Switzerland

On a happy personal note, I will be away on paternity leave for a short time, reacquainting myself with nappies. As such, there will be no Weekly Reports for the next two weeks, but you will receive two excellent Special Reports penned by my colleagues. Given the ongoing turbulence in the financial markets I will also send out short Alerts as and when necessary. Highlights After the worst three-day rout for stocks versus bonds in living memory, six-month investors have fully capitulated, and the markets are now priced for a technical recession. If the recession can be limited to two quarters, stocks are more likely to outperform long-dated bonds by 12 percent than to underperform by a further 12 percent. Tactical trade: overweight S&P500 versus German 30-year bund, currency hedged, setting a 12 percent profit target with symmetrical stop-loss. The closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline. Overweight positive yielding bonds versus negative yielding bonds, currency hedged. The most attractive structural pair is overweight the US 30-year T-bond versus the German 30-year bund. Feature Chart of the WeekWidow Makers: Shorting Bonds In Japan, Switzerland... And Now The US Widow Makers: Shorting Bonds In Japan, Switzerland... And Now The US Widow Makers: Shorting Bonds In Japan, Switzerland... And Now The US A Recession Is Now Fully Priced Financial markets have fully priced a downturn when the time horizon of investors that have fully capitulated = the length of the downturn. A week can be a long time in the financial markets. Seven days ago, the markets were not priced for a global recession. Then came the worst three-day rout for stocks versus bonds in living memory, in which stocks underperformed long-dated bonds by 25 percent (Chart I-2).1 Chart I-2The Worst 3-Day Rout: Stocks Underperformed Bonds By 25 Percent The Worst 3-Day Rout: Stocks Underperformed Bonds By 25 Percent The Worst 3-Day Rout: Stocks Underperformed Bonds By 25 Percent The upshot is that investors with six-month horizons have now fully capitulated, meaning the markets are now fully priced for a technical recession (Chart I-3) – defined as a downturn lasting two straight quarters. But the markets are not priced for a more prolonged downturn lasting longer than two quarters. Raising the question: can the downturn be limited to the first half of the year? Chart I-3Six-Month Investors Have Capitulated, Meaning A Recession Is Fully Priced Six-Month Investors Have Capitulated, Meaning A Recession Is Fully Priced Six-Month Investors Have Capitulated, Meaning A Recession Is Fully Priced The pessimistic case is that the coronavirus can neither be contained nor normalised by the summer. Or that even if its direct impact ebbs, there might be second-round effects. A major credit default from, say, a distressed airline or other travel-dependent company could trigger aftershocks in the financial system. Moreover, the recent collapse in the oil price injects new uncertainty into the energy patch as well as into geopolitics. The optimistic case is that large segments of the economy are set to receive a 2009 type triple-boost: from a sharp deceleration in bond yields; from a sharp deceleration in the oil price; and from government spending and/or tax cuts – creating a potent cocktail of stimulants for the second half of this year. Investors with six-month horizons have now fully capitulated. Balancing the pessimistic and optimistic cases, we assess that the downturn can be limited to two quarters – albeit this cannot be our highest conviction view, as we are not experts in epidemiology or immunology. Nevertheless, if this assumption holds, there is now a higher probability that stocks outperform long-dated bonds by 12 percent than that they underperform by a further 12 percent. This three-month tactical trade has a slight twist. It is best expressed as: overweight US stocks versus European bonds (currency hedged). This is because core European bond yields are close to their lower limit, meaning that core European bond prices are close to their mathematical upper limit. All of which brings us to a much higher conviction recommendation. The ‘Widow Maker’ Is Back First the widow maker came to Japan, next to Switzerland, then to the rest of Northern Europe. Now the widow maker has come to America. In the financial lexicon, ‘widow maker’ refers to the fatal strategy of shorting high-quality government bonds in an era when yields have been grinding inexorably lower. Any investment manager who has dared to bet that government bond yields would rise, whether starting from 3 percent, 2 percent, or even 1 percent, and whether in Japan, Switzerland, or even the US – has ended up being carried out of their job in a box, feet first (Chart of the Week). Except that in Switzerland over the past year, the widow maker trade has not been as fatal as it used to be. While the 5-year yield in the US has collapsed by 200 bps, in Switzerland it has edged down by just 20 bps (Chart I-4). Put another way, shorting the US 5-year T-bond has cost 11 percent, but shorting the Swiss 5-year bond has been relatively painless (Chart I-5). Chart I-4Swiss Bond Yields Cannot Fall Much... Swiss Bond Yields Cannot Fall Much... Swiss Bond Yields Cannot Fall Much... Chart I-5...Meaning Swiss Bond Prices Cannot Rise ...Meaning Swiss Bond Prices Cannot Rise ...Meaning Swiss Bond Prices Cannot Rise The simple reason is that Swiss government bond yields are now very close to their lower bound. The Lower Bound To Bond Yields Is Around -1 Percent The practical lower bound to the policy interest rate is -1 percent, because -1 percent counterbalances the storage cost of holding physical cash and/or other stores of value.2   Imagine the policy rate fell to well below -1 percent. If banks passed this deeply negative rate to their depositors, it would be logical for the bank depositors to flee wholesale into cheaper-to-hold physical cash. This deposit flight would kill the banking system. But if the banks didn’t pass the deeply negative policy rate to their depositors, it would wipe out the banks’ net interest margin – the gap between rates on loans and deposits. This inability to make profits would also kill the banking system. At deeply negative interest rates, bank deposits would flee. Could policymakers just abolish physical cash, forcing us all into ‘digital cash’ with unlimited negative interest rates? No, because that would just push us into other stores of value: for example, gold, or ‘decentralised’ cryptocurrencies. The common objections to cryptocurrencies are that their susceptibility to volatility and fraud makes them a poor store of value. But both objections are also true for gold. Yet who has ever argued that gold cannot be a store of value just because it is volatile and can be stolen (Chart I-6)! Chart I-6Gold Is A Store Of Value Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility The lower bound to the policy rate at around -1 percent also sets the lower bound of the bond yield, because a bond yield is just the expected average policy rate over the bond’s lifetime. For completeness, we should mention one technical exception. If bond investors price in the possibility of being repaid in a different and more valuable currency, the bond yield will carry a further redenomination discount as an offset for the potential currency gain. This is relevant to euro area bonds because there remains the remote possibility of euro disintegration. Therefore, bonds which carry the small possibility of a currency redenomination gain – notably, German bunds – possess a small additional discount on their yields. But in jurisdictions where no currency redenomination is possible, such as Switzerland or Sweden, the practical lower bound to bond yields is around -1 percent. Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Switzerland teaches us that the closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline (price gain), whereas the possibility for a yield increase (price loss) stays unlimited. Making such bonds a ‘lose-lose’ proposition. The convergence in bond yields has much further to go. Therefore, our high conviction recommendation is to short negative yielding bonds in relative terms. In other words, overweight positive yielding bonds versus negative yielding bonds. And currency hedge the position – as, right now, the cost of currency hedging is low. The recommendation is applicable for both tactical (3-month) and structural (2-year plus) investment horizons, and it is applicable for all bond maturities: 5-year, 10-year, and 30-year. Given where yields now stand, the most attractive structural pair is overweight the US 30-year T-bond versus the German 30-year bund (Chart I-7 and Chart I-8). Chart I-7Expect Yields To Converge At 10-Year Maturities... Expect Yields To Converge At 10-Year Maturities... Expect Yields To Converge At 10-Year Maturities... Chart I-8...And At Ultra-Long ##br##Maturities ...And At Ultra-Long Maturities ...And At Ultra-Long Maturities Our structural overweight to a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos at 30-year bond maturities is up by 7 percent in just nine months. But the convergence in yields has much further to go (Chart I-9). Chart I-9Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Fractal Trading System* As discussed, this week’s recommended trade is to overweight stocks versus long-dated bonds expressed as overweight S&P500 versus German 30-year bund. The profit target is 12 percent with a symmetrical stop-loss. In a turbulent week for financial markets, overweight Poland versus Portugal achieved its profit target, short US utilities versus oil and gas and short EUR/CHF hit their stop-losses, and short palladium versus nickel moved comfortably into profit. The rolling 1-year win ratio now stands at 62 percent. Chart I-10Poland Vs. Portugal Poland Vs. Portugal Poland Vs. Portugal When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 MSCI All-Country World Index (in dollars) versus US 30-year T-bond. 2 The cost of holding physical cash or gold is the cost of its safe storage. Fractal Trading Model The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced Cyclical Recommendations Structural Recommendations The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced The Widow Maker Is Back... And A Recession Is Fully Priced Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The breakout in the DXY indicates the investment universe could become precarious. The euro could fall to 1.04 on such an outcome. The yen and Swiss franc should outperform in this environment, barring recent weakness in the Japanese currency. This will catalyze the Swiss National Bank to start weaponizing its currency. EUR/CHF could first undershoot 1.06 but will then become very attractive. We were stopped out of long AUD/CAD for a loss of 3%. Weighing In On Recent Market Developments The rally in the dollar has been broad-based, with the DXY index threatening to break above 100. What is peculiar about this rally is that it is not driven by relative fundamentals, but rather by sentiment. For example, interest rate differentials across much of the developed world have risen versus the dollar, in stark contrast  with the drop in their exchange rates (Chart I-1). The risk is that as a momentum currency, the surge in the dollar triggers a negative feedback loop that tightens financial conditions in emerging markets, curtailing a key source of global demand (Chart I-2). Chart I-1Dollar Up, Rate Differentials Down Dollar Up, Rate Differentials Down Dollar Up, Rate Differentials Down Chart I-2A Strong Dollar Could Lead To Debt Deflation A Strong Dollar Will Lead To Debt Deflation A Strong Dollar Will Lead To Debt Deflation The most recent TIC data from the US Treasury confirmed that inflows into domestic bonds have surged, especially driven by private concerns. These inflows have been huge enough to alter the structural downtrend of outflows (Chart I-3). Given that hedged yields are currently unattractive for non-US investors, these flows are also a bet on an appreciating dollar. This fits anecdotal evidence that today’s sharp drop in the yen was driven by private investors, stampeding out of the local market, into the safety of US Treasurys and other assets. Chart I-3Positive Momentum Into US Treasurys Positive Momentum Into US Treasurys Positive Momentum Into US Treasurys We have elaborated in numerous reports why the risks to the dollar are to the downside, including expensive valuation and lopsided positioning. However, these obstacles fall to the wayside in a risk-off environment. As such, for risk management purposes, we are closing our short DXY position today for a loss of 2.5%. Bottom Line: The breakout in the dollar is at risk of becoming self-reinforcing in the near term. Stand aside on the DXY for now. Thought Experiment On A Few Scenarios Different market participants have taken different views on the durability and potential impact of the COVID-19 outbreak. Equity market indices in general are looking through a potential blip in the Q1 data on the assumption that the Q2 recovery will be V-shaped and powerful. The peak in momentum of new cases outside of Hubei province as well as a less-alarming death rate compared with the SARS episode certainly supports this view (Chart I-4). Chart I-4ACases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now Chart I-4BCases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now Cases Outside The Epicenter Have Peaked For Now The disconnect has been in the dismal performance of procyclical currencies. SEK/JPY, a key barometer of greed versus fear in financial markets, is near capitulation lows, despite secular highs for the stock-to-bond ratio (Chart I-5). Meanwhile, the EUR/USD has once again begun to inflect lower, continuing a trend in place since the beginning of 2018. Chart I-5Pro-Cyclical Crosses Are Pricing A Malignant Outcome Pro-Cyclical Crosses Are Pricing A Malignant Outcome Pro-Cyclical Crosses Are Pricing A Malignant Outcome This suggests one of three outcomes: Equity markets are correct to price in a benign scenario, with an eventual synchronized growth recovery led by the US (Chart I-6A). This is dollar bullish. Currency markets are right to be pricing in a catastrophic fallout in growth, with anything linked to China/global growth getting slaughtered. This is also dollar bullish. The bond markets are spot on in pricing in a goldilocks scenario, where rates stay low and non-US markets lead an eventual recovery (Chart I-6B). This is dollar bearish. Chart I-6AEquity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Chart I-6BEquity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Equity Markets Are Pricing A Benign Outcome Bottom Line: Two of three scenarios lead to a higher US dollar. For most developed market participants, the adjustment towards a higher dollar would have to occur through a lower euro, given its weight in the DXY index. How Low Could The EUR/USD Fall? The possibility of either a synchronized recovery led by the US or a catastrophic fallout to growth is certainly valid for the euro area. Chart I-7 plots relative GDP growth between the two regions. The conclusion is very evident: The collapse in the euro since the financial crisis has been driven by falling growth differentials between the Eurozone and the US. Based on higher-frequency indicators, this remains the case as of January – the ZEW survey showed that the expectations component for euro area activity slowed markedly, while that of the US improved. In the absence of a synchronized pickup in global growth, a weaker exchange rate helps.  