt so that the public sector can pay out pensions in future. Chart 9Only American Pensioners Are Ambivalent About The Pain Of Low Interest Rates Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics For the past four years, policies to boost inflation in Japan have received strong popular support. How else can we explain the continued political success of Prime Minister Shinzo Abe and his government, the most impressive run in twenty-first century Japan (Chart 10)? The inflation goal of Abenomics is clearly stated, not obfuscated by technocratic jargon, so it cannot simply be said that the public has been deceived. At the very least it suggests that the public understands the tradeoffs between inflation and deflation and is starting to favor the former over the latter as the household sector draws closer and closer to net debtor status. Europe The economies of the euro area have substantially different household saving rates. As such, political constraints to monetary financing are not equal across the currency union. Households in countries like Germany and France save a large fraction of their disposable income. In Spain and Italy, only a fraction of income is saved, whereas Greek and Portuguese households are net borrowers (Chart 11). Unsurprisingly, German trust in the ECB seems to be highly negatively correlated with increases in money supply (Chart 12). On the other hand, trust in the ECB in the peripheral states has recovered somewhat since the various efforts by the central bank to support their economies (Chart 13) through non-conventional monetary policy. Chart 10If Abenomics Is So Unpopular,##br## Why Is Abe Popular? bca.gps_sr_2016_09_26_c10 bca.gps_sr_2016_09_26_c10 Chart 11Discrepancy In Savings##br## Rates In The Euro Area Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Chart 12Germans Fret About Easy Money bca.gps_sr_2016_09_26_c12 bca.gps_sr_2016_09_26_c12 Chart 13Trust In ECB Recovering bca.gps_sr_2016_09_26_c13 bca.gps_sr_2016_09_26_c13 Many pundits and commentators have also pointed out that Germans will not accept higher inflation rates due to traumatic history. The 1922-23 hyperinflation is often blamed for the eventual collapse of the Weimar Republic. But this is a false narrative. The Weimar Republic did not suffer hyperinflation because of money printing but because its manufacturing base was destroyed by the First World War. This massive supply loss was exacerbated by the French and Belgian occupation of the Ruhr in January 1923 as punishment for unpaid reparations. This was a German industrial region where much of its surviving capacity was located. The cumulative loss of supply caused a price shock that the central bank attempted to assuage with money printing. Money printing was therefore primarily a consequence of a massive decline in supply, leading to rampant price inflation. In fact, it was the austerity policies of Chancellor Heinrich Brüning following the Great Depression that led to the rise of populism in Germany, not the money printing undertaken a decade earlier. At the moment, this narrative may not be the dominant one in Germany. But historical interpretations can change on a dime when circumstances demand it. The fact remains that the ECB has effectively pursued an activist monetary policy despite the supposed resistance of Germany. How do we explain this? First, EU integration remains a geopolitical priority for Germany, as well as other European states. Individual European countries are no longer capable of exerting a significant global influence independently and have sought to aggregate geopolitical power as a result.21 Whether the project will succeed may be debatable, but the reality that it has sound geopolitical logic is not. Second, Germany's export-oriented economy is particularly vulnerable to protectionism and competitive currency devaluation by its top trade partners. These policies are precisely what Berlin would suffer if it were to abandon its currency-union peers by choosing "exit" over the printing press. Italy and France would immediately devalue their currencies against the new Deutschmark, and would likely impose outright trade barriers and tariffs subsequently. In short, if Germany will not help sustain the low financing costs of France and Italy through currency union, then it will be denied access to their markets. Founders of the EU understood this dynamic, which is why multiple (unsuccessful) attempts were made to peg European currencies, first to the U.S. dollar, and later to the Deutschmark, prior to the advent of the euro. We suspect that if the euro area's sovereign-debt crisis were to arise anew, German policymakers would have to explain the tradeoff between staying true to historical narratives on hyperinflation and sustaining Germany's export-addicted economy to their public. The contest is not even close. Historical revisions would be revised. In addition, German households are, much like their Japanese peers, dependent on high interest rates for saving (see Chart 