Switzerland

Highlights The level of Fed interest rates, in absolute or relative terms, has been a poor determinant of dollar bull markets. A more useful marker has been the relative performance of U.S. assets as well as relative growth rates. The U.S. economy should continue to outperform the rest of the G10 on a cyclical basis, suggesting that the USD could rise further on a 12-18 months basis. April is seasonally the cruelest month for the USD. Once this hurdle is passed, the likelihood grows that the dollar correction will be over. The conditions are slowly falling into place for the SNB to abandon the floor under EUR/CHF. Bank of Canada: Bye-bye easing bias, hello neutrality. Feature One of the great paradox of modern finance is the relationship between the dollar and the Fed. Contrary to a priories, rising U.S. interest rates are not synonymous with a rising dollar (Chart I-1). In fact, since 1975, out of seven protracted Fed tightening campaigns, the greenback fell four times. Obviously, one could argue that domestic interest rates per say are irrelevant, what matters should be the trend of U.S. interest rates relative to the rest of the world. Here again, the evidence is rather inconclusive. As Chart I-2 illustrates, since 1975, out of the eight episodes where U.S. policy rates rose relative to the rest of the advanced economies, the dollar was down or flat five times. Chart I-1The Fed Is Not An All-Weather Friend The Fed Is Not An All-Weather Friend The Fed Is Not An All-Weather Friend Chart I-2Rate Differentials Are Also A Fickle Ally Rate Differentials Are Also A Fickle Ally Rate Differentials Are Also A Fickle Ally This modern Gordian knot is not as intractable as it seems. In fact, we would argue that focusing on the Fed misses some key drivers of flows inside the U.S. economy. What really matters for the U.S. dollar is not just what the Fed does, but in fact, how U.S. assets are performing relative to the rest of the world. It's Not Just The Fed, It's Everything Simple interest rate differentials have a poor long-term track record explaining the U.S. dollar. However, one factor does seem to work better: the relative performance of a portfolio of U.S. stocks, bonds, and money market securities relative to the rest of the world. This does make sense. Investors who want to buy the USD do so because they expect to receive higher returns on their U.S. assets, independently of whether these assets are cash, stocks or bonds. As Chart I-3 shows, the ups and down of the USD have been contemporaneous with the gyrations of a U.S. portfolio invested 40% in stocks, 30% in bonds, and 30% in cash relative to the same portfolio in the euro area (and its predecessor national markets), Japan, the U.K., and Canada. However, there is a problem with this observation. It is expected returns that should drive the inflows into a currency, not the ex-post returns like the one used in the previous chart. But this forgets a key factor influencing asset returns: the momentum effect. As Chart I-4 illustrates, playing momentum continuation strategies has historically been one of the best performing investment philosophies, a fact not lost on investors.1 As such, there is a very rational reason for previously outperforming markets to attract funds by virtue of their previous outperformance. This would also explain why peaks and troughs in the relative U.S. / global portfolios tend to lead the turning points in the dollar itself. Chart I-3It's All About Returns It's All About Returns It's All About Returns Chart I-4Don't Get Against The Crowd The Fed And The Dollar: A Gordian Knot The Fed And The Dollar: A Gordian Knot The same dynamics are prevalent when one looks at bilateral pairs. This is particularly true of the EUR/USD, which has a 58% weight in the dollar index vis-à-vis major currencies. As Chart I-5 illustrates, as was the case with the dollar against the majors, EUR/USD dynamics are a function of the relative performance of a European portfolio of various assets against a similar U.S. portfolio. As an aside, it is true that the secular trend in the dollar is not nearly as well explained by the dynamics in the asset markets. On longer time horizons, other factors dominate currency returns. While the most well know long-term exchange rate determinant has been relative inflation rates (the PPP effect), our research has corroborated well-known academic findings that relative productivity differentials and net international investment positions (NIIP) also play important roles.2 While U.S. productivity growth has been equal or superior to that of the other nations comprised in the dollar index against the majors, the other variables have forced the long-term fair value of the dollar downward. Relative to Europe and Japan (the crucial weights in the dollar index), the U.S. NIIP grows each year more deeply into negative territory, and the U.S. has also experienced structurally more elevated inflation than these currency blocs (Chart I-6). Going back to the cyclical moves in the dollar, another factor has had a very strong explanatory power for the USD: Relative trend growth (Chart I-7). The 5-year moving average of real growth rate differentials - when GDP is measured at PPP, thus eliminating some currency effects - has mimicked the moves in the greenback. In the context of portfolio flows, this also makes sense. Ultimately, a faster growing economy should be able to generate higher rates of returns than slower growing ones, and thus attract more funds. Chart I-5EUR/USD And Asset Returns EUR/USD And Asset Returns EUR/USD And Asset Returns Chart I-6Secular Drags On The USD Secular Drags On The USD Secular Drags On The USD Chart I-7Growth Is Paramount Growth Is Paramount Growth Is Paramount What do these observations mean for the future path of the dollar? Despite continued noise by President Trump, we think the outlook for the dollar remains bright. First, the dollar is still not nearly as expensive as it has been at the peak of previous cyclical bull markets, which raises the likelihood that the USD has yet to hit the historical pain thresholds of the U.S. economy (Chart I-8). Further reinforcing this probability, U.S. employment in the manufacturing sector represents 10% of the working population today, versus 15% in 2001 and more than 22% in 1985 (Chart I-9). Not only does this mean that the sector of the U.S. economy most exposed to the pain created by a strong dollar is much smaller than at previous dollar peaks - raising the resilience of the U.S. economy to the tightening created by a strong dollar - the share of employment in that sector today remains much lower in the U.S. than it is in Japan and Europe. Chart I-8Valuations Have Yet To Bite Valuations Have Yet To Bite Valuations Have Yet To Bite Chart I-9The U.S. Is More Resilient To XR Moves The U.S. Is More Resilient To XR Moves The U.S. Is More Resilient To XR Moves Second, on a multi-year basis, the U.S. economic outlook remains more exciting than what the majority of the rest of the G10 has to offer. Most obviously, even if Trump changes immigration laws, the U.S. demographic outlook still outshines that of other nations (Chart I-10). Also, the U.S. benefits from being much more advanced than the rest of the G10 in its deleveraging cycle. As Chart I-11 illustrates, U.S. non-financial private debt to GDP fell from 170% of GDP to a low of 146% of GDP, while outside of the U.S., the same ratio has plateaued at 175%. This means that debt is likely to represents a greater ceiling on growth outside than inside the United States. Chart I-10A Structural Help To The U.S. A Structural Help To The U.S. A Structural Help To The U.S. Chart I-11Lower Deleveraging Pressures In The U.S. Lower Deleveraging Pressures In The U.S. Lower Deleveraging Pressures In The U.S. Third, U.S. markets can continue to attract funds. For one, most of the net inflows in the U.S. since 2015 has been driven by a surge in U.S. funds repatriation. Foreign investors remain timid buyers of U.S. assets (Chart I-12). This phenomenon is most pronounced in the equity space, where investors have been net sellers of U.S. equities (Chart I-13). Additionally, if the U.S. continues to grow faster than most other large advanced economies, FDIs inflow into the U.S. are likely to improve further, something that could be reinforced by Trump's hard-nosed trade negotiations with the rest of the world (Chart I-14). Chart I-12Foreigners Still Have Room To Buy Foreigners Still Have Room To Buy Foreigners Still Have Room To Buy Chart I-13Big Deficit In U.S. Stock Purchases Big Deficit In U.S. Stock Purchases Big Deficit In U.S. Stock Purchases Chart I-14FDI Inflows In The U.S. Can Grow More FDI Inflows In The U.S. Can Grow More FDI Inflows In The U.S. Can Grow More Finally, when it comes to money markets, the U.S. continues to hold the advantage. As we have argued, U.S. rates are likely to remain in the top of the G10 distribution. While the level and direction of rate differentials between the U.S. and the rest of the world has been a poor predictor of the USD's trend, how high U.S. rates rank globally has been a better explanatory variable of the greenback (Chart I-15). This means that money markets in the U.S. are likely to remain more attractive to investors needing to park liquidity than money markets outside the U.S. We are currently still positioned negatively on the U.S. dollar against European currencies and the yen on a tactical