One way to arrest the rising growth divergence between the euro area and the US is to lower the cost of capital in the entire Eurozone, such that it makes sense even for the less-productive peripheral countries to borrow and invest. This will boost productivity, lifting the neutral rate. This has certainly been the case. Bond yields in peripheral Europe are collapsing relative to those in Germany. And, as expected, investment spending in the periphery is also picking up, which should close the productivity gap with the core countries (Chart I-8). Unfortunately, for the small, open countries that characterize the euro area, external demand is also needed to transform those productivity gains into profits Chart I-7Weak Growth Will Pressure ##br##The Euro Weak Growth Will Pressure The Euro Weak Growth Will Pressure The Euro Chart I-8Investment Spending Was Strong Going Into The Crisis Investment Spending Was Strong Going Into The Crisis Investment Spending Was Strong Going Into The Crisis In the absence of a synchronized pickup in global growth, a weaker exchange rate helps. Our intermediate-term timing model, which has been back-tested as a tool for profitably hedging portfolios, suggests the euro is cheap, but not excessively so. Medium-term bottoms have usually occurred when the euro is around 5% cheaper than current levels, or around 1.03-1.04 (Chart I-9). Since the peak in global trade in 2011, one of the few ways for countries to expand their trade pie has been via a “beggar thy neighbor” policy. This is even more important for the euro area, if the Phase One trade deal between the US and China results in less purchases of European machinery, cars, and aircraft. Coupled with a hiccup in Chinese growth in Q1, the euro will have to be the mechanism of adjustment. The European Central Bank has one powerful tool to ensure this occurs: quantitative easing. By crowding out locals from the domestic fixed-income market, investors will have to flock to either equities or foreign securities. This will weigh on the euro. This is especially the case since quantitative easing from the ECB is open-ended, while that from the Federal Reserve (not-QE) is not. Eventually, investors might begin to front-run the relative expansion in the ECB’s balance sheet. Since the peak in global trade in 2011, one of the few ways for countries to expand their trade pie has been via a “beggar thy neighbor” policy.  Chart I-10 shows that a rising basic balance in the euro area has been a key mechanism in preventing a further drop in the euro. This will change in the case of a catastrophic fallout to growth. Chart I-9The Euro Is Cheap, But Not A ##br##Screaming Buy The Euro Is Cheap, But Not A Screaming Buy The Euro Is Cheap, But Not A Screaming Buy Chart I-10A Positive Basic Balance Has Prevented A Much Lower Adjustment A Positive Basic Balance Has Prevented A Much Lower Adjustment A Positive Basic Balance Has Prevented A Much Lower Adjustment Eventually, all trends reverse, and there will be a pickup in growth, led by more growth-sensitive economies. Given both the internal and exchange rate adjustments in the euro area, the common-currency zone will be primed to benefit. The euro tends to be largely driven by pro-cyclical flows, and European equities, especially those in the periphery, are already trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Watch earnings revisions for euro zone equities versus the US. They tend to firmly lead the euro by about 9-to-12 months (Chart I-11). Chart I-11Watch Earnings Revisions For The Next EUR/USD Move Watch Earnings Revisions For The Next EUR/USD Move Watch Earnings Revisions For The Next EUR/USD Move Bottom Line: There is near-term downside to the EUR/USD towards 1.03. The SNB And The Franc The franc has been in a bull market against pretty much every European currency since the onset of the global growth slowdown, with the latest developments only supercharging that trend. The worst-case scenario for Switzerland is a global growth fallout, since the valuation starting point for the franc is expensive, not only vis-à-vis the euro (Chart I-12), but even more so against the Swedish krona and  Norwegian krone. So, the key question for the franc is the pain threshold for the SNB to step up intervention. Chart I-12The Franc Is Getting Incrementally Expensive The Franc Is Getting Incrementally Expensive The Franc Is Getting Incrementally Expensive The first mandate of the Swiss National Bank is price stability, consistent with inflation at 2%. On this front, it has clearly underdelivered. The central bank expects inflation to gradually pick up to 1.2% by 2023, but the backdrop for prices in Switzerland has been sub-1% for much of the post-crisis period (Chart I-13). Meanwhile, as a small, open economy, tradeable goods prices are important for domestic inflation, and import prices are deflating by over 1.9% year-on-year, in part driven by a strong currency (Chart I-14). If left unchecked, this could begin to un-anchor inflation expectations, leading to a negative feedback loop that the SNB will likely find very difficult to lean against. Chart I-13SNB Forecasts May Not Be Realized Soon SNB Forecasts May Not Be Realized Soon SNB Forecasts May Not Be Realized Soon Chart I-14The Risk From A Strong Franc Is Deflation The Risk From A Strong Franc Is Deflation The Risk From A Strong Franc Is Deflation Domestically, the Swiss economy was holding up well, but it is now an open question as to how much longer it can continue to defy the pull of a slowing external sector. As a highly export-driven country, the manufacturing sector usually dictates trends in the overall Swiss economy (Chart I-15). Sentiment indicators such as the ZEW expectations component were perking up ahead of the onset of COVID-19. It is now a sure bet that these will relapse in the coming months. More importantly, the impact on Switzerland might be bigger relative to its trading competitors, given the expensive franc. It is now an open question as to how much longer Switzerland can continue to defy the pull of a slowing external sector.  A key barometer for the SNB will be exports. Export volumes are already deflating (Chart I-16), yet the trade balance is still benefiting from the large share of precious metals exports, which are currently experiencing a terms-of-trade boost. This will not last forever, given the falling market share of precious metals in the Swiss trade balance Chart I-15How Long Can Employment Defy Gravity How Long Can Employment Defy Gravity? How Long Can Employment Defy Gravity? Chart I-16A Lower Franc Will Support Export Volumes A Lower Franc Will Support Export Volumes A Lower Franc Will Support Export Volumes There is a new twist for “operation weak franc.” The US Treasury department has put Switzerland on the currency-manipulator watch list. In general, the SNB is reticent on the issue of currency intervention, stating only that it intervenes to counteract negative effects on inflation and exports from an overly expensive franc. But it is encouraging that sight deposits at local banks started to accelerate at USD/CHF 0.96 (Chart I-17) and the SNB is also likely to act if EUR/CHF meaningfully breaks below 1.06. Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland and a rising debt-to-GDP ratio that pins it among the highest in the G10. The good news is that a lot of the imbalances resulting from excess liquidity in recent years are being addressed. The housing market is a case in point. Growth in rental housing units, which usually constitute the bulk of investment homes, is deflating, which contrasts favorably with growth in owner-occupied homes (Chart I-18). Macro prudential measures such as a cap on second homes as well as stricter lending standards have helped. Meanwhile, a slowdown in the working-age population in Switzerland has neutered a meaningful source of demand. Chart I-17The SNB Is Stepping Up Intervention The SNB Is Stepping Up Intervention The SNB Is Stepping Up Intervention Chart I-18A Healthy Housing Adjustment A Healthy Housing Adjustment A Healthy Housing Adjustment     Bottom Line: We are lowering our limit-buy on EUR/CHF to 1.05 to account for a potential undershoot. Housekeeping We were stopped out of our long AUD/CAD trade for a loss of 3.0%. As highlighted above, currency markets are beginning to price in a malignant scenario for global growth, where anything non-US gets decimated. In such an environment, the best policy is to stand aside.   Chester Ntonifor Foreign Exchange Strategist chestern@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 Recent data in the US have been mostly positive: Retail Sales excluding autos grew by 0.3% month-on-month compared to 0.2% in January. Industrial production contracted further by 0.3% month-on-month in January. The Michigan consumer sentiment index increased to 100.9 from 99.8 in February. The core producer price index grew by 1.7% in January, from 1.1% in December. Housing starts decreased to 1.57 million from 1.63 million, while building permits increased to 1.55 million from 1.42 million in December. The DXY index appreciated by 0.8% this week. As a momentum currency, the rise could become self-reinforcing. Stand aside on DXY. Report Links: Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 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 data in the euro area have been negative: The trade balance increased to EUR 22.2 billion, on a seasonally adjusted basis, from EUR 19.1 billion in December. GDP grew by 0.9% year-on-year in Q4 2019, slowing from 1.2% the previous quarter. ZEW economic sentiment declined to 10.4 from 25.6 in February. The current account surplus decreased to EUR 32.6 billion from 35.2 billion in December. Construction output contracted by 3.7% year-on-year in December, from growth of 1.4% the previous month. The euro depreciated by 0.5% against the US dollar this week. The disappointing ZEW numbers for the Eurozone and Germany and concerns about persistently low growth were a major headwind for the euro this week. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: GDP contracted by 1.6% quarter-on-quarter in Q4 2019, compared to growth of 0.4% the previous quarter. Industrial production contracted by 3.1% year-on-year in December. Capacity utilization decreased to -0.4% in December. The merchandise trade balance fell to a deficit of JPY 224.1 billion in January. Machinery orders contracted by 3.5% year-on-year in December. Imports contracted by 3.6% and exports contracted by 2.6% year-on-year in January. The Japanese yen depreciated by 1.9% against the US dollar this week. Domestic data was very disappointing, with GDP contracting more than expected. Meanwhile technical factors such as portfolio flows were also responsible. That said, short USD/JPY remains cheap insurance. Report Links: Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mixed: The Rightmove house price index grew by 2.9% year-on-year in February. The ILO unemployment rate remained flat at 3.8% in December. The growth in average earnings including bonuses slowed to 2.9% from 3.8% in December. The CPI grew by 1.8% while the retail price index grew by 2.7% year-on-year in January. Retail sales grew by 0.8% year-on-year in January. The British pound depreciated by 1.3% against the US dollar this week. The key worry for incoming BoE governor Andrew Bailey is a stagflationary environment, with increases in inflation driven by weak business investment and productivity growth. Stand aside on GBP for now. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: The six month annualized growth rate in the Westpac leading index fell to -0.46% from -0.28% in January. The wage price index grew by 2.2% year-on-year in Q4, staying flat from the previous quarter. The unemployment rate increased to 5.3% from 5.1% in January. The Australian Dollar depreciated by 1.4% against the US dollar this week. Much of the decline was driven by the perceived dovish tone of the minutes from the Reserve Bank of Australia (RBA) February meeting. The RBA’s primary concerns were slow consumption growth and the effects of the bushfires on growth in the near-term.  However, the housing market, led by Sydney and Melbourne, is picking up quickly. We remain positive AUD/USD but will stand aside if it breaches 60 cents. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Visitor arrivals declined by 0.2% year-on-year in December. The ANZ monthly inflation gauge remained flat at 3.2% year-on-year in January, The REINZ house price index grew by 0.3% month-on-month in January. The Global Dairy Trade price index declined 2.9% in February. The New Zealand dollar depreciated by 1.6% against the US dollar this week. Dairy trade was hampered by weak demand from China and Prime Minister Jacinda Ardern warned of a negative impact on GDP growth in the first half of 2020 from Covid-19.  Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mixed: Manufacturing sales contracted by 0.7% month-on-month in December. Headline CPI grew by 2.4%, while the BoC core measure grew 1.8% year-on-year in January. The Canadian dollar appreciated by 0.1% against the US dollar this week. The rally was driven by the surge in oil prices over the past two weeks coinciding with a decline in the number of new Covid-19 cases. While acknowledging the negative demand shock from China, our Commodity and Energy strategists currently believe that Chinese policy stimulus will help shore up oil demand going into the second half of this year. This will be bullish CAD. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mixed: Import prices contracted by 1.9% year-on-year in January, compared to a contraction of 3.2% the previous month.  