9 above). As such, they may eventually relent to a set of unorthodox policies that raises interest rates in future. Nevertheless, regardless of German history and geopolitics, the reality is that the German public is not ready for monetary financing today. As such, we suspect that the ECB will only fire up the helicopters once the integrity of the euro area is threatened anew. Thankfully for ECB policymakers, Japan will likely have already undertaken such heterodox monetary policy by that time, allowing the ECB to piggyback on BoJ efforts. The U.S. In contrast to Japan and the euro area, deflation is not as much of a risk in the United States and interest rates have not been pushed into negative territory (Chart 14). Therefore, the case for debt monetization is much weaker. In addition, U.S. households are increasingly preferring saving instead of spending (Chart 15), a dynamic that may impede the transmission mechanism of helicopter drops, which ultimately rely on household spending. Chart 14Inflation Remains Low, But Has Bottomed Inflation Remains Low, But Has Bottomed Inflation Remains Low, But Has Bottomed Chart 15U.S. Households Prefer To Save bca.gps_sr_2016_09_26_c15 bca.gps_sr_2016_09_26_c15 Despite their preferences for more savings, however, the actual savings rate for the bottom 90% households in terms of wealth is essentially zero. In fact, most U.S. households are concerned about poor job prospects, low wage growth, and high debt levels. How else can we explain the support for Donald Trump and Bernie Sanders?22 As such, the aggregate household savings rate may not be the best measure of political constraints to monetary financing in the U.S. It may overstate the preferences of the minority of the population that actually saves. The United Kingdom Chart 16Public Is Satisfied With BoE bca.gps_sr_2016_09_26_c16 bca.gps_sr_2016_09_26_c16 As in the U.S., interest rates remain positive in the U.K. In addition, growth is tolerable and the unemployment rate is near the BoE's definition of full employment (5%). Therefore, pressure for drastic measures is weak, albeit higher after the Brexit referendum shock than before. According to Chart 16, individuals are satisfied with the BoE and trust the bank to take the appropriate measures to achieve the inflation target, thus giving the BoE high political capital. British households would suffer under lower interest rates because they are heavily reliant on pension funds and life insurance for income (see Chart 9 above). Therefore, one could argue that they would rather support helicopter money than negative interest rates. Mark Carney, the BoE governor, has ruled out helicopter money even since the Brexit vote, arguing that the available stimulus tools are sufficient and "there's not a need for such flights of fancy here in the UK."23 Hence the chances of debt monetization may be low for now, assuming that the likely post-referendum recession is not very deep. However, they would increase if a shock were to hit the British economy. Just such a shock could occur after the U.K. formally exits the EU, which may still be two years away. Switzerland Swiss households save a high fraction of their net income (see Chart 6 above). In addition, the Swiss government's debt-to-GDP ratio is very low (34% as of 2015). Therefore, the current deflation is not as much of a burden for Switzerland as it would be for indebted countries. On the other hand, negative interest rates weigh heavily on pension funds, which account for a large fraction of households' financial assets (see Chart 9 above). Moreover, the overvalued Swiss franc drags on the Swiss economy. Instead of buying euros to stabilize the EUR/CHF exchange rate, the SNB could distribute this money to households. Swiss Trade, a powerful union representing the interests of 3,800 retail companies and over 10% of the Swiss labor force, has made this demand. So far, however, this kind of pressure from domestic interest groups has not made any difference. The situation could change if another sovereign-debt crisis were to hit the euro area and put further upside pressure on the Swiss franc, a safe haven asset. Sweden The Swedish population has great trust in national institutions, especially in the Riksbank.24 Its political capital is therefore large. Nevertheless, since there is no danger of deflation and the economy is doing well, it would be hard to justify such extreme policy measures. Moreover, Swedish households increased their savings rate drastically in the last few years (see Chart 6 above), making them more averse to inflation than they were a decade ago. In addition, there is no pressure for higher interest rates, since households are heavily invested in equities (see Chart 9 above), which profit from low interest rates. Political constraints are thus very high. Bottom Line: Our analysis shows that Japan has the lowest legal and political constraints to debt monetization, and recent events suggest it has begun laying the framework. In addition, if