basis. We expect this phenomenon to be toward its tail end. First, when it comes to seasonality, April is historically the weakest month for the dollar (Chart I-16). Second, Trump's comments on Wednesday regarding the dollar's strength were enough to prompt a vicious sell-off in the dollar. Yet, this seems overdone. Unlike Reagan in 1985, Trump has little levers to force a strong re-evaluation of the euro and the yen. Moreover, his endorsement of Janet Yellen implies that the Fed is less likely to lose its independence in the near future, suggesting that U.S. rates will continue to be tightened if the economy improves. Thus, a plunge in U.S. real rates relative to the rest of the world prompted by a too easy Fed is less of a risk, reducing the probability of the re-emergence of the 1970s.3 Chart I-15Being The Leader Of The Pack Is What Matters Being The Leader Of The Pack Is What Matters Being The Leader Of The Pack Is What Matters Chart I-16April Is The Cruelest Month April Is The Cruelest Month April Is The Cruelest Month Bottom Line: On a cyclical basis, more than simple interest rate differentials between the U.S. and the rest of the world, what matters for the dollar's trend is the return on U.S. assets vis-à-vis the rest of the world as well as the growth rate of the U.S. compared to other nations. On this front, relative growth rate differentials continue to be the best factor pointing toward further USD outperformance. Tactically, the USD is in the midst of its seasonally weakest month, suggesting another down leg in DXY is likely in the coming weeks. However, it may soon be time to start buying the USD once again. EUR/CHF: Getting Closer To The End Recent data in Switzerland have shown great improvement. The PMIs are at their highest levels in six years and CPI has moved back into positive territory. This raises the specter of the end of the Swiss National Bank floor under EUR/CHF (Chart I-17). Chart I-17The SNB Floor Lives On The SNB Floor Lives On The SNB Floor Lives On While we think this peg might be in its final innings, its end is not imminent. However, we think that if Swiss data continues to improve, late 2017 will be a more supportive environment for the SNB to bury this strategy. What key signals are we looking for? First, inflation may be in positive territory, but it remains very low by recent standards. Most specifically, core CPI stands at a low 0.1%, well below the 0.8% average experienced from 1999 to 2010, an era when the euro already existed, but when the euro area crisis was still outside of investors' lexicons. As well, wage dynamics continue to underwhelm. Swiss wages are growing at a 2.4% rate compared to 3.3% from 1999 to 2010. Growth conditions also remain weak. Swiss real GDP is growing at 1%, half of the average that existed before the euro area crisis. Nominal GDP growth is undershooting the mark by an even greater margin, standing at 0.7% versus an average of 3%. What does this mean for the SNB? We would expect these datasets to move closer to their historical average before the SNB adjusts its policy stance. The main reason for this is 2015. In late 2014, just before the SNB tentatively let the CHF float, nominal and real GDP growth were outperforming current readings, yet the Swiss economy was not strong enough to handle a stronger franc. While Europe and the global economy are in a better place than in these days, risk management and precaution are likely to dictate a more careful approach by the central bank, especially as the ECB has eased monetary policy since that period, potentially causing another slingshot move in the franc if the SNB lets it float once again. In terms of strategy, we would expect the SNB to manage any appreciation in the franc following a lifting of the floor. We expect a move more akin to that of the PBoC in 2005, when the yuan, after an original 2% move, was allowed to increase progressively to minimize disruptions. We think this type of strategy is also currently being employed by the Czech central bank, and that EUR/CZK will continue to depreciate over time. This means that we would use any rebound in EUR/CHF to 1.08 to begin shorting this cross, knowing that the timing of an SNB policy change will be uncertain, but that the conditions are falling into place. Bottom Line: Even if it is still too early to bet on an imminent fall in EUR/CHF, Swiss data is moving in the right direction to expect a lift of the EUR/CHF floor later this year. As such, with the large amount of uncertainty surrounding such a decision, we would use any rebound in EUR/CHF to 1.08 to implement some short positions on the cross to bet on the eventuality of a policy change in Switzerland. Bank Of Canada: Less Dovish But Far From Hawkish The Bank of Canada this week officially removed its dovish bias. Canadian data has been very strong, with recent housing starts coming in at 254 thousand, a 10-year high. Additionally, recent employment data has been strong and so have purchasing managers index and business surveys. As a result, the BoC used this meeting as an opportunity to increase its growth expectation for the year - albeit a move heavily based on a stronger Q1 - and also brought forward in time its expectation of the closing of the output gap to early 2018. Chart I-18Canadian Surprises: More Likely##br## To Roll-Over Than Not Canadian Surprises: More Likely To Roll-Over Than Not Canadian Surprises: More Likely To Roll-Over Than Not Despite this more upbeat picture, the Bank of Canada also highlighted heavy risks to the Canadian economy. Obviously, the risks from the potential for a U.S. border adjustment tax and renegotiations of NAFTA were seen as crucial. The housing market too continues to be a big worry for the Bank of Canada, with affordability being extremely poor. Moreover, the BoC also decreased its estimate of the neutral rate and observed that monetary conditions are not as accommodative as was believed in January. Going forward, we think that the upside for the CAD remains limited. Canadian economic surprises are stretched and are very likely to rollover in the coming months (Chart I-18). This suggests that further upgrades to the Canadian economic outlook may take some time to emerge. As such, we continue to expect rate differentials between the U.S. and Canada to continue to support a higher USD/CAD, especially as Canadian money markets are already pricing in a full rate hike by Q1 2018. Bottom Line: The Bank Of Canada abandoned it dovish bias, but it is still far away from moving toward a hawkish bias. While a rate hike in 2018 is now much more likely, the market already anticipates this. As such, since the Canadian surprise index is very elevated, the likelihood of a move downward in interest rate expectations grows as surprises are likely to roll over. Stay long USD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a discussion on why momentum continuation strategies may have worked, see the April 24, 2015 Global Investment Strategy Special Report titled "Investing In Style" available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "A Guide To Currency Markets (Part I)", dated April 8, 2016, and the Foreign Exchange Strategy Special Report titled "Assessing Fair Value In FX Markets", dated February 26, 2016, both available at fes.bcaresearch.com 3 For a more detailed discussion of the 1970s stagflation, please see Foreign Exchange Strategy Special Report titled "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 President Trump, once again, delivered dollar-nuking remarks, after saying it was "getting too strong". The dollar dropped 0.7% on the news, while other currencies appreciated. The dollar has since regained most of its losses, but further upside remains questionable in the coming weeks. The market has already priced-in large amounts of monetary tightening, and recent producer price figures disappointed expectations: PPI increased at a 2.3% annual pace and contracted 0.1% monthly; core PPI increased at a 1.6% annual pace, and did not grow at a monthly pace. Additionally, in the past 5, 10 and 26 years, April has been the weakest month for the dollar. Upside is most likely limited until after the French elections. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent movements in the euro remain largely a function of the dollar. Even after the Trump-induced dollar gyrations, the euro appreciated this week. The ZEW Survey for Economic Sentiment and Current Situation both outperformed expectations, however weak industrial production figures were also evident, which contracted by 0.3% on a monthly basis, and grew at less than expectations at 1.2%. Peripheral economies are also showing strength, with inflation outperforming expectations in Italy and Greece. Nevertheless, the outlook for the euro this month remains decent, as April is notorious for dollar weakness. Moreover, Melanchon's rising popularity is a double-edge sword: while it increases the risk that yet another euro-sceptic becomes the French president, if it grows further it is likely to take away potential voters from Le Pen. In fact, with the chances of Macron winning remaining elevated, this election could ultimately could provide further support to the euro. Report Links: ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 Et Tu, Janet? - March 3, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 USD/JPY continues to fall rapidly, and now stands at 109. However, we believe the yen could still have more upside. Indeed, EM assets continue to struggle with a technical resistance, and a down leg seems imminent, given the tightening in liquidity conditions that China is currently experiencing. As evidenced by the events of early 2016, such as sell off of EM assets could supercharge yen rallies. On the data side the Japanese economy continues to show mixed signs: Labor cash earning underperformed expectations, growing by a paltry 0.4% from a year ago. However domestic corporate goods prices outperformed expectations, growing by 1.4% year on year. Overall Japanese economic activity continues to be too tepid for the BoJ to have a shift from its ultra-dovish policy. This makes us yen bears on a 12 to 18 month basis. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data from the U.K. has been mixed this week: Industrial production growth underperformed coming in at 2.8% The goods trade balance also underperformed coming in at -12.46 billion pounds. However, average hourly earnings including bonus outperformed coming in at 2.3%, while core inflation come in at 1.8%, below expectations. This last point bodes well for consumption as it would limit the downside to real income caused by the inflationary shock resulting from the depreciation of the pound. Moreover, long term inflation expectations remain relatively stable, which means that British households are looking past the temporary nature of the inflation caused by the pound sell-off. Both of these factors should help the British economy outperform expectations, and ultimately help the GBP rally against the EUR. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The ConqueringDollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 An unfortunate tropical storm, Cyclone Debbie, ravaged through the state of Queensland at the end of March. Queensland is known for its agriculture and mining industries, which suffered heavily during the hurricane. March and April export figures are likely to weaken as output was destroyed and reparations may delay production. Exacerbating this weakness is the risk of faltering import demand from China, which is the most likely the reason behind the current weakness in industrial metal prices. As this trend continues, the AUD is likely to suffer for the remainder of the year. On the bright side, the labor market has regained some vigor as full-time employment outperformed part-time employment in two consecutive months, with full-time job growing at a 30-year-high pace. However, a durable trend needs to be apparent for the labor market to fully strengthen. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 After positive import and export data out of China, the kiwi rallied strongly. The market interpreted this data as evidence that global growth is on a solid footing and that it will continue to surprise to the upside. Although we agree with the first point we disagree with the second one, as outperformance in global growth amid a sharp tightening in Chinese monetary conditions, a slowdown in Chinese shadow banking credit and a deceleration in Chinese house prices, is highly unlikely. Thus, carry currencies like the NZD are likely to underperform against the dollar. Against other commodity currency the picture is more nuanced, as strong PMI numbers of 57.8 as well as solid credit and employment numbers are evidence that the kiwi economy is better equipped to deal with a Chinese shock than Australia. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The BoC left its overnight rate unchanged at 0.5%, citing recent stronger than expected economic activity and a sooner-than-previously-anticipated closure of the output gap. The gains in the energy sector are unlikely to provide as much of a tailwind as earlier this year as the base effects from rising oil prices prove transitory on inflation and exports. The Bank highlighted labor market slack as a key factor which may contribute to the brevity of this growth impulse, as well as the business sector being hampered by low investment aimed at maintenance rather than expansion. Similarly strong data are needed to keep growth rate high enough for the Bank to become hawkish. For the time being, employment data still remains mixed. Although employment increased by 19,400, the unemployment rate ticked up to 6.7%. With only 38% of firms planning to add jobs over the next 12 months, job gains could be modest and slack could remain. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 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 After a short rally in early March, EUR/CHF cross is once again at 1.066, very close to the SNB's implied floor of 1.065. This sell-off is most likely the result of risk-off flows caused by the French presidential elections. However, we believe these fears are overstated, as Macron seems primed to win the election. Once these political fears dissipate, and economic fundamentals take over, EUR/CHF would likely be at a point where it would become an attractive short, given that there are some early signs that inflation is slowly coming back to the alpine country and that the franc has strong structural forces pushing up its value. While an abandonment of the SNB's floor in unlikely until the end of the year, investors could still begin positioning themselves for this eventuality given that a rally in EUR/CHF beyond the French election should be limited. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 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 relationship between the NOK and oil prices continues to be a strange one, as the NOK has depreciated this last month even in the face of a strong rally in oil prices. Plummeting inflation and inflation expectations in Norway are probably the main culprit, as it entrenches the Norges Bank dovish bias. All this being said, there are some faint signs that the economy is starting to recover as manufacturing PMI is at 5 year highs while consumer confidence keeps creeping up and is now at its highest point since early 2015. While we are still NOK bears, we will continue to monitor these developments, as the NOK could become an attractive buy against other commodity currencies. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 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 Recent inflation numbers corroborate downside risk to the krona. Headline inflation dropped by 0.5% to 1.3% on an annual basis; Core inflation dropped by 0.3% to 1%. This is most likely a follow-through of February's producer prices contraction. This may justify the Riksbank's fear over deflationary risks, as inflation remains tamed despite increased economic activity. However, it is likely that this proves to be a temporary phenomenon, as manufacturing new orders expanded at 12% in February, while industrial production expanded at 4.1%. Given that the next monetary policy meeting is in July, it is too early to tell if the Riksbank will further pursue its dovish stance: inflation will need to be consistently underperform further for that to happen, which is still not our base case. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 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 In January, the model outperformed global equities and the S&P 500 in USD terms, but underperformed in local-currency terms. For February, the model cut its weighting in stocks and increased its allocation to bonds (Chart 1). Within the equity portfolio, the weightings to both the U.S. and emerging markets were decreased. The model boosted its allocation to French bonds at the expense of Swedish and Canadian paper. The risk index for stocks, as well as the one for bonds, deteriorated in January. Feature Performance In January, the recommended balanced portfolio gained 1.4% in local-currency terms, and 3.6% in U.S. dollar terms (Chart 2). This compares with a gain of 3.2% for the global equity benchmark and a 2% 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 provide other suggestions on currency risk exposure from time to time. The performance of bonds was a detractor from the model's performance in local currency terms in January. Chart 1Model Weights Model Weights Model Weights Chart 2Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Weights The model decreased its allocation to stocks from 57% to 53%, and upgraded its bond weighting from 43% to 47% (Table 1). Table 1Model Weights (As Of January 26, 2017) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators The model increased its equity allocation to France, Italy, and Sweden by one point each. Meanwhile, weightings were cut by 2 points in the U.S., and by 1 point in Germany, Spain, Switzerland, Emerging Asia, and Latin America. In the fixed-income space, the allocation to French paper was increased by 6 points and the U.K. by 1 point. The model cut its exposure to Swedish bonds by 2 points and Canadian bonds by 1 point. 