The trade balance increased to CHF 4,788 million in January from CHF 1,975 million the previous month. Industrial production grew by 1.6% year-on-year in Q4 2019, slowing from 7.9% the previous quarter. The CHF depreciated 0.4% against the US dollar this week. The SNB has repeatedly emphasized that it stands ready to prevent rampant appreciation in the Swiss franc which could hurt exports. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: The trade balance decreased to NOK 21.2 billion in January from NOK 25.6 billion the previous month. The Norwegian krone depreciated by 0.7% against the US dollar this week. The past two weeks saw a remarkable rally in oil prices, which should help the petrocurrency, but a strong dollar has weighed on NOK/USD. However, our NOK/EUR position, a part of our long petrocurrencies basket trade, has benefitted from the oil rally and weakness in the euro. In an annual speech this week, Governor Olsen of the Norges Bank stressed the need for Norway to decrease reliance on the sovereign wealth fund and transition to a less oil-dependent economy. In the long run, this could mean krona leaving behind the “petrocurrency” moniker. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 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 data in Sweden have been negative. The unemployment rate increased to 7.5% in January from 6% the previous month. The CPI grew by 1.3% year-on-year in January, compared to 1.8% the previous month. The Swedish krona depreciated by 1.9% against the US dollar this week. In the February monetary policy report released last week, the Riksbank revised down inflation forecasts due to lower energy prices in 2020. However, they expect this to be a transitory shock and see inflation moving closer to 2% once it subsides. Although the krona depreciated on the unemployment and inflation data this week, it looks unlikely to be enough for the Riksbank to change its policy stance. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Most central banks still consider economic risks asymmetrical to the downside. This means that even if global growth rebounds in earnest, policy is likely to stay pat over the next three to six months. The conclusion is that relative growth fundamentals rather than central bank policy will likely drive FX price action in the next few months. Our bias remains that the growth impulse will be strongest outside the US during the first half of this year. Stay short the DXY index. The BoJ’s inaction this week makes long yen bets cheap insurance against a rise in FX volatility.  Remain short USD/JPY and go short CHF/JPY. The pound remains a buy on dips but will likely underperform the euro over the next few months. EUR/GBP should touch 0.88. The BoC kept rates on hold, but erred on the dovish side, in line with our expectations. Stay short CAD/NOK and long AUD/CAD. We were stopped out of our long NOK/SEK trade for a profit of 1.8%. We will look to rebuy the cross at lower levels. Feature Chart I-1Currency Markets Have Priced In A Benign Recovery Currency Markets Have Priced In A Benign Recovery Currency Markets Have Priced In A Benign Recovery The powerful bounce in global equity markets since the August lows has pushed many stock indices into overbought territory. Chart I-1 shows that the rise in global stocks has already discounted an improvement in global manufacturing in order of magnitude similar to the 2012 and 2016 episodes. However, currency markets have been discounting a much more benign outcome (bottom panel). The divergence between currency and equity performance is a marked change from what has prevailed during past cycles. For example, trough to peak, AUD/JPY, a key barometer of greed versus fear in currency markets, appreciated 40% during the 2012 episode, and 25% in 2016-2017, along with rising equity prices. The performance of even more high-octane currency pairs such as the RUB/JPY, the ZAR/JPY, or even the BRL/JPY, was explosive. More muted currency action this time around therefore calls into question the durability of this recovery. Perhaps given that equities are long-duration assets, it is quite plausible that the drop in interest rates in 2019 has increased their relative appeal, boosting nominal values. While that makes sense, most bond markets have also seen higher yields over the past few months, making this explanation questionable. Alternatively, the easing in trade tensions and/or the Federal Reserve’s liquidity injections may have rekindled animal spirits among domestic investors. Or perhaps, a synchronized recovery has narrowed G10 growth differentials, muting currency performance in the process but boosting share prices. The rise in global stocks has already discounted an improvement in global manufacturing. However, currency markets have been discounting a much more benign outcome. Either way, the resolution to this dissonance will be either through marked improvement in global economic data in the coming months (which will support pro-cyclical currencies), or a period of indigestion for stock markets (which will lift volatility) – or a combination of both. At a minimum, this suggests tweaking currency portfolios in anticipation of these dynamics.   On Volatility And The Dollar Everyone understands that currency markets are about relative trends. Therefore, the implicit assumption that the dollar will weaken as global growth picks up is that the epicenter of this recovery will be outside the US. Chart I-2 shows that economic data is not yet surprising to the upside outside the US, even though there has been marked improvement on a rate-of-change basis. Beneath the surface, the strongest data surprises have been in the euro area, Switzerland, New Zealand and Australia, while disappointments have been in Canada and the UK. In hindsight, the chart also highlights why the Canadian dollar was the best performing G10 currency in 2019, while the Swedish krona was the weakest. Chart I-2Growth Dispersion Has Fallen Growth Dispersion Has Fallen Growth Dispersion Has Fallen The drop in economic dispersion has pushed currency volatility near record lows (Chart I-3). Every seasoned investor does and should pay attention to low volatility. This is because what destroys portfolios is not exuberance, but complacency. This might sound like a tautology, but during the last three episodes of volatility dropping to these levels, the dollar soared and pro-cyclical currencies suffered severe losses. Everyone remembers 1997-1998, 2007-2008 and 2014-2015. Will this time be the same? While a rise in volatility is usually associated with a higher dollar, there are three key differences this time around. First, real rates turned positive in the US relative to its G10 counterparts in 2014 (Chart I-4). This meant the US dollar, which has typically been a funding currency (not least because it is a reserve currency), became the object of carry trades. It is a fair contention that any capital that wanted to find its way into US Treasurys has had more than five years of positive real carry to do so. With real relative yields in the US now rolling over, which way will capital gravitate? Chart I-3Volatility Near Record Lows Volatility Near Record Lows Volatility Near Record Lows Chart I-4Real Rates Lower In The US Real Rates Lower In The US Real Rates Lower In The US The dollar has been in a bull market since 2011, which has shifted valuations towards expensive quartiles. This is a key difference from previous low-volatility episodes when the dollar was much earlier into bull-market territory (Chart I-5). The dollar tends to run in long cycles, and a spike in volatility can either mark the beginning or the end of a cycle. As we have emphasized numerous times in previous reports, being long the US dollar is a consensus trade. Our primary basis for this is CFTC positioning data. However, a timelier leading indicator to watch is the gold-to-bond ratio. Currencies are about confidence, and a key measure of confidence in the US dollar is the total return in the US 10-year Treasury compared to gold bullion, which has collapsed (Chart I-6). The budget deficit in the US is about to explode, while it was low and falling during prior dollar riot points.   Chart I-5The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-6Tug Of War Between US Bonds And Gold Tug Of War Between US Bonds And Gold Tug Of War Between US Bonds And Gold More importantly, currency markets are likely to gyrate with relative fundamentals. The slowdown in the global economy was driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. Historically, cyclical swings in most economies tend to be driven by manufacturing and exports rather than services (and consumption). More specifically, the currencies that have borne the brunt of the manufacturing slowdown should logically be the ones to experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the US. For example, yields in Norway, Sweden, Switzerland and Japan have risen significantly versus those in the US since the bottom. A synchronized recovery in global growth will go a long way in further eroding the US’ yield advantage. Currencies are about confidence, and a key measure of confidence in the US dollar is the total return in the US 10-year Treasury compared to gold bullion. Bottom Line: Remain short the DXY index with an initial target of 90 and a stop loss at 100.  The Yen As Portfolio Insurance Should our thesis that the dollar is in a downtrend for 2020 be correct, it is unlikely to occur in a straight line. This argues for having some portfolio insurance. The Bank of Japan’s inaction this week may have been a red herring, since one of the most potent moves in asset markets in recent months has been the +130-basis-point move in favor of Japanese yields (Chart I-7). The gap between the USD/JPY and real rates has opened up a rare arbitrage opportunity. Should a selloff in global risk assets materialize, the yen will strengthen. On the other hand, if global growth does eventually accelerate, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This keeps short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. The rise in Japanese yields has been driven by three key pivotal developments: For most of the past five years, the BoJ was one of the most aggressive central banks in terms of asset purchases. This was a huge catalyst for a downturn in the trade-weighted yen (Chart I-8). With a renewed expansion in the Fed’s balance sheet, monetary policy is tightening on a relative basis in Japan. Total annual asset purchases by the BoJ are currently running at about ¥20 trillion, while JGB purchases are running at ¥15 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon. Chart I-7Japanese Bond Yields Have Surged Japanese Bond Yields Have Surged Japanese Bond Yields Have Surged Chart I-8The Yen And QE The Yen And QE The Yen And QE Movements in the yen are as influenced by external conditions as what is happening domestically, given Japan’s huge export sector. Credit default swap spreads of cyclical sectors are collapsing to new lows, symptomatic of an improving profit outlook (Chart I-9). This suggests it is the growth component driving Japanese yields higher (Japanese CPI swaps have indeed been flat). This also mirrors the recent outperformance of Asian cyclical sectors relative to defensive ones. The Abe government announced a huge fiscal package last year, in part driven by the disastrous typhoons as well as the upcoming Olympics. This allowed the BoJ to upgrade its growth forecasts in its latest policy minutes. The relative performance of construction and engineering stocks are an important barometer for when the funds are flowing into the economy (Chart I-10). Chart I-9Default Risk Easing In Japan Default Risk Easing In Japan Default Risk Easing In Japan Chart I-10Fiscal Stimulus And Construction Stocks Fiscal Stimulus And Construction Stocks Fiscal Stimulus And Construction Stocks As a defensive currency, the yen tends to weaken as global growth improves, given it is usually used to fund carry trades. That said, our contention is that the yen will surely weaken at the crosses, but could still strengthen versus the dollar. As mentioned above, one catalyst is the divergence from the traditional relationship with real rates. More importantly, the USD/JPY and the DXY tend to have a positive correlation, because the dollar drives the yen most of the time. Meanwhile, net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-11). Given extremely low volatility, this places short USD/JPY bets as an attractive vehicle to play a rise in volatility. Chart I-11Investors Are Short The Yen Investors Are Short The Yen Investors Are Short The Yen More conservative investors could go short CHF/JPY. The recent rise in the Swiss franc threatens the nascent recovery in inflation (Chart I-12), while weakness in the Japanese yen will help lift domestic tradeable goods prices. This puts more pressure on the Swiss National Bank rather than the BoJ. Meanwhile, as a safe haven, the yen is cheaper than the franc. This is confirmed by many of our in-house models. In simple terms, relative inflation with the US has been lower in Japan over the last several decades, but the franc has been stronger. In simple terms, relative inflation with the US has been lower in Japan over the last several decades, but the franc has been stronger (Chart I-13). Meanwhile, over the last two years, a rise in volatility has benefited the yen more than the franc. Chart I-12Strong Franc Is A Headwind For Swiss Inflation Strong Franc Is A Headwind For Swiss Inflation Strong Franc Is A Headwind For Swiss Inflation Chart I-13The Yen Is Cheaper ##br##Insurance The Yen Is Cheaper Insurance The Yen Is Cheaper Insurance Bottom Line: The yen is the most attractive safe-haven currency at the moment. Remain short USD/JPY and sell CHF/JPY. Housekeeping We were stopped out of our long NOK/SEK trade for a profit of 1.8%. We will look to rebuy this cross at lower levels. The trade is mostly about carry, and we are both positive on the NOK and SEK. This makes market timing important. NOK/SEK at 1.04 will be attractive. There were no new insights from the Norges bank this week, in the context of all the central bank meetings. We will also be looking to opportunistically buy the pound, but buying EUR or GBP volatility might be a better bet. For now, despite the robust labor report, economic surprises in the UK remain negative (Chart I-14). Stay tuned. Chart I-14GBP Is Vulnerable GBP Is Vulnerable GBP Is Vulnerable Chester Ntonifor Foreign Exchange Strategist chestern@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 Recent data in the US have been mixed: Industrial production fell by 1% year-on-year in December. The preliminary Michigan consumer sentiment index fell slightly to 99.1 in January. MBA mortgage applications fell by 1.2% for the week ended January 17th. However, existing home sales surprised to the upside, rising 3.6% month-on-month in December. Chicago Fed national activity index fell to -0.35 from 0.41 in December. Initial jobless claims increased to 211K for the week ended January 17th, better than expectations. The DXY index increased by 0.4% this week. There are growing concerns over whether China's coronavirus would significantly drag down global growth. While this is a hiccup in the short term, we remain positive and believe that global growth will accelerate this year on easy financial conditions and faded trade war risks. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 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 data in the euro area have been mostly positive: The current account balance came in at €33.9 billion in November. Headline and core inflation were both unchanged at 1.3% year-on-year respectively in December. The ZEW economic sentiment survey soared to 25.6 from 11.2 in January. The euro fell by 0.8% against the US dollar this week. On Thursday, the ECB maintained interest rates at -0.5%. The key takeaway from the ECB is that they are grappling with a review of their monetary policy objective in a manner that might increase accommodation. A switch to an explicit 2% inflation target and/or including a climate change objective into quantitative easing decisions heralds a much more dovish ECB. We are tightening our stop on long EUR/CAD to 1.42. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Industrial production fell by 8.2% year-on-year in November. The trade deficit widened to ¥152.5 billion in December. Imports and exports both fell by 4.9% and 6.3% year-on-year, respectively. All industry activity index increased by 0.9% month-on-month in November. Both the coincident index and the leading economic index fell to 94.7 and 90.8, respectively in November. The Japanese yen appreciated by 0.3% against the US dollar this week. The BoJ kept interest rates unchanged, in line with expectations. More importantly, the outlook report revised the growth forecast upward to 0.9% from 0.7% for the fiscal year 2020. Moreover, the BoJ revised down the inflation forecast by 10 bps due to lower crude oil prices. Please refer to our front section this week for a more in-depth analysis on the Japanese yen. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: Retail sales grew by 0.9% year-on-year in December. The Rightmove house price index increased by 2.7% year-on-year in January. The ILO unemployment rate was unchanged at 3.8% in November. Average earnings grew by 3.2% year-on-year in November. This followed a 3-month improvement in employment of 208K, after what had been a dismal employment report for most of 2019. The British pound appreciated by 0.7% against the US dollar this week. The biggest volatility in European currencies in the next few weeks is likely to emerge in the EUR/GBP cross. European economic data has had the best positive surprises in the last few weeks, in part due to base effects.  However, the ECB’s transcript this week suggests leaning against any currency strength. In the UK, the pound will still trade partly on politics for now. Buying GBP and EUR volatility looks like a good bet. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: The Westpac consumer confidence index fell by 1.8% in January. Consumer inflation expectations increased to 4.7% from 4% in January. 28.9K new jobs were created in December, above consensus. This was a combination of 29.2K part-time jobs but a loss of 0.3K full-time jobs. The participation rate was unchanged at 66% in December, while the unemployment rate fell further to 5.1%. The Australian dollar fell by 0.6% against the US dollar this week. The positive jobs report placed a bid under AUD, but that quickly dissipated as the coronavirus scare started to dominate headlines. We discussed AUD in depth last week and are buyers at 68 cents. Our primary rationale is that this is a potent contrarian bet. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Visitor arrivals fell by 3.5% year-on-year in November. Net migration fell to 2610 from 3400 in November. The performance services index fell to 51.9 from 52.9 in December. The New Zealand dollar fell by 0.5% against the US dollar this week. While we believe that the kiwi dollar will outperform the US dollar this year amid improving global growth, domestic constraints including decreasing net migration might limit upside potential. Stay long AUD/NZD and SEK/NZD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been soft: Manufacturing sales fell by 0.6% month-on-month in November. Headline inflation was unchanged at 2.2% year-on-year in December. Core inflation however, fell to 1.7% from 1.9% in December. New house prices grew by 0.1% year-on-year in December. The Canadian dollar fell by 0.8% against the US dollar this week. On Wednesday, the BoC decided to put interest rates on hold, while opening the door for possible rate cuts later this year if the Canadian data disappointed. In short, like most other central banks, the BoC is data dependent. Our story for CAD is simple – if the epicenter of a growth rebound is outside the US, CAD will underperform its antipodean counterparts. Stay long AUD/CAD. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There have been scant data from Switzerland this week: Producer prices fell by 1.7% year-on-year in December, compared with a decrease of 2.5% the previous month. Money supply (M3) grew by 0.7% year-on-year in December. The Swiss franc has been more or less flat against the US dollar this week. We continue to favor the Swiss franc as global risks persist, including concerns about the coronavirus. However, as discussed in the front section of this report, the yen is a better hedge than the franc at the current juncture. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: The Labor Force Survey recorded an increase in the unemployment rate to 4% in November.  The Norwegian krone fell by 1.3% against the US dollar this week amid lower energy prices. On Thursday, the Norges Bank kept interest rates on hold at 1.5%, as widely expected. Moreover, the Bank Governor Øystein Olsen said that "The Committee’s current assessment of the outlook and the balance of risks suggests that the policy rate will most likely remain at the present level in the coming period," implying no change in the policy rate in the near-term. This suggests that going forward, relative fundamentals rather than policy decisions will dictate NOK’s path. Our bias is that a valuation cushion offers a margin of safety for long NOK positions. Remain short USD/NOK and CAD/NOK. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There was scant data out of Sweden this week: After rising from 6% to 6.8% in November, the unemployment rate fell back to 6% in December. The Swedish krona fell by 0.2% against the US dollar this week. Going forward, improving global growth, diminished trade tensions, and fewer concerns about a near-term recession all underpin the Swedish economy and the krona. SEK is the most potent G10 cross to play a global manufacturing rebound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Net inflows into US assets have been rolling over since the beginning of 2019, given that the repatriation associated with the 2017 tax cuts was a one-off effect. Besides, fading interest rate differentials are making US Treasuries less attractive, which is a headwind for the greenback.  A trade war ceasefire between the US and China should improve the balance of payments dynamics for export-oriented nations. We maintain a pro-cyclical stance.  A revival in oil demand and curbs on supply should underpin oil prices through 2020, which could lift the trade balances of Norway and Canada. However, we expect the Canadian dollar to underperform, weighed by pipeline constraints and the divergence between WCS and WTI prices. Stay short CAD/NOK. Feature The balance of payments is one of the key indicators we watch on a regular basis to gauge the direction of exchange rates. While the power of BoP on currency moves differs from one country to another, it provides a big picture view of a country's transactions with other nations. Generally speaking, persistent surpluses are usually associated with appreciation in currencies, and vice versa. Ongoing trade disputes since early 2018 have caused some fluctuation in current account balances globally. Political uncertainties and rising protectionism have also limited foreign investments in some countries. Going forward, should global growth stabilize amid a possible trade détente, export-oriented regions will have more scope to improve their balance of payments dynamics. In what follows we present balance of payments across G10 through five categories: the trade balance, the current account balance, foreign direct investment, the basic balance, and lastly, portfolio investment. United States Chart 1US Balance Of Payments US Balance Of Payments US Balance Of Payments The US trade deficit has been more or less flat, lingering around 3% of GDP. The trade deficit mostly comes from manufactured goods. On the positive side, the US has been producing and exporting more petroleum and related products, which has decreased oil demand from abroad. Meanwhile, exports of pharmaceutical products are on the rise. The current account is at a smaller deficit of 2.5% of GDP, thanks to a positive net international investment position. Foreign direct investment had been increasing due to repatriation by US companies since the 2017 Trump tax cuts. If this one-off tax break was a source of US dollar strength in 2018, that support is now gone. Meanwhile, dollar strength since the beginning of 2018 may have made US assets less attractive to foreign investors. Since the beginning of 2019, net inflows into US assets have been rolling over, and have fallen to 0.9% of GDP. This has brought the US basic balance down to -1.6% of GDP. In terms of portfolio investment, US bond markets are still appealing to foreign investors, but interest rate differentials are moving against the greenback. Total foreign purchases of US Treasury bonds have been negative this year, of which official purchases stand at US$350 billion of net outflows. In short, the path of least resistance for the US dollar is down, due to a widening current account deficit, waning foreign direct investment, fading interest rate differentials and increasing dollar liquidity. Euro Area Chart 2Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments The slowdown in global trade has hit European exports, but the trade balance is still sporting a “healthy” surplus of 1.7% of GDP, albeit far below its peak. As a result, the current account as of September 2019 was still at a healthy level of 2.7% of GDP. Should a US-China "phase one" deal be finalized, the trade balance in the euro area is likely to rebound going into 2020. Foreign direct investment has been increasing to the point of being at its highest level over the past 20 years, or 1% of GDP. This has been aided in part by the peripheral countries, further evidence that we are getting a convergence in competitiveness across Eurozone countries. The cheap euro and lower cost of capital have helped. As a result, the basic balance for the euro area reached a new high of 3.8% of GDP in September 2019. Portfolio investment into the euro area has stopped deteriorating since the beginning of 2017 and is now sporting net inflows of 0.8% of GDP. European purchases of both foreign equities and foreign bonds are falling, probably a sign that domestic assets are becoming more attractive. For example, ETF inflows are accelerating. The restart of the European Central Bank’s asset purchase program will continue to act as an anchor for spread convergence in the euro area. Meanwhile, a rally in European equities will be another signal of recovery in the euro area. A healthy current account balance and improving foreign investments both signal a higher euro going forward. Japan Chart 3Japanese Balance Of Payments Japanese Balance Of Payments Japanese Balance Of Payments The trade slowdown has dealt a small blow to Japan’s current account balance. The trade deficit widened further in 2019, reaching -0.5% of GDP in Q3. Exports have been falling for a 10th consecutive month, weighed down in part by lower sales of auto parts and semiconductor equipment. But these will pick up should a trade truce be reached. Among its major trading partners, sales to the US, China and other Asian countries have fallen, but have risen in the Middle East and Western Europe. That said, Japan’s large net international investment position has helped keep the current account surplus at an elevated level of 3.4% of GDP. Foreign direct investment in Japan has been dismal for many years due to an offshoring of industrial production. Net FDI is currently standing at -4% of GDP, which has brought the basic balance below zero for the first time since 2016. The recent deceleration is further evidence that corporate Japan needs structural reforms. Portfolio investment remains in negative territory mostly due to Japanese residents' large purchases of foreign long-term bonds. Going forward, fund inflows to Japan could face more headwinds with the proposed change to the Foreign Exchange and Foreign Trade Act. The change aims to lower the minimum stake for foreign investors without government approval from 10% to 1%. Other changes include requiring foreign directors to seek permission before becoming a board member. That said, Japan’s large net international investment position, which produces a high current account surplus, will continue to make the yen a safe haven amid global uncertainties. United Kingdom Chart 4UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments So far, a cheap pound has not yet staunched the deterioration in UK balance of payments. The UK trade deficit remained wide at 7% of GDP in the third quarter. Among its major trading partners, the trade deficit comes mainly from Germany and China, offset by a smaller surplus from the US, the Netherlands and Ireland. Net receipts are positive, but the current account balance is still in negative territory at -5% of GDP. The Brexit imbroglio has led to an exodus of foreign direct investment. Many international companies are fleeing the UK, but to the extent that we get a quick resolution