another euro crisis were to occur, the ECB and the SNB might be forced to join the BoJ in mustering the helicopters. On the other hand, it would be rather surprising in the short and medium term if the Fed, BoE, or Riksbank took concrete steps toward debt monetization. Uncharted Waters? Would helicopter money mark a dangerous voyage into uncharted waters? Not really. Western governments used debt monetization several times in the twentieth century. During the Second World War, various countries printed money to finance war costs. In the U.S., debt monetization continued after the war with the Fed purchasing government bonds directly from the Treasury from time to time. It was only in April 1979 that these purchases ceased.25 An even more striking example is Italy, which monetized its debt down to 1981: the Bank of Italy was actually forced by law to purchase all public debt not taken up by the market.26 In Canada, the Bank of Canada financed public debt down to the 1970s. Between 1935 and 1939, the BoC funded a remarkable two thirds of public debt and, during the Second World War, fiscal and monetary policy effectively merged. Inflation never exceeded 5% until the early 1970s, indicating that monetary financing can contribute to positive non-inflationary economic outcomes if conditions (and management) are right.27 Another example of a successful implementation of helicopter money is the expansionary policy undertaken by former Japanese Finance Minister Takahashi Korekiyo between 1932 and 1936. His debt monetization program is said to be the prime reason why Japan recovered so quickly from the Great Depression. At the same time, the example is instructive about the risks of helicopter money: Takahashi was ultimately assassinated by the military when he changed course on debt monetization, and the whole episode fed into Japan's slide into fascism.28 To these substantial risks, we will now turn. Bottom Line: Helicopter money is not merely theoretical. Major economies - including responsible ones like Canada and Italy - used debt monetization into the late twentieth century. Dangers Of Releasing The Kraken Chart 17Unlimited Resources ##br## Undermine Democracy Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Democracy is a process by which various interest groups and segments of the population bargain over limited resources. Democracies are successful because they institutionalize the bargaining process so that it legitimizes the decisions over who gets what. Countries with unlimited resources tend to be authoritarian regimes (Chart 17). This phenomenon is referred to as the "resource curse" and is well documented in political science. Essentially, countries that are endowed by massive natural resources can distribute the wealth to all interest groups and all segments of the population, thus obviating the need to institutionalize any part of their bargaining process. The ruling elite stays in power because it can keep buying off the population and stave off demands for representation.29 We are not saying that Japan or Europe would turn fascist because of helicopter money, but rather that it will be difficult to restrain the policy once it is unleashed. When resources become unlimited, how would democratically-elected policymakers manage to limit them? It is easy to tell various interest groups - pensioners, veterans, single mothers, low-income households - that they cannot receive what they want when the resources are limited. But the danger of helicopter money is that once the decision is taken to drop the cash from the air, the decision of who gets money for what will become extremely politicized and polarizing. Proponents argue that just as monetary policy has become independent of government, so too can fiscal policy. For example, the central bank could decide how much fiscal spending is needed to achieve its inflation target and then print the requisite amount, leaving it up to political decision-makers to decide how to divvy out the manna from heaven. The problem is that monetary policy has already become politicized in a number of countries, mainly in the emerging markets, and pressure has been mounting in the developed world. That pressure would become extraordinary once central banks start creating resources from thin air. The essence of representative government - popular control of fiscal powers - would erode. Our colleague Dhaval Joshi, Chief Strategist of European Investment Strategy, has also posited that the population could easily lose trust in institutions, even the currency itself, if the experiment gets out of control.30 This is unlikely in its first iteration, but it could happen if the process becomes politicized, which we think would happen. The other problem is that the effort to print money could become a source of geopolitical conflict if it produces a competitive debt monetization regime. For example, if the BoJ implements helicopter money and weakens the yen, China could counter by devaluing the renminbi. Since