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 weakened in January and our Dollar Capitulation Index fell close to neutral levels. Uncertainty over the size of the fiscal push by the U.S. administration could prolong the dollar's consolidation phase, especially if coupled with any negative economic surprises. However, this would only be a pause since continued monetary policy divergence should translate into another leg up in the dollar bull market (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The deterioration of the value and cyclical components led to a higher risk index for commodities. The model continues to shun this asset class (Chart 4). The risk index for global equities increased to a 3-year high in January due to the deterioration in the value indicator. While the global risk index for global bonds also deteriorated, it remains firmly in the low-risk zone. The model slightly decreased its allocation in equities to the benefit of bonds (Chart 5). Chart 4Commodity Index And Risk Commodity Index And Risk Commodity Index And Risk Chart 5Global Stock Market And Risk Global Stock Market And Risk Global Stock Market And Risk Following the latest uptick in the risk index for U.S. equities, the allocation to this asset class was trimmed. U.S. stocks have been propped up by the growth-positive aspects of the new U.S. administration's policies and are at risk should this optimism deflate (Chart 6). The risk index for Canadian equities improved slightly in January as the better readings in the liquidity and momentum indicators offset continued worsening in value. That said, the overall risk index remains at the highest level in this business cycle. This asset remains excluded from the portfolio (Chart 7). Chart 6U.S. Stock Market And Risk U.S. Stock Market And Risk U.S. Stock Market And Risk Chart 7Canadian Stock Market And Risk Canadian Stock Market And Risk Canadian Stock Market And Risk The risk index for U.K. equities deteriorated, reaching a post-Brexit high. For the first time in over two years, the value component crossed into expensive territory (Chart 8) The model trimmed its allocation to Emerging Asian stocks following the slight uptick in the risk index. While the global reflationary pulse should bode well for this asset class, rumblings about protectionism threaten to de-rate growth expectations (Chart 9). Chart 8U.K. Stock Market And Risk U.K. Stock Market And Risk U.K. Stock Market And Risk Chart 9Emerging Asian Stock Market And Risk Emerging Asian Stock Market And Risk Emerging Asian Stock Market And Risk The unwinding of oversold conditions was the main reason behind the deterioration in the risk index for bonds in January. However, the latter is still in the low-risk zone as the bond-negative reading from the cyclical indicator remains overshadowed by the ongoing oversold conditions in the momentum indicator (Chart 10). The risk index for U.S. Treasurys deteriorated in January on the back of a less-stretched momentum indicator. While the cyclical backdrop is bond-bearish, there is arguably more room for scaling down optimism over the economy than there is to having an even more upbeat outlook. As a result, any resumption of the rise in Treasury yields could end up being very gradual (Chart 11). Chart 10Global Bond Yields And Risk Global Bond Yields And Risk Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk U.S. Bond Yields And Risk U.S. Bond Yields And Risk The risk index for euro area government bonds also deteriorated in January, but unlike the U.S., it is in the high-risk zone. There are notable differences in the risk readings within euro area markets (Chart 12). Given the upcoming presidential elections, France is next in line in terms of investors' focus on political risks. French bonds are heavily oversold based on the momentum indicator, pushing the overall risk index lower. An unwinding of the risk premium would bode well for French bonds, which the model upgraded in January (Chart 13). Chart 12Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Euro Area Bond Yields And Risk Chart 13French Bond Yields And Risk French Bond Yields And Risk French Bond Yields And Risk The risk index for Spanish government bonds ticked down slightly reflecting minor improvements in all three of its components. However, it remains much higher than the risk index for the French paper, which is preferred by the model (Chart 14). With the risk index little changed in January, Swiss government bonds remain in the high-risk zone. The model continues avoiding this asset which possesses negative yields (Chart 15). Chart 14Spanish Bond Yields And Risk Spanish Bond Yields And Risk Spanish Bond Yields And Risk Chart 15Swiss Bond Yields And Risk Swiss Bond Yields And Risk Swiss Bond Yields And Risk Currency Technicals The dollar depreciated after the 13-week momentum measure indicated last month that the greenback could face near-term resistance. Further consolidation cannot be ruled out, but the 40-week rate of change measure is not signaling an end to the dollar bull market. The monetary policy divergence between the Fed and its peers provides underlying support for the dollar, while heightened uncertainty on the fiscal front implies more volatility going forward (Chart 16). EUR/USD was not able to stay below 1.05. The short-term rate-of-change measure is approaching neutral levels, which could test the EUR/USD bounce. A risk-off episode or continued solid economic data are two factors that could provide some support for the euro in the near term (Chart 17). The 40-week rate of change measure for GBP/USD continues to hover near the most oversold level since 2000 (excluding the great recession). Meanwhile, the 13-week momentum measure crossed into positive territory, but is not extended. The pound will remain event-driven and possibly range-bound in the near term as the mood bounces within the hard Brexit / soft Brexit spectrum (Chart 18). Chart 16U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* U.S. Trade-Weighted Dollar* Chart 17Euro Euro Euro Chart 18Sterling Sterling Sterling Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights The recent tightening in U.S. monetary conditions increases the risk of a pause in the dollar bull market. The yen is in a strong cyclical bear market, but it is best placed to benefit from a dollar correction. The ECB just eased policy; monetary divergences between the euro area and the U.S. will only grow wider, hurting the cyclical prospects for EUR/USD. We are opening a short EUR/JPY tactical trade. The SNB's EUR/CHF floor is firmly in place. USD/CHF will continue to mirror EUR/USD until Switzerland's output gap is fully closed. Feature The dollar will make new cyclical highs against all currencies, but the short-term outlook for the greenback is poor. The 7% appreciation in the dollar and the 100 basis point move in 10-year Treasury yields have tightened U.S. monetary conditions considerably. This development would be manageable in the face of actual stimulus, but it is a much greater handicap when the economy has not yet received any shot in the arm. Tactically, the yen is well positioned to benefit from a dollar correction as the ECB just deepened its easing bias. The Dollar Faces Short-Term Headwinds The dollar is extremely overbought, as our Capitulation Index warns of an imminent correction (Chart I-1). The likelihood that the dollar weakens further around the Fed's meeting is growing. Our discounter suggests the market is already expecting rates to be 60 basis points higher a year from now. While we do think this hurdle will ultimately be beaten, the move has been too fast. The U.S. economy has surprised to the upside, a reality highlighted by the strong rebound in the U.S. surprise index. However, this development is backward looking. While the economy has yet to receive the benefit of the potential Trump stimulus, it still has to contend with large adjustments in financial variables. Take mortgage rates as an example. They have risen by 70 basis points since July to 4%; however federal income tax withholdings - a proxy for income growth - have plunged (Chart I-2). Falling income growth and rising financing costs create a major tightening of U.S. household financial conditions. Chart I-1Overbought Dollar bca.fes_wr_2016_12_09_s1_c1 bca.fes_wr_2016_12_09_s1_c1 Chart I-2Tightening The Screw On Households bca.fes_wr_2016_12_09_s1_c2 bca.fes_wr_2016_12_09_s1_c2 On the corporate front, while the ISMs paint a very upbeat picture, the shock from the dollar's surge is large. The 7% increase in the broad trade-weighted dollar since August could curtail profits growth by 15%. This could lead to additional weakness in capex and a slowdown in employment. Altogether, based on the Fed FRB model, the recent interest rate and dollar moves could shave 1% from GDP over the next 8 quarters. This is not a trivial amount when trend growth is around 1.5%. This reality is unsustainable. As such, we agree with our U.S. Bond Strategy service that a temporary pullback in yields is likely. As we argued three weeks ago, this would mean a correction in the overbought dollar.1 Ultimately, this correction should prove temporary. The U.S. economy was on a strong footing before liquidity conditions tightened. A reversal of the recent dollar and bond moves will only solidify this economic trend. And exactly as the economy's strength redoubles, Trump's fiscal stimulus will take shape. The timing of this development is uncertain. Our current bet is that this will happen in late Q1 2017. Once our Composite Capacity Utilization Gauge moves back into "no-slack" territory, the market's now-premature Fed pricing will be warranted (Chart I-3). This is when the USD can rise again. Chart I-3Conditions For Repricing The Fed: Almost There bca.fes_wr_2016_12_09_s1_c3 bca.fes_wr_2016_12_09_s1_c3 Bottom Line: The dollar is in the midst of a cyclical bull market. However, markets rarely move in a straight line. This time is not different. The recent surge in the dollar and bond