after the December elections, the uncertainty is likely to subside. Portfolio investment in the UK has been volatile over the past few years and has not really helped dictate any discernable trend in the UK basic balance. More recently, inflows into UK gilts have been £19 billion in the second quarter, while flows into equities are also improving. Relative interest rate differentials are also likely to move in favor of the UK, especially if reduced uncertainty provides scope for the Bank of England to hike interest rates. At a minimum, compared with other European nations, gilts remain appealing to international investors. We remain positive on the pound and are long GBP/JPY in our portfolio. Canada Chart 5Canadian Balance Of Payments Canadian Balance Of Payments Canadian Balance Of Payments The Canadian trade deficit has been hovering near -1% of GDP over the past few years. The goods trade deficit narrowed this year, led mostly by an increase in energy exports and lower imports of transportation equipment. Further improvement in energy product sales will require an improvement in pipeline capacity and a smaller gap between WCS and Brent crude oil prices. The current account deficit has been narrowing, now standing at -2% of GDP, the smallest since 2008. This is helped by net receipts, especially driven by a rise in direct investment income. FDI has been the bright spot in Canadian BoP dynamics. FDI inflows have been in part helped by increased cross- border M&A activities. Net FDI into Canada now accounts for 2.7% of GDP. This has brought the basic balance back above zero for the first time since 2015. Portfolio investment is positive on a net basis, but the trend looks quite worrisome. Foreign entities are fleeing Canada. In the meantime, Canadian investment in foreign securities is on the rise, reaching C$6 billion in Q3. Profitability, liquidity concerns and a global push towards sustainable investing are making Canadian energy and mining companies unappealing for foreign capital. Moreover, with elevated house prices and depressed interest rates, the outlook for banking profitability is also concerning. A drop in the US dollar will help the loonie in the short term. Over the longer term, however, we prefer to be underweight the Canadian dollar, especially via the Australian dollar and the Norwegian krone, which have a better macro outlook. Australia Chart 6Australian Balance Of Payments Australian Balance Of Payments Australian Balance Of Payments Australia has seen the best balance of payments improvement among the G10. The Australian trade balance soared this year and now stands at 2.5% of GDP, the highest in several years. Terms of trade, which have increased by 45% since their 2016 bottom, have been one of the main drivers. Exports of iron ore and concentrates increased by 64% year-on-year in September 2019, adding to the positive trade balance. Ergo, Australia is benefitting from both a price and volume boost. Trade has lifted the current account to be on track to post its first surplus since the ‘70s. Going forward, we expect Australian trade to continue improving amid the US-China trade détente. Foreign direct investment dipped slightly in 2019, but from very elevated levels. At present, it still stands at 3.5% of GDP. This has allowed for a very healthy basic balance surplus of 2.9% of GDP. The largest sources of Australian foreign direct investment are the US and the UK. The FDI inflows tend to be concentrated in the mining and manufacturing sectors and generate a negative income balance for Australia. This has been part of the reason behind the country’s chronic current account deficit, but it is impressively becoming less and less important. Portfolio investment in Australia plunged in 2019, and now stands at -4.2% of GDP. This has been driven by an exodus from the bond market. The repatriation of capital back to the US probably helped exacerbate this trend. The Australian dollar is likely to rebound from a contrarian perspective. We are playing Aussie dollar strength via the New Zealand and Canadian dollars. New Zealand Chart 7New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand is also benefitting from a terms-of-trade boost. The trade deficit marginally narrowed to -1.7% of GDP in the third quarter. Exports rose by 4% year-on-year in the third quarter, while imports rose by 3.6% year-on-year. Terms of trade increased in 2019, mainly driven by a rise in dairy and meat prices. It appears the pork crisis in China is benefitting New Zealand exports. As a result, the current account deficit narrowed slightly to 3.4% of GDP. Foreign direct investment in New Zealand rose sharply to 3.1% of GDP, partly driven by reinvestment in the banking sector. This almost brought the basic balance back into positive territory. If this trend continues, it will be the first time the basic balance is in positive territory in two decades. Portfolio investment in New Zealand has been deteriorating, with net outflows of $6.2 billion in the second quarter. This is almost 4% of GDP on an annualized basis. The withdrawal of equity and investment fund shares by foreign entities, as well as divestment of debt securities by the general government, are some of the reasons behind falling portfolio investment. In a nutshell, increased portfolio investment in New Zealand will be predicated on a terms-of-trade shock that boosts margin growth for agricultural exporters, or a policy shift that boosts domestic return on capital. We like the kiwi versus the dollar, but are underweight against its pro-cyclical peers, namely the Australian dollar and the Swedish krona. Switzerland Chart 8Swiss Balance Of Payments Swiss Balance Of Payments Swiss Balance Of Payments The Swiss trade balance has been in a structural surplus, and hugely underpins the nation’s large current account surplus. The improvement this year, a rebound to 5.4% of GDP in the third quarter, is notable. The increase in exports has been partly driven by higher sales of chemical and pharmaceutical products, jewelry, and metals. Combined with income inflows from its large net international investment position, this has produced a current account balance of 10.7% of GDP. The slowdown in foreign direct investment has eased sharply from a record-low of -16% to -8% of GDP. Tax breaks from the US Jobs Act in 2017 allowed for favorable divestment of FDI in Switzerland and repatriation back to the US. This was a one-off that is now behind us, which explains why the basic balance is shifting back into surplus territory, to the tune of 2.5% of GDP.  Portfolio investment has been gradually improving and now stands at 0.3% of GDP. Swiss paper and equities (which are defensive) have benefitted from increased safe-haven demand this year. The Swiss franc is likely to continue its slow structural appreciation in the years to come, interspersed with bouts of volatility. In the short-term, however, the Swiss National Bank is likely to use the currency to fight deflationary pressures. This suggests the EUR/CHF has upside tactically. Sweden Chart 9Swedish Balance Of Payments Swedish Balance Of Payments Swedish Balance Of Payments The Swedish trade balance has been in structural decline since 2004 and turned negative in 2016. A large component of Swedish exports are machinery and automobiles which have suffered stiff competition from other global giants. The good news is that the weak krona is starting to help. The third-quarter trade balance shifted to a surplus for the first time since 2016 and is currently standing at 0.2% of GDP. Combined with inflows from Sweden’s external investments, this has nudged the current account balance to 3.3% of GDP. Despite net FDI inflows falling to -2.1% of GDP, the basic balance still managed to remain stable at 1.2% of GDP due to the improvement in the current account balance. The recent decline in Swedish FDI has mirrored those in other countries. However, Swedish exports will benefit from a trade détente as well as from a broader improvement in global growth. This should stem FDI outflows. Net portfolio investment in Sweden has been volatile in recent years, but our expectation is for improvement. A weak krona has typically helped the manufacturing sector with a lag of 12 months. Moreover, with the krona trading at a large discount to its long-term fair value, foreign investors will likely benefit from both equity and currency returns, should cyclical stocks continue to outperform defensives. In summary, Sweden’s basic balance should recover to levels that have prevailed over the past few years. Norway Chart 10Norwegian Balance Of Payments Norwegian Balance Of Payments Norwegian Balance Of Payments The bottom in oil prices since 2016 has gone a long way towards improving Norway’s trade balance. Net trade has fallen marginally this year due to lower exports of oil and natural gas, but still stands at 7.2% of GDP. The trade balance is the primary driver of the current account balance, and the latter now stands at 6.4% of GDP. Norway has seen an exodus of foreign capital from both direct and portfolio investment.  Net FDI and portfolio investment stand at -3% and -4% of GDP, respectively. Declining oil production in the North Sea has been partly responsible for falling FDI. On the portfolio side of the equation, it has been mainly due to increased purchases of foreign equities and bonds, especially via the Oil Fund. Concerns around sustainable investing have also likely diverted investors away from Norwegian assets. Despite this, Norway still sports a basic balance surplus of 3.4% of GDP. Eventually, this basic balance will move from being supported by trade to income inflows from Norway’s large net international investment position. The Norwegian krone is cheap on many metrics, and is one of our favorite petrocurrencies at the moment. Should global growth stabilize, which will revive oil demand, inflows into Norway should improve.   Kelly Zhong Research Analyst kellyz@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Client, In addition to this short weekly report, you will also receive our 2020 outlook, published by the Bank Credit Analyst. Next week, I will be on the road visiting clients in South Africa. I hope to report my discussions and findings the following week. Best regards, Chester Ntonifor Highlights According to a simple attractiveness framework, the most desirable currencies are the Norwegian krone, the Swedish krona, and the Japanese yen. The least attractive are the New Zealand dollar and the British pound. Take profits soon on our long GBP/JPY position. Feature In this report, we use a simple framework for ranking G10 currencies. First, we consider the macroeconomic environment using as proxies a country’s basic balance and external vulnerability. Next, we look at valuation metrics,  surveying a variety of both short-term and longer-term models. Finally, we consider positioning, to gauge if our view is mainstream or out of consensus. Below are our results. Basic Balance Chart I-1Basic Balance A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies We consider the basic balance to be one of the most important concepts in determining the attractiveness of a currency. In a nutshell, it captures the ebb and flow of demand for a country’s domestic assets. Persistent basic balance surpluses are usually associated with an appreciating currency and vice versa. The euro area sports the best basic balance surplus in the G10 universe, followed by Norway and then Australia (Chart I-1). In simple terms, this means there is constant strong underlying demand for these currencies - either for domestic goods and services, or for investment into portfolio assets. The UK and the US rank the worst in terms of basic balances, driven by Brexit uncertainty and the ebbing of tax reform benefits in the US. We will explore balance of payments dynamics within all of the G10 countries in detail next week. External Debt A currency is sometimes only as vulnerable as its external liabilities. In an absolute sense, external debt as a share of GDP is highest in the UK, euro area, and Switzerland (Chart I-2). However, what matters most times for vulnerability are net external assets rather than gross liabilities. On this measure, Japan, Switzerland, and Norway are the most attractive countries, while the US and Australia rank the worst (Chart I-3). Chart I-2External Vulnerability A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies Chart I-3US Is Least Attractive A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies Purchasing Power Parity (PPP) Chart I-4PPP Model A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies Various models have shown PPP to be a very poor tool for managing currencies, but an excellent one at extremes. However, there is a roadblock that comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, two adjustments are necessary. First, categorizing the consumer price index (CPI) into five major groups. In most cases, this breakdown captures 90% of the national CPI basket. This includes food, restaurants and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, as opposed to using the national CPI weights. The US dollar is overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone.  The results show the US dollar as overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex, the Japanese yen is more attractive than the Swiss franc. The euro is less undervalued than implied by the overvaluation in the DXY index (Chart I-4). Intermediate-Term Timing Model (ITTM) Back in 2016, we developed a set of currency indicators to help global portfolio managers increase their Sharpe ratio in managing currency exposure. The idea was quite simple: For every developed world country, there were three key variables that influenced the near-term path of its exchange rate versus the US dollar. Our intermediate-term timing models are not sending any strong signals at the moment.  