there are natural limits to how much money can be printed before inflation takes off, and neither country would want to destroy the value of its currency, the two sides might seek to counter helicopter devaluations via protectionism. Bottom Line: Debt monetization and helicopter money would short-circuit the democratic process itself. The entire point of representative government and democratic institutions is to allow for bargaining over limited resources. Once the option of unlimited resources becomes real, it will be very difficult to decide who gets to benefit. It would take a very strong government indeed - perhaps an authoritarian one - to impose limits. Investment Implications Debt monetization is not going to be fully implemented in any major economy until a serious economic crisis arrives. As such, this research effort is largely exploratory. We have presented a list of legal and political constraints that we believe will determine the sequence and the form of helicopter money in major economies. We agree with our colleague Peter Berezin that Japan may attempt some form of debt monetization in 2017-18. The monetary policy framework is already being laid. In the long term, the world is slowly moving away from its current deflationary paradigm. On the geopolitical front, we are seeing less, not more, globalization. Global multipolarity is a constraint to geopolitical stability, and this is as true today it has been over the past 200 years. We identified this trend in a 2014 Special Report, "The Apex Of Globalization: All Downhill From Here," which we encourage our clients to re-read.31 On a shorter timeline, we are seeing policymakers move away from austerity and towards greater willingness to use fiscal policy. The U.S. presidential election is instructive, as the issues of budget deficits and debt sustainability have been completely ignored throughout the campaign, despite their prominence as recently as 2012. Other major economies, including Europe, are moving away from austerity. More government spending, less globalization, and more unorthodox monetary policy all point to the end of the current deflationary era. As a play on this theme, we would recommend that investors take long positions on Japanese and German inflations swaps. We also think that it is time to turn structurally bullish on gold.32 In addition, we recommend going short JPY/long USD, even though markets will initially test the BoJ and drive the yen higher. We are renewing our strategic long Japanese stocks trade, hedged for currency, to capitalize on the ongoing paradigm shift in Japan that we identified in 2012.33 Nicola Grass, Contributing Author Marko Papic, Managing Editor marko@bcaresearch.com 1 Specifically, the BoJ pledged to keep the 10-year JGB yield at around zero, at least until inflation stabilizes at a rate above 2%. This decision amounts to a commitment to correct past inflation undershoots and to keep 10-year yields at zero regardless of the supply of new debt. Please see "Japan: Don't Count Abenomics Out," in Geopolitical Strategy Monthly Report, "Who's Afraid Of Big Bad Trump," dated August 10, 2016, and Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Helicopter Money" A Semi-Hostile Q&A," dated May 13, 2016, "Escape from the Land of The Rising Yen," dated April 15, 2016, "Japan: On The Road to Debt Monetization," dated February 5, 2016, and Global Investment Strategy Outlook, "Ten Predictions For The Rest Of The Year," dated April 1, 2016, available at gis.bcaresearch.com. In addition, please see Foreign Exchange Strategy Weekly Report, "Down the Rabbit Hole," dated April 15, 2016 available at fes.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report, "The Case Against More Monetary Mischief," dated August 16, 2016, available at bca.bcaresearch.com. 4 The term helicopter money refers to the statement by Milton Friedman in his 1969 paper "The Optimum Quantity of Money," where he proposes that a central bank could throw money out of a helicopter to increase inflation. 5 The "Ricardian Equivalence" theory suggests that individuals are forward looking and thus will assess that today's tax cuts or fiscal expenditure must be financed by tomorrow's higher tax burden. Since the intertemporal budget constraint is binding, rational individuals will not necessarily increase their current consumption even while benefiting from expansionary fiscal policy. 