yields hurt the very fundamentals that have supported these moves in the first place. With the pain being inflicted on the economy before the benefits of any Trump stimulus package are felt, the likelihood of a partial reversal of recent trends is growing. The Yen: A Vehicle To Play A Dollar Correction The yen should be the key beneficiary of a dollar counter-trend fall. Our yen Capitulation Index shows that USD/JPY has not been as overbought as it is now in 21 years (Chart I-4). Moreover, bond yields continue to correlate tightly with the yen (Chart I-5). This simply reflects the low beta of Japanese yields. When global rates move up, JGB yields rise less, implying widening rate differentials in favor of USD/JPY. The opposite is also true. Chart I-4Yen Is Massively Oversold bca.fes_wr_2016_12_09_s1_c4 bca.fes_wr_2016_12_09_s1_c4 Chart I-5Yen And Bonds: Brothers In Arms bca.fes_wr_2016_12_09_s1_c5 bca.fes_wr_2016_12_09_s1_c5 While we continue to hold our short USD/JPY tactical trade, we remain very worried over the long-term outlook for the yen. The old policy of the Bank of Japan, targeting the quantity of money, was a failure. The monetary base increased by 220% between December 2012 and today, but M2 only grew 15% or so. In effect, the BoJ changed the composition of Japanese money, skewing it toward bank reserves as the money multiplier collapsed by 65% (Chart I-6). However, the new policy of targeting the price of money - interest rates - should deliver a higher growth dividend. As the economy improves, inflation expectations perk up (Chart I-7). But with the BoJ keeping nominal rates capped near 0%, this depresses real rates, further stimulating the economy and boosting inflation expectations. This also hurts the yen. Chart I-6Targeting The Quantity Of ##br##Money Was A Failure bca.fes_wr_2016_12_09_s1_c6 bca.fes_wr_2016_12_09_s1_c6 Chart I-7Stronger Japan = Higher##br## Inflation Expectations Stronger Japan = Higher Inflation Expectations Stronger Japan = Higher Inflation Expectations \ Additionally, by capping JGB yields at 0%, the BoJ accentuates the upward pressure on yield differentials between the rest of the globe and Japan that naturally occurs when global yields move up. This means that an upward move in global rates is even more harmful to the yen than before. Finally, the Abe administration is ramping up its fiscal stimulus rhetoric as the job-opening-to-applicants-ratio hits its highest level since 1991. Stimulating the economy in the face of labor market tightness is inflationary. With the BoJ committing to an accommodative policy stance until inflation overshoots by a wide margin, this policy is tantamount to willingly crush real rates and the yen.2 Bottom Line: The yen cyclical bear market is intact. However, if the dollar corrects and Treasurys temporarily rally, the extremely oversold yen will be the prime beneficiary. The Euro: This Is Not Tapering Mario Draghi managed to please both the hawks and the doves on the ECB's governing council. But once the dust settles, this week's policy move represents an important easing. While the ECB's purchases will be curtailed to EUR60 billion from EUR80 billion in April 2017, the asset purchase program now has an unlimited time frame. Additionally, not only can the ECB buy securities with a maturity of 1-year, the -40 basis-point floor on eligible securities has been scrapped. The staff forecasts reinforced a dovish message. Inflation expectations have been revised down, from 1.6% to 1.3% in 2017, despite an acknowledgement that energy prices will positively contribute to inflation. Furthermore, when a journalist asked President Draghi if the 2019 HICP forecast of 1.7% was in line with the ECB's target of "close but under 2%", Draghi squarely responded that 1.7% was not within the target; and therefore, the ECB would persist in maintaining its monetary accommodation. Moreover, the market responded with all the signs that the ECB had eased policy. The yield curve steepened by 11 basis points - its sharpest daily move since mid-2015, the euro plunged 1.3%, and European stocks, led by financials, rallied. With regards to the economic outlook, recent survey data have improved, with eurozone manufacturing and service PMIs rising to 53.7 and 53.8, respectively. However, worrying signs highlight the persistence of the euro area output gap. Euro area core CPI has rolled over and wage growth is slowing, despite the falling unemployment rate (Chart I-8). Additionally, broad money supply growth has rolled over sharply, seconding the omen bank equities have flashed for future credit growth (Chart I-9). Therefore, the European credit impulse could wane in the coming quarters. Chart I-8European Labor Market Slack Is Evident ##br##Signs Of European Excessive Slack bca.fes_wr_2016_12_09_s1_c8 bca.fes_wr_2016_12_09_s1_c8 Chart I-9Money, It's ##br##A Crime bca.fes_wr_2016_12_09_s1_c9 bca.fes_wr_2016_12_09_s1_c9 Going forward, monetary divergence between the euro area and the U.S. will grow further, supporting our bearish EUR/USD stance and our bullish dollar view. We are closing our long EUR/AUD trade as the ECB is clearly bent on goosing the European economy. Tactically, the outlook is much trickier and the euro could rebound. The euro capitulation index is oversold and relative positioning between the EUR and the USD is skewed (Chart I-10). For now, we are expressing our negative view on the euro by shorting EUR/JPY. Being in place since late September, the dovish implications of the BoJ's policy are much better appreciated by the market than the recent ECB's move. Moreover, short-term technicals for EUR/JPY are stretched and are beginning to roll over (Chart I-11). A pull back in EUR/JPY toward 116.5 is likely. Chart I-10Euro: Oversold... bca.fes_wr_2016_12_09_s1_c10 bca.fes_wr_2016_12_09_s1_c10 Chart I-11...But Overbought Against The Yen bca.fes_wr_2016_12_09_s1_c11 bca.fes_wr_2016_12_09_s1_c11 Bottom Line: The ECB eased policy this week. With the European economy exhibiting fewer signs of an impending pickup in inflation than the U.S., monetary divergences between the Fed and the ECB will only grow wider in the future. This will weigh on EUR/USD. In the short-term, risks to the USD could help the euro. Thus, we elect to express our bearish view on the euro by shorting EUR/JPY for now. The Swiss Franc: A Floor Is A Floor The SNB unofficial floor below EUR/CHF 1.06 is firmly in place. The Swiss economy sports a negative output gap of around 2.5% of GDP according to the IMF and OECD. Even after recent improvements, headline and core CPI remain below 0%. Both nominal and real Swiss retail sales are contracting at a 2.5% annual pace. This fits with wage growing near 0%, with consumer confidence hovering near levels last registered when the euro crisis was raging, and with house price annual growth falling to 1%. Unsurprisingly, Swiss business confidence is below its post-crisis average and business investment is tepid. In line with this poor corporate and consumer backdrop, Swiss non-financial credit growth has fallen to near 0% - among the lowest readings in the past 20 years, and the money multiplier remains depressed (Chart I-12). This suggests that the output gap will continue to narrow only slowly. Interestingly, the outlook for Switzerland was on a definite upswing in 2014, but the botched CHF unpegging of January 2015 caused the economic relapse witnessed in 2015 and 2016. With Swiss stocks - financials and exporters particularly - underperforming global averages, financial markets are still flashing a red flag for the SNB. This means USD/CHF will continue to mirror EUR/USD. Moreover, positioning on the CHF is at oversold extremes, highlighting the risk of a correction in USD/CHF (Chart I-13). Chart I-12No Credit Growth In Zurich bca.fes_wr_2016_12_09_s1_c12 bca.fes_wr_2016_12_09_s1_c12 Chart I-13Swissie Is Oversold bca.fes_wr_2016_12_09_s1_c13 bca.fes_wr_2016_12_09_s1_c13 On a structural basis, the outlook for the CHF is much brighter. The Swiss economy will firm as the SNB keeps the EUR/CHF floor in place. Employment growth is strong, real exports are healthy, and financial as well as monetary conditions are very supportive. Money supply should ultimately pick up. The SNB is expanding its balance sheet through the reserve accumulation required to maintain the peg. In due time, inflationary pressures and wage growth will re-emerge in Switzerland. In terms of signal, once we see Swiss inflation and wage growth back above 1%, as well as non-financial private-credit growth moving back to its post-2010 average, the SNB should abandon its peg. Supported by a net international investment position of 120% of GDP and a current account surplus of 11% of GDP, the long-term equilibrium exchange rate for CHF will continue to rise, lifting the Swiss franc in the process (Chart I-14). Chart I-14The CHF Has A Long Term Positive Bias bca.fes_wr_2016_12_09_s1_c14 bca.fes_wr_2016_12_09_s1_c14 Additionally, the inflationary consequences of Trump's policies may take time to emerge, but U.S. inflation could rise markedly when the USD cyclical rally ends.3 Because Switzerland is structurally a low-inflation economy and a net creditor to the world, the long-term appeal of the Swiss franc will only increase. Bottom Line: The SNB unofficial floor under EUR/CHF is alive as the Swiss economy still exhibits deflationary tendencies. On a 12-18 months basis, USD/CHF will move higher as the CHF will be dragged down by EUR/USD. Structurally, the Swiss franc will become a buy only once the SNB abandons its current policy. We are monitoring inflation, wages, and credit growth to judge when this will become a reality. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "One Trade To Rule Them All", dated November 18, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the BoJ's policy, 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 3 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_12_09_s2_c1 bca.fes_wr_2016_12_09_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_12_09_s2_c2 bca.fes_wr_2016_12_09_s2_c2 The dollar rose substantially on Thursday after the ECB policy decision. Before this, DXY had already hit overbought levels, as shown by the RSI. Currently, the capitulation index is also in overbought territory, suggesting that a correction is to come. Moreover, it is likely that the market had overpriced Trump's fiscal proposals, as details have yet to be released. The U.S. economy remains strong for now. The ISM Manufacturing and Non-Manufacturing hit 53.2 and 57.2, respectively. The labor market remains healthy despite the recent disappointing job reports. However, the tightening in U.S. financial conditions represents a short-term hurdle. Report Links: Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_12_09_s2_c3 bca.fes_wr_2016_12_09_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_12_09_s2_c4 bca.fes_wr_2016_12_09_s2_c4 The euro encountered significant volatility following the ECB's decision. Although the interest rates were left unchanged, the ECB put forth an extension of the asset purchase program (APP) at the current pace of EUR 80 billion, but plan to reduce purchases to EUR 60 billion by April 2017. The euro declined on the news, and on a possible increase of the purchases if "the outlook becomes less favorable". Recent data reflects a strong economy overall, as well as strong performances from its participants. This will limit the euro's downside. However, the euro may encounter some volatility in the long run as potential political risks begin to be priced in, and stimulating monetary policy continues. 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_12_09_s2_c5 bca.fes_wr_2016_12_09_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_12_09_s2_c6 bca.fes_wr_2016_12_09_s2_c6 The oversold U.S. bond market is finally stabilizing, a development that has also put a halt on the rapid yen sell-off of the past month, with USD/JPY encountering resistance at around 114.5. We are of the view that then yen downturn is overdone, as USD/JPY currently stands at highly overbought levels. That being said we continue to reiterate that past the short term, the outlook for the yen remains extremely bearish. The BoJ will continue to implement radical measures until it sees any signs of life in Japanese inflation. Recent data suggest this is not likely to happen any time soon: Japanese consumer confidence continues to be very depressed, standing at 40.9. Japanese GDP grew by a measly 1.3% YoY in Q3, underperforming expectations. Industrial production continues to contract, declining by 1.3%. Report Links: Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_12_09_s2_c7 bca.fes_wr_2016_12_09_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_12_09_s2_c8 bca.fes_wr_2016_12_09_s2_c8 GBP/USD has rallied by about 4% from its end of October lows, being the best performer against the U.S. dollar among G10 currencies in this time period, in part because the U.K. economy has consistently beaten expectations. Nevertheless, recent data has been a mixed bag: while both construction PMI and Markit Services PMI outperformed expectations, Industrial and manufacturing production underperformed them, contracting by 1.1% and 0.4% respectively. We have often pointed to the cable as an attractive buy given that it is very cheap and fears of a significant slowdown in the British economy have been overblown. However it is important to point out that at levels near 1.30 the pound is no longer such a bargain, as the potentially damaging effects of Brexit still have to be taken into account. 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_12_09_s2_c9 bca.fes_wr_2016_12_09_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_12_09_s2_c10 bca.fes_wr_2016_12_09_s2_c10 Recent data paint a dull picture for the Australian economy, the most concerning of which is the quarterly contraction in GDP of -0.5%, and an annual growth of 1.8%, below expectations of 2.5%. Before GDP was published, the RBA left its cash rate unchanged at 1.5% on the basis of a weak labor market and poor investment prospects. With only part-time employment growing, and full-time employment contracting, it is unlikely that this growth will translate into improving consumer spending or inflation. RBA Governor Philip Lowe also highlighted that tightening monetary conditions and uncertainty have subdued business investment. We remain bearish on the AUD. The recent GDP figures may also cause the RBA to become slightly dovish in the future if data does not compensate for current weaknesses. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_12_09_s2_c11 bca.fes_wr_2016_12_09_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_12_09_s2_c12 bca.fes_wr_2016_12_09_s2_c12 We continue to be bearish on the kiwi on the short term, given that dollar strength will continue to weigh on this currency. That being said, some factors make this currency attractive against its crosses. While it is true that inflation is very low, this is mostly due the price of tradable goods falling by 2.1% YoY, which reflects the fall in commodity prices. Non-tradable inflation on the other hand stands at a healthy 2.4%. With base effects taking hold, inflation should pick up again, a development which could put upward pressure on rates and support the NZD on its crosses. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_12_09_s2_c13 bca.fes_wr_2016_12_09_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_12_09_s2_c14 bca.fes_wr_2016_12_09_s2_c14 Canada's export sector has recently come into light as a factor hurting the economy. Although export figures for October increased by 0.5% on a monthly basis, this reflected a 1.2% increase in energy export prices offsetting a 0.7% decline in volume, and this was despite a stronger U.S. economy and a weaker CAD. Recent news highlights that Mexico has overtaken Canada as the second biggest exporter of goods to the U.S, reflecting rising Canadian unit labor costs and declining productivity, as well as the recent appreciation in CAD/MXN. Domestically, Canada continues to be mired by a bleak outlook. Wednesday's monetary policy statement highlights that uncertainty and tightening monetary conditions are hampering business confidence and investment. The BoC, therefore, kept rates unchanged at 0.5%. Rate divergences will lift USD/CAD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_12_09_s2_c15 bca.fes_wr_2016_12_09_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_12_09_s2_c16 bca.fes_wr_2016_12_09_s2_c16 USD/CHF will continue to mirror the Euro as the unofficial peg by the SNB is likely to stay enforced. The Swiss economy continues to be plagued by deflationary pressures. Additionally, Switzerland's real retail sales continue to contract by 2.5%YoY, while wage growth remains at 0% and consumer confidence is hovering near 2010/2011 lows. The SNB will try to avoid their 2015 blunder, where they unpegged the currency, and derailed the economic recovery that Switzerland was experiencing. On a longer time basis the outlook for the franc is very positive. This currency continues to be supported by a current account surplus of 11% of GDP and monetary conditions are as accommodative as they can be, which means that eventually SNB will have to break the floor under EUR/CHF, letting the Swiss Franc follow rising fair value. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_12_09_s2_c17 bca.fes_wr_2016_12_09_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_12_09_s2_c18 bca.fes_wr_2016_12_09_s2_c18 We are bearish on the NOK versus the dollar, yet we are positive on this currency on its crosses, as oil should outperform other commodities. Moreover, Norway is the only country in the G10 where inflation is above target, which should put pressure on the Norges Bank to abandon its easing bias. The housing sector is also in dire need of higher rates. However, a big portion of household indebtedness in Norway is in adjustable rate mortgages. As house prices and household debt keeps rising, rising rates will become more dangerous as an ever larger pool of fragile debt would be at risks. Thus, it is imperative for the Norges Bank to not keep monetary policy too accommodative for too long in order to avoid further excess in household debt and in the housing market. This will eventually prove bullish for the NOK. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_12_09_s2_c19 bca.fes_wr_2016_12_09_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_12_09_s2_c20 bca.fes_wr_2016_12_09_s2_c20 Despite recent resilience in the consumer sector, a risk is looming. Rising house prices and increased mortgages have become a notable issue, as Riksbank research points out. Low rates have allowed households to finance their mortgages at a low cost and markets are worrying about household indebtedness, with around 35% of new borrowers burdened with debt above 650% of their disposable income, according to an IMF study. This may be a potential danger as consumers substitute consumption for debt-servicing, limiting the upside for Swedish interest rates. In the short run, the outlook remains more upbeat for the SEK as the dollar will swap overbought optimism for economic reality. But longer term, USD/SEK has more upside. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Despite a tough week, the dollar bull market is intact. The U.S. economy's resilience to a strong dollar is growing. But, if Trump wins, the dollar could temporarily sell off against EUR, CHF, and JPY. Favor these currencies against EM and commodity currencies. Thanks to the High Court's Brexit ruling, the outlook for the pound is brightening. Wait for the appeal procedure to be over before implementing directional bets. Feature Despite this week's violent correction in the dollar, we remain dollar bulls. However, the recent reaction of the greenback to the rising probability of a Trump victory raises the need to hedge such an outcome. Still Bullish On The Dollar... The U.S. is unlikely to fall from its perch at the top of the distribution of G10 interest rates, a historically dollar-bullish environment (Chart I-1). Chart I-1Dollar Tailwinds Dollar Tailwinds Dollar Tailwinds The hidden slack in the U.S. labor market has dissipated. The amount of workers outside of the labor force who do want a job is at 6.2%, a level in line with the readings recorded between 2000 and 2007, when hidden slack was low (Chart I-2). Moreover, wages and salary continue to grow in the national income. Skewing the income distribution away from profits and rents is akin to a redistribution of income away from the top 1% of households, who derive nearly 50% of their income from profits. Importantly, middle-class households have a much higher marginal propensity to consume than rich ones. So great is the difference that since 1981, the 10% increase in the share of national income accruing to the top 1% of households has helped depress consumption by 3%. As a result, income redistribution will depress the U.S. savings rates going forward (Chart I-3). Since 70% of household consumption is geared toward the service sector, a component of the economy where productivity growth is hard to come by, increasing consumption is likely to directly result in job creation. Chart I-2U.S. Wages Can Rise U.S. Wages Can Rise U.S. Wages Can Rise Chart I-3The U.S. Savings Rate Has Downside bca.fes_wr_2016_11_04_s1_c3 bca.fes_wr_2016_11_04_s1_c3 With the unemployment gap being closed, consumption growth will cause wage growth to accelerate, further supporting consumption. Hence, the Fed can increase rates more aggressively than the 70 basis points priced into the OIS curve until the end of 2019. These kinds of dynamics have historically been very dollar bullish (Chart I-4). Moreover, the feedback loop linking the dollar and financial conditions to the economy is weakening. Not only is the economy increasingly driven by household expenditures, but the weight of commodity and manufacturing capex in the economy has collapsed in response to the dollar's strength (Chart I-5). Even if the sensitivity of these sectors to the dollar and financial conditions is unchanged, their impact on the broad economy has diminished. Chart I-4A Virtuous Circle##br## For The Dollar bca.fes_wr_2016_11_04_s1_c4 bca.fes_wr_2016_11_04_s1_c4 Chart I-5Lower Impact Of Manufacturing ##br##And Commodities bca.fes_wr_2016_11_04_s1_c5 bca.fes_wr_2016_11_04_s1_c5 Outside of the U.S. some key factors will prevent a normalization of policy rates in the major economies. Euro area rates will stay depressed for much longer. Conditions to generate inflation are absent. The output gap remains wide and negative, unemployment is significantly above NAIRU, and fiscal austerity, while diminished, is still de rigueur (Chart I-6). While the IMF pegs the output gap at 1.2% of GDP, the ECB estimates it to stand at 6% of GDP. Additionally, the European credit impulse is likely to roll-over. European bank stock prices have led European credit growth. They now point to slowing loan growth (Chart I-7). Even if loan growth were only to stabilize, this would imply a fall in the impulse. Chart I-6Inflationary Pressures##br## In Europe Inflationary Pressures In Europe Inflationary Pressures In Europe Chart I-7Downside Risk To The##br## Euro Area Credit Impulse bca.fes_wr_2016_11_04_s1_c7 bca.fes_wr_2016_11_04_s1_c7 These forces will weigh on the euro. The SNB floor under EUR/CHF remains credible and exercised. Therefore, USD/CHF will mostly stay a function of EUR/USD. For Japan, as we highlighted in the September 23 and October 28 reports, conditions are falling into place to see rising wages and inflation expectations. Rates being pegged at 0% until inflation greatly overshoots 2% will lower Japanese real rates along with the yen. Bottom Line: The 12-18 months outlook for the dollar remains bright. The resilience of U.S households will lead to stronger wage growth and an economy powered by consumption. The Fed will surprise markets with more rate hikes than anticipated. Meanwhile, European and Japanese real rates are unlikely to rise much if at all. ...But The Short-Term Outlook Is Bifurcated Yet, the short-term outlook is murky. BCA believes that a Trump presidency is likely to supercharge any dollar rally. Not only would his presidency imply huge infrastructure projects, his trade tactics should put upward pressure on wages and inflation, prompting an even more hawkish Fed than we anticipate. However, if recent dynamics are any clue, a Trump victory next week could also cause an immediate but temporary knee-jerk sell-off in the dollar. Since the FBI announced a re-examination of the Clinton emails affair, Trump's probability of winning has skyrocketed. While USD/MXN has rallied, so has EUR/USD, driven by a favorable move in interest rate differentials (Chart I-8). This raises the specter of a bifurcated move in the dollar over the next month or so. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer against EUR, CHF, and JPY. Why would the dollar rise against EM and commodity currencies? Cyclically and tactically, the stars are lining up against this set of currencies. The economic situation in EM and China is as good as it gets right now. The Keqiang index is near cyclical highs, suggesting that the upswing in Chinese industrial activity is unlikely to strengthen further, especially as loan demand remains tepid (Chart I-9). Chart I-8A Trump Indigestion bca.fes_wr_2016_11_04_s1_c8 bca.fes_wr_2016_11_04_s1_c8 Chart I-9China: As Good As It Gets China: As Good As It Gets China: As Good As It Gets Worryingly, Chinese fiscal stimulus is dissipating, which will act as a drag on the nation's investment and industrial activity. Chinese authorities panicked in 2015 as the Chinese economy was moving toward a hard landing. The government direct fiscal spending impulse surged (Chart I-10). Also, private-public partnerships originally expected to invest $1.2 trillion in infrastructure over three years were deployed in six months. As these tactics caused the economy to deviate from Beijing's stated goal to rebalance China away from investment, they are now being rolled back. Additionally, Chinese deflationary pressures are likely to resurface. Our bullish stance on the dollar implies a negative view on commodity prices. PPI will suffer if the dollar rallies given that Chinese producer prices are highly correlated with commodity prices (Chart I-11). This increases the likelihood that industrial activity in China will slow again. Chart I-10Vanishing Fiscal##br## Support Vanishing Fiscal Support Vanishing Fiscal Support Chart I-11Chinese PPI And Commodity Prices:##br## Brothers In Arms Chinese PPI And Commodity Prices: Brothers In Arms Chinese PPI And Commodity Prices: Brothers In Arms These risks are not priced in by EM assets and related plays. Risk reversals on EM currencies are priced in for perfection. Slowing Chinese growth would represent a negative surprise for EM debt, EM currencies, and commodity currencies (Chart I-12). An additional worry for EM currencies is momentum. A paper by the BIS shows that momentum continuation strategies are very profitable in EM FX.1 Hence, if EM currencies begin to fall, this fall will prompt further weaknesses. Finally, a Trump presidency is another headwind for EM and commodity currencies. In an earlier Special Report, we argued that a key factor that boosted the profitability of FX carry strategies was the rise of globalization (Chart I-13).2 This growing global trade mostly benefited small open economies, EM economies, and commodity producers, the so-called "carry-currencies". Trump's rhetoric promises a roll-back of this trend, a move that will disproportionally hurt such currencies. Compounding this risk, this cycle, the performance of FX carry trades has been inversely correlated to global bond yields (Chart I-14). BCA's underweight duration represents another problem for EM and commodity currencies. Chart I-12EM Plays Are Priced For Perfection EM Plays Are Priced For Perfection EM Plays Are Priced For Perfection Chart I-13Carry Trades Love Globalization Carry Trades Love Globalization Carry Trades Love Globalization Chart I-14Rising Yields Hurt Carry Currencies Rising Yields Hurt Carry Currencies Rising Yields Hurt Carry Currencies However, what could temporarily lift the euro, the Swiss franc, and