Interest Rate Differentials: Under the lens of interest rate parity, if one country is expected to have lower interest rates versus another, the incumbent’s currency will fall today so as to gradually appreciate in the future and nullify the interest rate advantage. Chart I-5Intermediate-Term Model A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies Inflation Differentials: Assuming no transactional costs, the price of sandals cannot be relatively high and rising in Mumbai versus Auckland. Either the Indian rupee needs to fall, the kiwi rise, or a combination of the two has to occur to equalize prices across borders. Risk Factor: Exchange rates are not government bonds in that few treasury departments and central banks can guarantee a par value on them. Ergo, the ebb and flow of risk aversion will have an impact on the Norwegian krone as well as the yen. For the most part, our models have worked like a charm. On a risk-adjusted return basis, a dynamic hedging strategy based on our ITTMs has outperformed all static hedging strategies for all investors with six different home currencies since 2001. These results give us confidence to continue running these models as a sanity check for our ever-shifting currency biases. That said, our intermediate-term timing models are not sending any strong signals at the moment. The Swedish krona, Norwegian krone, and New Zealand dollar are the most attractive currencies, while the British pound and Swiss franc are the least attractive (Chart I-5). Long-Term Fair Value Model Chart I-6Long-Term Model A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies Our long-term FX models are also part of a set of technical tools we use to help us navigate FX markets. Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials, and proxies for global risk aversion. These models cover 22 currencies, incorporating both G10 and emerging market FX markets. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their main purpose is to provide information on the longevity of a currency cycle, depending on where we are in the economic cycle. Our long-term FX models are not sending any strong signals right now, with the US dollar at fair value. The cheapest currencies are the yen, the Norwegian krone, and Swedish krona (Chart I-6). The priciest currencies are the South African rand and the Saudi riyal. Real Interest Rates One defining feature of the currency landscape is that pretty much across the G10 countries, we have negative real rates (Chart I-7). Within  the G10 universe, the US and New Zealand dollars are the highest-yielding currencies, while the British pound and Swedish krona are the least attractive. Chart I-7Real Rates A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies Speculative Positioning Being long Treasurys and the dollar has been a consensus trade for many years now (Chart I-8). According to CFTC data, this has been expressed mostly through the aussie and kiwi, although our bias is that the Swedish krona and Norwegian krone have been the real victims. Chart I-8Positioning A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies That said, flow data highlights just how precarious being long US dollars is right now. Net foreign purchases by private investors are still positive, but the momentum of these flows is clearly rolling over. This is being more than offset by official net outflows. As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Concluding Thoughts Should the nascent pickup in global growth morph into a synchronized recovery, it will go a long way in further eroding the US’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. For example, yields in Norway, Sweden, Switzerland, and Japan have risen by much more than those in the US since the bottom. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar. This is the message being sent by an aggregate of our ranking model. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar (Chart I-9). Take profits soon on our long GBP/JPY position. Chart I-9Favor Norway, Japan and Sweden A Simple Attractiveness Ranking For Currencies A Simple Attractiveness Ranking For Currencies   Chester Ntonifor Foreign Exchange Strategist chestern@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 Recent data in the US have been mixed: Retail sales grew by 0.3% year-on-year in October. Industrial production contracted by 0.8% month-on-month in October. On the housing market front, building permits and housing starts both increased by 5% and 3.8% month-on-month in October. However, MBA mortgage applications contracted by 2.2% for the week ended November 15th. The NY Empire State Manufacturing index fell to 2.9 from 4 in November. The Philly Fed manufacturing index, on the other hand, soared to 10.4 from 5.6 in November. The DXY index depreciated by 0.3% this week. The FOMC minutes released this Wednesday showed that the Fed now sees little need to further reduce rates. Last week, we did a reassessment of global growth and the USD, and entered a limit sell for the DXY index at 100. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4UR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly positive: The seasonally-adjusted trade balance fell to €18.3 billion in September. The current account surplus slightly narrowed by €0.3 billion to €28.2 billion. Headline and core inflation were both unchanged at 1.1% and 0.7% year-on-year respectively in October. Consumer confidence improved from -7.6 in October to -7.2 in November. EUR/USD increased by 0.5% this week. The improvement in soft data confirms that the economy is in a bottoming process in the euro area. The fact that the largest economy, Germany, skirted a recession last week also boosted investor confidence. We continue to remain overweight the euro. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been positive: Exports decreased by 9.2% year-on-year in October. Imports slumped by 14.8% year-on-year. The total trade balance shifted to a surplus of ¥17.3 billion.  The industry activity index increased by 1.5% month-on-month in September. USD/JPY fell by 0.2% this week. While global growth is set to improve given a possible trade détente and easy monetary policy worldwide, uncertainties continue to loom. The US Senate unanimously passed legislation on the "Hong Kong Human Rights and Democracy Act," adding more difficulties to finalize the Phase I trade deal. Global trade uncertainty is positive for safe-haven demand. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Rightmove house price index increased by 0.3% year-on-year in November. Public sector net borrowing increased by £3 billion to £10.5 billion in October. The British pound continues to appreciate by 0.7% against the US dollar this week. With Brexit being less of a threat, the pound is poised to rise through next year. We are long GBP/JPY in our portfolio and it is in the money at 6.1%. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been soft: The Westpac leading index fell by 0.1% month-on-month in October, following a slight decline the previous month. AUD/USD has been more or less flat this week. In the monetary policy minutes released this week, the RBA expressed their expectations for stronger growth at 2.75% in 2020 and around 3% in 2021, supported by accommodative monetary policy, infrastructure spending, stabilizing house prices, and strong steel-intensive activities in China. The minutes also presented an argument against lower interest rates: while lower interest rates can support the economy through the usual transmission channels, they could be negative for savers and confidence. That said, the RBA is "prepared to ease monetary policy further if needed." Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: Both output and input components of the producer price index have increased in Q3: the output component grew by 1% quarter-on-quarter and input component by 0.9% quarter-on-quarter. NZD/USD increased by 0.7% this week. Both growth and inflation in New Zealand are showing signs that the economy is in a bottoming process. We are positive on the kiwi against the US dollar while we remain short against the Australian dollar and Swedish Krona. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Manufacturing shipments fell by 0.2% month-on-month in September. Both headline and core inflation were unchanged at 1.9% year-on-year in October. ADP employment showed a loss of 22.6K jobs in October. The Canadian dollar fell by 0.6% against the US dollar this week. While a possible trade détente between US and China and rising oil prices could put a floor under the loonie, the pipeline constraints in Canada have dampened the correlation between the oil prices and the loonie.  This will limit the upside potential for the Canadian dollar. Report Links: Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The trade surplus narrowed to CHF 3.5 billion in October from CHF 4.1 billion the previous month, due primarily to growth in imports, which grew by 1.9 billion month-on-month. Exports also increased by 1.3 billion month-on-month. Import demand remains firm for chemical products. Industrial production grew by 8% year-on-year in Q3. USD/CHF increased by 0.2% this week. The trade balance still remains at a high level in Switzerland, which is bullish for the franc. Moreover, global uncertainties could underpin the safe-haven franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been positive: The trade balance shifted to a surplus of NOK 5.9 billion in October, after a deficit of NOK 1.4 billion in September. However, this is compared to a surplus of NOK 32.6 billion in the same month last year. On a year-on-year basis, exports slumped by 27%, caused by a decrease in exports of mineral fuels and chemical products. The Norwegian krone appreciated by 0.3% against the US dollar this week, supported by the oil price recovery. On Wednesday, the EIA posted an increase of crude oil inventories by 1.4 million barrels from the previous week, lower than expectations. WTI crude oil prices thus surged by 4% on the news. Going forward, we remain overweight energy prices and the Norwegian krone. Report Links: Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 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 data in Sweden have been positive: Capacity utilization increased to 0.5% in Q3, up from 0.1% in the previous quarter. The Swedish krona increased by 0.7% against the US dollar this week. The Swedish krona has depreciated by 23% against the USD since its 2018 peak. A global growth revival is likely to give a boost to the krona from a valuation perspective. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Rising recession risk, shaky economic fundamentals, and absence of positive yielding assets motivate us to reexamine which assets can be counted on to protect a portfolio in the future. We analyze 10 safe havens on four different dimensions: consistency, versatility, efficiency, and costs. Using this framework, we examine the historical performance of each safe haven and provide an outlook on their likely effectiveness over the next decade. We conclude that U.S. TIPS and farmland should provide the best portfolio protection. Cash, U.S. Treasuries and gold are other good alternatives. Meanwhile, U.S. investment-grade bonds, global ex-U.S. bonds, silver, and currency futures are likely to be poor protection choices. Feature For most investors, capital preservation is the most important goal when managing money. However, how to go about it remains a difficult question.  Investing in safe havens can be painful during bull markets, as their returns are usually lower than those of equities. Moreover, economic, political, and financial regimes change over time, which means that an asset that protected your portfolio in the past might not do so in the future. Therefore, it becomes good practice to review one’s safety measures periodically, even if one does not think that a crash is imminent. The current environment in particular, is a propitious time to review safe havens given that: Chart I-1A Great Time To Review Safety Measures A Great Time To Review Safety Measures A Great Time To Review Safety Measures A key recession signal is flashing red: The yield curve inverted in the United States in August (Chart I-1 – top panel). An inversion of the yield curve does not necessarily imply a recession, but historically it has been a very reliable signal of one, given that it indicates that monetary policy is too tight for the economy. Structural risks are rising: Rich equity valuations in the U.S. and high leverage levels elsewhere are signs that the pillars supporting this bull market might be fragile (Chart I-1 – middle panel). In addition, protectionism and populism, forces that BCA has long argued are here to stay, threaten to upend the regime of free trade that has benefited equities since the 1950s.1 Yields are near all-time lows: Historically, investors have been able to endure bear markets by hiding in safe assets with positive yield, as these assets will normally provide a reliable cash flow regardless of the economic situation. However, these type of assets are increasingly hard to find, particularly in the government bond space, where 50% of developed country bonds have negative yields (Chart I-1 – bottom panel). Considering these factors, how should investors protect their portfolios in the next decade? To answer this question, we analyze 10 safe havens divided into five broad asset classes: Nominal government bonds: U.S. Treasuries and global ex-U.S. government bonds. Other fixed income: U.S. investment-grade credit and U.S. TIPS.2 Currencies: yen futures and Swiss franc futures. Precious metals: gold futures and silver futures. Other assets: farmland and U.S. cash. We look at historical performance since 1973 for all safe havens except for global ex-U.S. bonds and farmland. For these assets, we look at performance since 1991 due to limited data availability. We mainly look at quarterly returns in order to compare illiquid assets to publicly traded ones. We do not consider each safe haven in isolation, but rather as an addition to equities within a portfolio. Specifically, we explore our safe haven universe relative to the MSCI All Country World equity index from the perspective of a U.S. investor. For our non-U.S. clients, we will release a report from the perspective of other countries if there is sufficient interest. Importantly, we do not look only at historical performance. We also examine whether there is a reason to believe that future returns will be different from past ones, by analyzing how the properties of each safe haven might have changed. When evaluating each safe haven, we focus on four properties: Consistency: a safe haven should generate consistent positive returns during periods of negative equity performance, with returns increasing with the severity of the equity drawdown. Versatility: safe havens should perform well across different types of crises. Efficiency: a safe haven should produce enough upside during crises, so only a small allocation to the safe haven is necessary to reduce losses. Costs: drag to portfolio overall performance (opportunity costs) should be as small as possible. Readers who wish to see just our overall conclusions should read our Summary Of Results section below. For our analysis of how safe havens have performed in the past, please