6 See Willem H. Buiter, "The Simple Analytics of Helicopter Money: Why It Works - Always," Economics E-Journal 8 (2014), pp. 1-38. Available at dx.doi.org. 7 Please see Global Investment Strategy Weekly Report, "Escape from the Land of The Rising Yen," dated April 15, 2016, available at gis.bcaresearch.com. 8 Please see Laura Jaramillo and Alexandre Chailloux, "It's not all Fiscal: Effects of Income, Fiscal Policy, and Wealth on Private Consumption," IMF Working Paper 15/112 (May 2015), available at www.imf.org. 9 Please see Bank of Japan, "'Comprehensive Assessment' of the Monetary Easing: Concept and Approaches," dated September 5, 2016, available at www.boj.or.jp/en. 10 According to Protocol No. 15, Article 10 of the Lisbon Treaty, the "Government of the United Kingdom may maintain its 'ways and means' facility with the Bank of England if and so long as the United Kingdom does not adopt the euro." 11 Article 132.2 of the Treaty of Lisbon: "Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions." 12 ECB, "Emergency liquidity assistance (ELA) and monetary policy," dated 2016, available at www.ecb.europa.eu. 13 Please see ECB, "Opinion of the European Central Bank of 21 November 2008," dated November 21, 2008, https://www.ecb.europa.eu/ecb/legal/pdf/en_con_2008_74_f.pdf. 14 Eric Lonergan, "Legal helicopter drops in the Eurozone,"dated February 24, 2016, available at www.philosophyofmoney.net. 15 Various academics argue that an explicit allowance of monetary financing would not undermine the independence of central banks as long as governments decide how the money will be spent and central banks decide how much money to print. See Buiter (above, note 4) and Adair Turner, "The Case for Monetary Finance - An Essentially Political Issue," 16th Jacques Polak Annual Research Conference (2015), available at www.imf.org. See also "Helicopter Ben" Bernanke, "Some Thoughts on Monetary Policy in Japan," Federal Reserve, Speech at Japan Society of Monetary Economics, dated May 31, 2003, available at www.federalreserve.gov. 16 Please see U.S. Code 355, "Purchase and sale of obligations of National, State, and municipal governments," Legal Information Institute, accessed 2016, available at www.law.cornell.edu. 17 Title 6, Article 48.6 of the Lisbon Treaty. 18 Please see footnote 3 above. 19 The longstanding Japanese household opposition to inflation has been shifting in recent years, as revealed by voter behavior since 2012. Yet some elements of the trend persist, as in the BoJ's public survey in April 2016, in which over 80% of respondents argued that a general price increase would be unfavorable. Please see Martin Feldstein, "Japan's Savings Crisis," Project Syndicate, dated September 24, 2010, available at www.project-syndicate.org. 20 See Bank of Japan, "Results of the 65th Opinion Survey on the General Public's Views and Behavior (March 2016 Survey)," dated April 18, 2016, available at www.boj.or.jp/en. 21 Please see Geopolitical Strategy Special Report, "The Euro And (Geo)politics," dated February 11, 2015, and Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit," dated November 2011, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 23 Please see Will Martin, "Carney: We Will Take 'Whatever Action Is Needed,'" Business Insider UK, dated August 4, 2016, available at uk.businessinsider.com, and Jake Cordell, "Mark Carney dismisses helicopter money as a 'compounding Ponzi scheme,'" City AM, dated April 19, 2016, available at www.cityam.com. 24 Please see European Commission, "Introduction Of The Euro In The Member States That Have Not Yet Adopted The Common Currency," Flash Eurobarometer 418 (May 2015), p.44, available at ec.europa.eu. 25 Kenneth Garbade, "Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks," Federal Reserve Bank of New York, Staff Report No.684, 2014, available at www.newyorkfed.org. 26 Guido Tabellini, "Central bank reputation and the monetization of deficits: The 1981 Italian monetary reform," Economic Inquiry 25 (1987), p.185-200, available at onlinelibrary.wiley.com. 27 Josh Ryan-Collins, "Is Monetary Financing Inflationary? A Case Study of the Canadian Economy, 1935-75," Levy Economics Institute, Working Paper No. 848 (2015), available at www.levyinstitute.org. 28 Myung Soo Cha, "Did Korekiyo Takahashi Rescue Japan from the Great Depression?" Hitotsubashi University, Institute of Economic Research Discussion Paper Series No. A395, dated September 30, 2000, available at hermes-ir.lib.hit-u.ac.jp. 29 Please see Jeffrey Sachs and Andrew Warner, "Natural Resource Abundance and Economic Growth," NBER Working Paper 5398 (December 1995), available at www.nber.org. 30 Please see European Investment Strategy Weekly Report, "The Case Against Helicopters," dated May 5, 2016, available at eis.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 32 Please see footnote 2 above. 33 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Invest Implications," dated December 21, 2012, available at gps.bcaresearch.com.

We extracted the key factors driving currency returns; these variables approximate the dollar, EM spreads, and commodities. Any currency's sensitivity to these factors can be estimated, offering a great degree of flexibility for investors to generate trade ideas. Based on our macro views, this approach recommends being short commodity currencies and being long the dollar. The BoJ, BoE, and Riksbank are also covered.

In August, the model outperformed the S&P 500 and global equities in both USD and local-currency terms. For September, the model increased its allocation to cash and trimmed its exposure to equities.