the yen despite a negative cyclical outlook? Risk aversion and a global equity market correction prompted by a Trump victory. In short, a flight to safety amid uncertain times. These currencies are underpinned by current account surpluses ranging from 3% of GDP for the euro area to 10% for Switzerland. They therefore export investments abroad. This capital usually displays a strong home bias when global risks spike, and EUR, CHF, and JPY strengthen when global equities weaken. Finally, our current negative predisposition toward carry trades would also support funding currencies, currencies with deeply negative rates like EUR, CHF, or JPY. Bottom Line: In the direct aftermath of a Trump victory, the dollar could suffer from some temporary downward pressure against the EUR, CHF, and JPY. However, it will strengthen against EM and commodity currencies. On a cyclical basis, the USD will be stronger against these latter currencies than against European currencies. Key Investment Recommendations We are opening long EUR/AUD and short CAD/JPY positions. The EUR is less sensitive to EM downside than the AUD. Deteriorating EM currencies' risk reversals often coincide with a stronger EUR/AUD (Chart I-15). Also, the euro is cheaper than the Aussie, trading at a 5% discount to PPP. Additionally, EUR/USD could appreciate in the event of a Trump presidency, but its negative impact on EM economies and global trade will drag down AUD. The CAD/JPY position is primarily a Trump hedge. CAD will sell off if Trump wins as investors ponder the future of NAFTA. Meanwhile, the yen will benefit from safe-haven flows and from the eradication of any probability of MoF interventions (Chart I-16). Japan already meets two of the three criteria to be labeled a currency manipulator by the U.S. Treasury. Under a Trump presidency, such a label will have very real consequences. Chart I-15A Fall In EM Assets Would##br## Support EUR/AUD A Fall In EM Assets Would Support EUR/AUD A Fall In EM Assets Would Support EUR/AUD Chart I-16If Trump Wins, The MoF ##br##Will Not Intervene If Trump Wins, The MOF Will Not Intervene If Trump Wins, The MOF Will Not Intervene Moreover, CAD/JPY is also negatively affected by a deterioration of EM risk reversals. However, we are more worried for the JPY's long-term outlook than the EUR's. This is because of the more aggressive policy stance taken by the BoJ. Thus, this trade is more tactical than the EUR/AUD bet. Finally, investors wanting to play a Trump victory using European currencies should consider going long CHF/SEK. Sweden, a small open economy with deep trade links with EM, has been a key beneficiary of globalization. It will be a big loser if global trade shrinks. Meanwhile, CHF is likely to rally. Critically, this trade is for very nimble traders. At EUR/CHF 1.06, the SNB will intervene with all its might. The U.K.'s Über Thursday Yesterday, not only did the Bank of England announce its monetary policy decision and economic forecasts, but also, the High Court ruled that the Article 50 process preceding Brexit requires a vote from Parliament. While we expect Parliament to follow the popular vote and engage in Brexit, a parliamentary vote is much more likely to result in negotiating a "soft Brexit" rather than a "hard Brexit". In a "soft Brexit", the U.K. would retain access to the common market, and passporting of financial services would be allowed. However, freedom of movement would have to be maintained and the U.K. would have to contribute to the EU's purse. Unsurprisingly, the government is appealing the decision. Practically, this means it is still too early to aggressively bid up the pound. If the government wins its appeal, GBP/USD will move toward 1.10. If the government loses its appeal, FDI flows in the U.K. could regain some composure and help finance the large British current account deficit. This would lift GBP/USD toward 1.30 - 1.40. Probabilities are skewed toward the government losing its appeal. Economics, too, warrants caution. While the household sector's resilience has been a surprise to the Bank of England, it is unlikely to continue for long. First, the U.K. household credit impulse has rolled over and is now contracting at a GBP 1 billion pace, pointing to slowing growth. Second, in line with falling capex intentions, employers are paring their hiring intentions (Chart I-17). A slowdown in household nominal income growth should ensue. British households' real income will soon be squeezed, especially as the BoE increased it inflation forecast to 2.7% for 2018 due to the pass-through from the 15% fall in the trade-weighted GBP (Chart I-18). Additionally, the RICS survey points to further weakness in house prices. Chart I-17Deteriorating U.K. Labor Market Outlook Deteriorating U.K. Labor Market Outlook Deteriorating U.K. Labor Market Outlook Chart I-18Mechanics Of A Real Income Squeeze Mechanics Of A Real Income Squeeze Mechanics Of A Real Income Squeeze Hence, the BoE is on hold for a longer time than was anticipated in August. Moreover, Chancellor Hammond has made it clear that while the fall budget will loosen the fiscal austerity penciled in under the Osborne budgets, it is too early for investors to expect a large fiscal easing from the government. This suggests that risks remain tilted toward further easing by the "Old Lady." Bottom Line: Until we get clarity on the results of the government's appeal of yesterday's High Court Brexit ruling, we are inclined to fade strength in the pound. Any move above GBP/USD 1.25 would create a tactical shorting opportunity. A strangle with strikes at 1.27 and 1.15 and a January maturity makes sense for investors wanting to play the volatility around the ultimate ruling on the government's appeal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies", BIS Working Papers (2011). 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Policy Commentary: "The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives" - FOMC Statement (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 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: "[On ECB Stimulus]...the initial date set to end the buying program is March, but the most advisable action is that it be a process that's as slow as possible" - ECB Governing Council Member Luis Maria Linde (October 28, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_04_s2_c5 bca.fes_wr_2016_11_04_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_04_s2_c6 bca.fes_wr_2016_11_04_s2_c6 Policy Commentary: "[On wether the BOJ would buy regional domestic bonds]..Regional domestic bonds are issued by the various local governments, and are traded separately. There are various factors that would make it difficult to consider them for monetary policy, but we will give the suggestion due consideration" - BoJ Governor Haruhiko Kuroda (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 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: "...indicators of activity and business sentiment have recovered from their lows immediately following the referendum and the preliminary estimate of GDP growth in Q3 was above expectations. These data suggest that the near-term outlook for activity is stronger than expected three months ago" - BOE Monetary Policy Report (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_04_s2_c9 bca.fes_wr_2016_11_04_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "In Australia, the economy is growing at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently" - RBA Statement (November 1, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 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: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ 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: "There are unconventional monetary policies that give us more room to maneuver than previously believed...These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 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: "In Switzerland the negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc and the globally low level of interest rates" - SNB President Thomas Jordan (October 24, 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: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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.

In September, the model outperformed the S&P 500, while it underperformed global equities in both USD and local-currency terms. For October, the model trimmed its allocation to stocks and boosted its weightings in bonds and cash.

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.

Investors are being forced into riskier asset classes by the TINA effect, but the gaping macro disequilibria makes it difficult for investors to see how we move back to equilibrium in a benign way. Monetary policy on its own is limited in its ability to soften the adjustment, but the good news is that the political pendulum is swinging toward fiscal stimulus.

U.S. inflationary forces remain tame, forcing the Fed to maintain an easy bias. Yet, the global economy is improving. This confluence could weigh on the dollar and boost commodity currencies. The NZD has more upside, but it will lag petro currencies. The BoJ will act, but timing is uncertain. Keep a negative bias toward the yen. CAD/NOK has more downside.

The euro area's NPL problem is unlikely to be solved quickly, constraining bank profitability and the capacity to lend. There are three important repercussions for investors.