see the Historical Performance section. Finally, for our analysis of how we expect the performance of safe havens to change, please see our Outlook section. Summary Of Results The Best Safe Havens U.S. TIPS should be an excellent safe haven to protect a portfolio in the next decade. While TIPS might not be as cheap to hold as they have been in the past, upside potential remains strong, which means that a moderate allocation can provide substantial protection to an equity portfolio. Moreover, U.S. TIPS are one of the best hedges against crises triggered by rising rates and inflation, which in our view are the biggest structural risks that asset allocators face. Farmland could also be a great safe haven for investors who have the ability to allocate to illiquid assets given that it is the cheapest safe haven in terms of portfolio drag. However, investors should be aware that the current low yield could potentially affect its performance during crises. Good Alternatives Cash can be a good alternative to protect an equity portfolio, given its outstanding performance during equity drawdowns caused by inflation. Moreover, its opportunity costs should decrease relative to the past. However, investors should take into account that the efficiency of cash at the current juncture is poor, which means that a relatively large allocation is needed in order to achieve meaningful portfolio protection. A portfolio with a 30% allocation to Treasuries historically provided the same downside protection as a portfolio with a 44% allocation to gold. We also like gold futures as a safe haven since they offer some of the most attractive opportunity costs. In addition, their upside is greater than that of most safe havens due to their negative correlations with real rates. However, gold’s volatility makes it an unreliable asset, which prevents us from placing it higher in the safe haven hierarchy. Historically, U.S. Treasuries have been one of the best safe havens to hedge an equity portfolio. Will this performance continue in the future? We do not think so. While yields are still high enough to provide plenty of upside potential, they have fallen to the point where they have increased the opportunity costs of U.S. Treasuries and reduced their consistency. The Rest Global ex-U.S. bonds have very limited upside due to their low yields. Meanwhile U.S. investment-grade credit remains at risk from poor corporate balance sheets, compounded by the fact that credit no longer has an attractive yield cushion. Currencies like the yen and the Swiss franc will continue to be unreliable and very expensive safe havens. Finally, while silver’s costs and reliability could improve, its high cyclicality relative to other safe havens will make silver a poor protection choice. Historical performance Consistency How did safe havens perform when equities lost money? To assess consistency, we plot the performance of each safe haven during all quarters when global equities had losses (Chart I-2). Cash and farmland were the only assets to have positive returns during every equity drawdown. U.S. Treasuries and U.S. TIPS were also very consistent, and had the additional advantage that their returns tended to increase as equity losses worsened. Global ex-U.S. bonds, while not as consistent, generated positive returns most of the time. Chart I-2Safe Haven Returns During Drawdowns In Global Equities Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s On the other hand, investment-grade bonds, the yen, the Swiss franc, gold, and silver were much more inconsistent. In general, even though these assets had larger positive returns than other assets, they were prone to deep selloffs concurrent with equity drawdowns. Silver was the worst of all safe havens, being mostly a negative return asset during quarters of negative equity performance. Versatility How did the type of crisis affect the performance of safe havens? We classify crises according to their catalyst into the following four categories: bursts of U.S. asset bubbles (tech bubble, 2008 housing crisis), ex-U.S. crises (1998 EM crisis, European debt crisis), flash crashes/political events (1987 Black Monday, 9/11 terrorist attack),  rate/inflation shocks (1974 oil crisis, 1980 Fed shock) and others (every other equity drawdown we could not classify).3  We look at the performance of seven safe havens since 1973 (Chart I-3A) and of all 10 since 19914 (Chart I-3B): Chart I-3ASafe Haven Return During Different Type Of Crisis (1973 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-3BSafe Haven Return During Different Type Of Crisis (1991 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s   During bursts of U.S. asset bubbles, U.S. Treasuries were the most effective hedge in both sample periods, followed by U.S. TIPS and farmland. Corporate bonds, cash, gold, and the Swiss franc also had positive returns, though they were small. Finally, the yen and silver had negative returns. During crises happening outside of the U.S., U.S. Treasuries were once again the best option. U.S. TIPS, yen futures, farmland, gold, and U.S. investment-grade bonds also provided strong returns.  Meanwhile, global ex-U.S. bonds and cash provided relatively weak returns, while both the Swiss franc and silver accrued losses. During flash crashes/political events, the Swiss franc had the best performance followed by global ex-U.S. bonds, though in general all safe havens but silver provided positive returns. Rate/inflation shocks were the most difficult type of crisis to hedge. Cash and U.S. TIPS were by far the best performers. Moreover, while U.S. Treasuries were able to eke out a small positive return, all other safe havens lost money during these crises. Efficiency How much allocation to each safe haven was needed to protect an equity portfolio? Chart I-4 show how adding incremental amounts of each safe haven5 to an equity portfolio reduced the overall portfolio’s 10% conditional VaR (the average of the bottom decile of returns).6 Since 1973, U.S. TIPS and U.S. nominal government bonds were the most efficient safe havens, providing the most protection per unit of allocation (Chart I-4 – top panel). Conditional VaR was reduced by almost half when allocating 40% to either Treasuries or TIPS. Cash, U.S. investment-grade, the yen, the Swiss franc, gold, and silver followed in that order. The difference between the safe havens was significant. As an example, a portfolio with a 30% allocation to U.S. Treasuries historically provided the same downside protection as a portfolio with a 36% allocation to U.S. IG credit, a 39% allocation to the yen or a 44% allocation to gold. Meanwhile, there was no allocation to silver which would have provided the same level of protection. When using a sample from 1991, the main difference was the reduced efficiency of cash – the result of lower average interest rates when using a more recent sample. Other than cash, the efficiency of most safe havens remained unchanged: U.S. Treasuries were the best option, followed by U.S. TIPS, farmland, U.S. investment-grade bonds, global ex-U.S. government bonds, cash, the yen, gold, the Swiss franc, and silver in that order (Chart I-4 – bottom panel). Chart I-4Historically, Fixed-Income Assets Were The Most Efficient Safe Havens Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Costs How do safe haven returns compare to equities? To evaluate opportunity costs, we compare the difference of the historical return of each safe haven versus global equities. Overall, hedging with currencies was extremely costly, as their return was well below that of equities in both samples (Chart I-5). Cash was also an expensive safe haven to hedge with, particularly in the most recent sample. On the other hand, fixed-income assets like U.S Treasuries, investment-grade credit, and U.S. TIPS had very low costs (global ex-U.S. bonds also had cost of around 2% in a limited sample).  Farmland had negative opportunity costs because it outperformed equities during the sample period.7 Chart I-5Historically Fixed Income Assets And Farmland Had The Lowest Opportunity Cost Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Outlook Chart I-6No More Yield Cushion Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-7Silver Has Become Less Cyclical Silver Has Become Less Cyclical Silver Has Become Less Cyclical For our outlook, we assess how the four traits under study have changed for all safe havens: Consistency: Will safe havens continue to be reliable in the absence of high coupons? Many of the safe havens in our sample were effective at hedging equities due to their high yield. Even if they had negative capital appreciation, total returns stayed positive thanks to the offsetting effect of the yield return. However, as rates have declined, yield return has also decreased substantially (Chart I-6). Therefore, safe havens, like cash, government bonds, and even farmland will not be as consistent as they were in the past. Credit could be even more vulnerable: the combination of a low yield, and unhealthy fundamentals will turn U.S. corporate bonds into a negative-return asset in the next crisis. Silver might be the lone safe haven to improve its consistency. Industrial use for silver has fallen substantially in the past 10 years, decreasing its cyclical nature (Chart I-7). Thus, while silver might still be an erratic safe haven, it should be more consistent in the future than its historical performance would suggest.   Versatility: What will the next crisis look like? Chart I-8Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Determining what the next crisis will look like is crucial for safe haven selection. Below we rank the types of crises in order of how likely and severe we think they will be in the future: Inflation/rate shock: We expect inflation to be significantly higher over the next decade. This will be the highest risk for asset allocators in the future. As we explained in our May 2019 report, a change in monetary policy framework, procyclical fiscal policy, waning Fed independence, declining globalization, and demographic forces are all conspiring to lift inflation in the next decade.8 Importantly, we believe that the Fed will be dovish initially, as it cannot let inflation continue to underperform its target after missing the mark for the last 10 years (Chart I-8 – top panel). However, this will cause an inflationary cycle, which will eventually lead the Fed to raise rates significantly and trigger a recession. Political events/flash crashes: Political events will also pose a risk to the markets on a structural basis. The rise of China as a superpower has shifted the world into a paradigm of multipolarity, which historically has resulted in military conflict. Moreover, animus for conflict is not dependent on President Trump. The American public in general feels that the economic relationship with China is detrimental to the United States (Chart I-8 – bottom panel). This means that any president, Democrat or Republican will have a political incentive to jostle with China for economic and political supremacy for years to come. Ex-U.S. crises: We expect Emerging Markets in general, and China in particular, to be among the most vulnerable parts of the global economy as we enter the next decade. Over the last 10 years, China’s money supply has increased four-fold, becoming larger than the money supply of the U.S. and the euro area combined. In addition, corporate debt as a % of GDP stands at 155%, higher than Japan at the peak of its bubble and higher than any country in recorded history (Chart I-9). We rank this type of crisis slightly below the first two because Emerging Market assets are depressed already. Thus, while we believe that there is further downside to come for these economies, some weakness has already been priced in. U.S. asset bubble burst: We believe that there are no systemic excesses in the U.S. economy, making a U.S. asset bubble burst a lesser risk than other types of crises. Although it is true that U.S. corporate debt stands at all-time highs, it is still at a much lower level than in other countries. Moreover, weakness of corporate credit is not likely to have systemic consequences on the economy, given that leveraged institutions like banks and households hold only a small amount of outstanding corporate debt (Chart I-10). Chart I-9EM crises Are Also A Risk EM crises Are Also A Risk EM crises Are Also A Risk Chart I-10A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences What does this ranking mean in terms of safe haven performance? U.S. TIPS and cash should be held in high regard as they will be some of the only assets that will perform well during an inflation/rate shock. The Swiss franc and global ex-U.S. bonds should be best performers during political crises, although U.S. TIPS could also provide adequate protection. Efficiency: Is there any upside left for safe havens when interest rates are near zero? As yields go below the zero bound it becomes harder for bonds to generate large positive returns. European or Japanese government bonds in particular would need their yields to go deep into negative territory to counteract a large selloff in equities (Table I-1). But can interest rates go that low? We do not think so. The recent auction of German bunds, where a 0%-yielding 30-year bond attracted the weakest demand since 2011, suggests that interest rates in these countries might be close to their lower bound.  On the other hand, though U.S. yields are low, they are still high enough for U.S. Treasuries to provide high returns in case of a crisis. Table I-1No Room For Positive Returns In The Government Bond Space Outside Of The U.S. Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Low rates also have an effect on the efficiency of U.S. investment-grade bonds, cash, and farmland because their upside during crises does not come from capital appreciation but rather from their yield, (the price of IG credit actually declines during most crisis). As mentioned earlier, their yield has declined substantially compared to the past, which means that a larger allocation will be necessary to counteract a selloff. Chart I-11Switzerland Has A High Incentive To Prevent The Franc From Appreciating Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s The upside of the yen could also be compromised. The Bank of Japan is likely to intervene aggressively in the currency market to prevent the Japanese economy from falling into a deflationary spiral, since it is very difficult for it to lower Japanese rates further. The Swiss franc is even more vulnerable. In contrast to Japan, Switzerland is a small open economy that has to import most of its products (Chart I-11). This means that the Swiss National Bank has a very high incentive to intervene in currency markets during a crisis, given that a rally in the franc could depress inflation severely. What about U.S. TIPS? In contrast to nominal government bond yields or even yields on corporate debt, U.S. real rates are not limited by the zero bound (Chart I-12).  This makes TIPS a more attractive option than other fixed-income assets, since real rates can have much more room for further downside than nominal ones. To be clear, this will only be the case if our forecast of an inflationary crisis materializes. Likewise, since gold is heavily influenced by real rates, it should also offer significant upside during the next crisis.9 Chart I-12Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Costs: Can I afford to hold safe havens in a world of low returns? To provide an outlook for the expected cost of each safe haven, we use the return assumptions from our June Special Report.10 We subtract the expected return on global equities from the expected return for each safe haven to reach an expected cost value. However, three of the safe havens (global ex-U.S. government bonds, the Swiss franc and silver) did not have a return estimate. We compute their expected returns as follows: For the Swiss franc we use the methodology we used for all other currencies in our report. We base the expected return on the current divergence from the IMF PPP value, as well as the IMF inflation estimates. In addition, we add the relative cash rate assumed return for both our yen and Swiss franc estimates, as futures take into account carry return. For global ex-U.S. bonds we take the weighted average of the expected return of the euro area, Japan, U.K., Canada, and Australia government bonds. We weight the returns according to their market capitalization in the Bloomberg/Barclays government bond index. Due to silver’s dual role as an inflation hedge and industrial metal, silver prices are a function of both gold prices and global growth. To obtain a return estimate we run a regression on silver against these two variables and use our growth and gold return estimate to arrive at an assumed return for silver. Chart I-13 shows our results: while their cost will improve, currency futures remain the most expensive hedge. The opportunity cost of precious metals and cash will decrease, making them more attractive options than in the past. Meanwhile, low yields will increase the opportunity costs of most fixed-income assets. Finally, farmland will remain the cheapest safe haven, even with decreased performance. Chart I-13Oportunity Cost For Fixed Income Safe Havens Will Be Higher Than In The Past Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Juan Manuel Correa Ossa Senior Analyst juanc@bcaresearch.com Appendix A Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Footnotes 1 Please see Geopolitical Strategy Special Report, "The Apex Of Globalization – All Downhill From Here, " dated November 12, 2014, available at gps.bcaresearch.com. 2 We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 3 For a detailed list of how we classified each equity drawdown, please see Appendix A. 4 The only crises caused by a rate/inflation shock occurred in 1974 and 1980. Thus we have this type of drawdown only in Chart 3A and not in Chart 3B. 5 For yen, Swiss franc, silver and gold futures we assume an allocation to an ETF which follows their performance. Since futures have zero initial costs they cannot be directly compared to traditional assets in terms of percentage allocation. 6 We prefer this measure over VaR given that it captures the properties of the left tail of returns more accurately. 7  While the farmland index subtracts management fees, we recognize that there are costs involved in holding these illiquid assets which are not necessarily captured by the return indices. Thus, the real historical cost of holding farmland was not negative but likely close to zero. 8 Please see Global Asset Allocation Strategy Special Report "Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises," dated May 22, 2019, available at gaa.bcaresearch.com. 9 Please see Commodity & Energy Strategy Special Report "All that Glitters…And Then Some" dated July 25, 2019, available at ces.bcaresearch.com. 10 Please see Global Asset Allocation Strategy Special Report "Return Assumptions - Refreshed and Refined" dated June 25, 2019,  

Highlights On a tactical horizon, underweight bonds versus cash, especially those bonds with deeply negative yields… …and underweight bonds versus equities. On a strategic horizon, remain overweight a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos, at either 10-year or 30-year bond maturities. Investors could also play the component pairs: overweight U.S. T-bonds versus German bunds; and overweight Italian BTPs versus Spanish Bonos. New recommendation: switch Japanese yen long exposure into Swedish krona long exposure. Fractal trade: long SEK/JPY. Feature Chart of the WeekSwiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Swiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Swiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Anybody who has dared to bet that JGB yields would rise has ended up being carried out of their job, feet first. Shorting Japanese government bonds (JGBs) is known as the widow maker trade. Over the past 20 years, any investment manager who has dared to bet that JGB yields would rise – whether starting from 2 percent, 1 percent, or even 0.5 percent – has ended up being carried out of their job in a box, feet first. Today, the Bank of Japan’s policy of ‘yield curve control’ means that JGB yields are constrained within a tight range around zero, limiting their immediate scope to break higher. The European equivalent of the widow maker trade has been to short Swiss government bonds. Just as with JGB’s during the past two decades, anybody who has dared to bet that Swiss government bond yields would rise – whether starting from 2 percent, 1 percent, or 0.5 percent – has been proved fatally wrong (Chart I-2). Chart I-2Widow Makers: Shorting Japanese And Swiss Bonds Widow Makers: Shorting Japanese And Swiss Bonds Widow Makers: Shorting Japanese And Swiss Bonds That is, until this year, when Swiss government bond yields reached -1 percent. The Lower Bound To Bond Yields Is Around -1 Percent According to several senior central bankers who have spoken to us, the practical lower bound to the policy interest rate is -1 percent, because “-1 percent counterbalances the storage cost of holding physical cash and/or other stores of value”. They argue that if bank deposit rates were to fall much below -1 percent, it would be logical for bank depositors to flee wholesale into physical cash, and such a deposit flight would destroy the banking system.1 Still, couldn’t central banks just abolish physical cash, forcing us all into ‘digital cash’ with unlimited negative interest rates? No, because that would just push us into other stores of value: for example, gold, or the rapidly growing ‘decentralised’ cryptocurrency asset-class. The common counterargument is that cryptocurrencies’ volatility makes them a poor store of value. But that is also true for gold: during a few months in 2013, gold lost one third of its value (Chart I-3). Yet who has ever argued that gold cannot be a store of value just because its price is volatile! Chart I-3Gold Is A Store Of Value ##br## Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility The practical lower bound to the policy interest rate is around -1 percent because the central bank policy rate establishes the banking system’s funding rate – for example, the Eonia rate in the euro area (Chart I-4). If the funding rate fell well below the rate that the banks were paying on deposits, the banking system would come under severe strain and ultimately go bust. The lower bound of the policy rate also sets the lower bound of the bond yield, because a bond yield is just the expected average policy rate over the bond’s lifetime. Chart I-4The Policy Interest Rate Establishes The Banking System's Funding Rate The Policy Interest Rate Establishes The Banking System's Funding Rate The Policy Interest Rate Establishes The Banking System's Funding Rate There is one important exception. If bond investors price in the possibility of being repaid in a different and more valuable currency, the bond yield will carry a further redenomination discount as an offset for the potential currency gain. This is relevant to euro area bonds because there remains the remote possibility of euro disintegration. Bonds which would expect to see a currency redenomination gain – notably, German bunds – therefore carry an additional discount on their yields. But for bonds where no currency redenomination is possible, the practical lower bound to bond yields is around -1 percent. Overweight High Yielding Bonds Versus Low Yielding Bonds To state the obvious, the closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline (capital gain), while the possibility for a yield increase (capital loss) stays unlimited. This unattractive lack of upside combined with plenty of potential downside is called negative skew or negative asymmetry. It follows that, close to the lower bound of yields, the cyclicality or ‘beta’ of bond prices also becomes asymmetric. In risk-off phases, the bond prices cannot rally; while in risk-on phases, bond prices can plummet. Making such bonds a ‘lose-lose’ proposition. Case in point: Swiss bond yields have found it difficult to go down this year, but very easy to go up (Chart of the Week). Because their yields were already so close to -1 percent, Swiss bond yields could not decline much during the bond market’s recent strong rally – meaning, Swiss bond prices were very low beta on the way up. But in the recent reversal, Swiss bond yields have risen much more than others – meaning, Swiss bond prices are high beta on the way down (Chart I-5).   Chart I-5Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Does this mean the widow maker trade can finally work? Yes, but only on a tactical horizon. For the full rationale, which we will not repeat here, please see Growth To Rebound In The Fourth Quarter, But Fade In 2020. However in summary, expect bond yields to edge modestly higher, and especially those yields that are deeply in negative territory. Also on a tactical horizon, prefer equities over bonds.  On a longer term horizon, a much safer way to play the asymmetric beta is to short low yielding bonds in relative terms. In other words, overweight high yielding bonds versus low yielding bonds.2 Close to the lower bound of yields, the cyclicality or ‘beta’ of bond prices becomes asymmetric. Our strategic recommendation is to overweight a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos, at either 10-year or 30-year bond maturities. Since initiation five months ago, the recommendation at the 30-year maturity is already up by almost 7 percent. Nevertheless, it has a lot further to go (Chart I-6). Investors could also play the component pairs: overweight U.S. T-bonds versus German bunds; and overweight Italian BTPs versus Spanish Bonos (Chart I-7 and Chart I-8), but the combined two bonds versus two bonds recommendation has better return to risk characteristics. Chart I-6Expect High Yielding Bonds To Outperform Low Yielding Bonds Expect High Yielding Bonds To Outperform Low Yielding Bonds Expect High Yielding Bonds To Outperform Low Yielding Bonds Chart I-7Expect Yield Spread Convergence At 10-Year Maturities... Expect Yield Spread COnvergence At 10-Year Maturities... Expect Yield Spread COnvergence At 10-Year Maturities... Chart I-8...And At 30-Year ##br##Maturities ...And At 30-Year Maturities ...And At 30-Year Maturities Switch Into The Swedish Krona   Bond yield spreads are also an important driver of currency moves. The currency corollary of overweighting high yielding versus low yielding bonds is to tilt towards low yielding currencies, because these are the currencies that have the most scope for substantial upside. Our favourite low yielding currency has been the Japanese yen, and this has worked very well. Since early 2018, the yen has been the strongest major currency, and is up 16 percent versus the euro. But our favourite currency is now changing to the Swedish krona, for three reasons: The SEK is depressed from a valuation perspective. For example, it is the only major currencies that is weaker than the GBP compared to before the Brexit vote in 2016 (Chart I-9). Chart I-9The Swedish Krona Has Underperformed The Pound Despite Brexit The Swedish Krona Has Underperformed The Pound Despite Brexit The Swedish Krona Has Underperformed The Pound Despite Brexit Unlike other major central banks, the Riksbank is seeking to normalise the policy rate upwards. The SEK is technically oversold on its 130-day fractal dimension, signalling over-pessimism in the price (Chart I-10), while the JPY is showing the opposite tendency. Chart I-10The Swedish Krona Is Due A Countertrend Move The Swedish Krona Is Due A Countertrend Move The Swedish Krona Is Due A Countertrend Move Bottom Line: switch Japanese yen long exposure into Swedish krona long exposure. Fractal Trading System* (Chart 1-11) As just discussed, this week's recommended trade is long SEK/JPY. Set the profit target at 1.5 percent with a symmetrical stop-loss. In other trades, long NZD/JPY has started off very well and long Spain versus Belgium achieved its 3.5 percent profit target, at which it was closed, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 NZD VS. JPY NZD VS. JPY The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European  Investment Strategist dhaval@bcaresearch.com Footnotes 1 The cost of holding physical cash is the cost of its safe storage. 2 Please see the European Investment Strategy Weekly Report ‘Growth To Rebound In The Fourth Quarter, But Fade In 2020’, October 3, 2019 available at eis.bcaresearch.com. Fractal Trading Model Cyclical Recommendations Structural Recommendations Fractal Trades The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term.  Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland   Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits:   Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union.   Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD.  For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System*  Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 NZD VS. JPY NZD VS. JPY For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. 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