Switzerland

Highlights The slowdown in the U.S. manufacturing sector is at risk of becoming deeper than elsewhere. This is not bearish for the U.S. dollar, given that it is a countercyclical currency, but it is not a constructive development, either. This impasse can be solved by an easier Federal Reserve, which would knock down the dollar. For now, we are maintaining our trade focus on the crosses rather than on outright dollar bets. The Swiss National Bank is likely to start weaponizing its currency, given the domestic slowdown: Go long EUR/CHF at 1.06. Long yen positions have become a consensus trade, but we will await a better exit point for our short USD/JPY positions. Feature The Swiss economy is slowly stepping into deflation. The latest inflation print this week stood at 0.1%, well below the SNB’s central forecast of 0.4% for this year. Goods inflation has completely ground to a halt, while service inflation is now at the lowest level since 2016. 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-1). Chart I-1The SNB Will Have To Lean ##br##Against This The SNB Will Have To Lean Against This The SNB Will Have To Lean Against This Chart I-2A Strong Franc Is Exerting A Powerful Deflationary Impulse A Strong Franc Is Exerting A Powerful Deflationary Impulse A Strong Franc Is Exerting A Powerful Deflationary Impulse Global disinflationary trends are definitely playing a role, but the strong currency has been front and center at exacerbating these trends. As a small, open economy, tradeable goods prices are important for Switzerland. Import prices are deflating by over 3% year-on-year, in part driven by a strong trade-weighted currency (Chart I-2). This is increasing the odds that the SNB will begin to use the currency to stimulate monetary conditions. Operation Weak Franc Chart I-3How Long Can You Defy The Pull Of Gravity? How Long Can You Defy The Pull Of Gravity? How Long Can You Defy The Pull Of Gravity? Domestically, the Swiss economy is holding up well, but it is an open question as to how much longer it will continue to defy the pull of a slowing external sector. The KOF employment indicator is at its highest level since 2010, and the expectations component continues to exceed the current assessment. During normal times, this is a bullish development. However, for a highly export-driven economy, the manufacturing sector usually dictates trends in the overall economy (Chart I-3). The manufacturing PMI print is currently sitting at 44.6, the worst since the financial crisis. These levels have usually rung loud alarm bells along SNB corridors. Back in 2011, Switzerland was rapidly stepping back into deflation, having just barely escaped it a year earlier. The SNB quickly realized that for a small, open economy, the exchange rate often dictates the trend in domestic inflation. Ergo, sitting and watching the trade-weighted Swiss franc continue to appreciate, especially given the euro was in a cascading downdraft, appeared to be a recipe for disaster. This sounds eerily similar to today. With the European Central Bank resuming quantitative easing and with an SNB that left rates unchanged at its most recent policy meeting, the signal is that interest rates have probably hit a floor. This view is further reinforced by the SNB’s additional tiering of reserves. In other words, rates have probably begun to teeter on the edge of financial stability. This leaves the currency as the policy tool of choice. Our bias is that the whisper floor of 1.08-1.10 for EUR/CHF will continue to persist until the Swiss economy decisively exits deflation. However, markets can tilt the Swiss exchange rate to an overshoot. If that happens, four key factors suggest the Swiss economy needs a weaker currency, especially versus the euro: The Swiss trade balance has held up well in the face of the global slowdown, but this has been largely driven by terms of trade. The Swiss trade balance has held up well in the face of the global slowdown, but this has been largely driven by terms of trade (Chart I-4). However, in a downturn, while commoditized goods prices are the first shoe to drop, the slowdown eventually starts to infect more specialized goods prices. Swiss goods are not easily substitutable, but other countries such as Sweden that have dropped their currency will benefit more from any recovery. Chart I-4Rising Terms Of Trade Have Helped ##br##Support Exports Rising Terms Of Trade Have Helped Support Exports Rising Terms Of Trade Have Helped Support Exports Chart I-5A Gold ##br##Haven A Gold Haven A Gold Haven Part of the improvement in the Swiss trade balance has been driven by precious metals exports. For example, exports of precious metals to the U.K. are soaring towards new highs as storage demand for ETF accounts rises (Chart I-5). However, there has been a lack of physical demand in Asia, while the riots in Hong Kong are causing gold to be rerouted to Switzerland, then London. This might soon end. Our models suggest the franc is now almost 10% overvalued versus the euro. Over the history of the model, franc overvaluation peaks at a high of 15%, and is often followed by intervention by the SNB (Chart I-6). While the unemployment rate is at 2.3%, domestic wage pressures are none existent. It will be difficult for service inflation to pick up without a build-up in wage pressures. This is unlikely to happen over the next six to nine months. Part-time employment continues to dominate job gains, meaning the need for precautionary savings will continue to restrain spending. Meanwhile, the manufacturing sector is unlikely to start raising wages before a recovery is in sight. However, more recently, foreign exchange reserves have started reaccelerating and the stability in the monetary base suggests some spectre of sterilization. It has been surprising that in the global race towards lower rates and amidst the potential for global currency devaluation, the SNB has been sitting and watching other central banks like the ECB and the Riksbank eat part of its lunch. The message from SNB Central Bank Chair Thomas Jordan has been very clear: Interest rates could be lowered further, along with powerful intervention in the foreign exchange market if necessary. This might slightly suggest disagreement within the governing council. Chart I-6The Franc Is ##br##Expensive The Franc Is Expensive The Franc Is Expensive Chart I-7Is The SNB Sterilizing Reserve Accumulation? Is The SNB Sterilizing Reserve Accumulation? Is The SNB Sterilizing Reserve Accumulation?   Interestingly, the SNB has not had to ramp up its balance sheet significantly in recent years. Part of the reason is that the slowdown in global trade eased natural demand for francs, which meant the SNB was no longer accumulating foreign exchange reserves at a rampant pace. This has helped drain excess liquidity from the system and somewhat renormalize policy. This means that the wiggle room for more FX intervention has reopened. However, more recently, foreign exchange reserves have started reaccelerating, and the stability in the monetary base suggests some spectre of sterilization (Chart I-7). 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 G-10. Too little stimulus and the economy runs the risk of entering a debt-deflation spiral, as inflation expectations continue to be anchored strongly to the downside. Too much stimulus, and the result will be a build-up of imbalances, leading to an eventual bust. Currency Cap Post-Mortem While the SNB may favor stealth depreciation of the franc, there are both political and economic constraints to an outright cap. The good news is that the economic forces are ebbing as the economy slows down. Meanwhile, there had already been a rising chorus of discontent among right-wing politicians in 2014, specifically those within the Swiss People’s Party (SVP) who wanted the central bank to stop buying foreign currencies and significantly lift its gold holdings instead. With the SVP currently ahead in opinion polls ahead of this month’s elections, this is likely to remain a constraint. The good news is that new issues such as climate change have taken the fore, rather than whether Switzerland should start backing it reserves via gold (Chart I-8). The key risk to a cap is that if the euro drops substantially, it will invite speculation back into the Swiss economy. This risk is clearly unpalatable for both Swiss politicians and the SNB, which is why two-way asymmetry was reintroduced into the system in 2015. Chart I-8The Swiss People's Party Will ##br##Like This Up! The Swiss People's Party Will Like This Up! The Swiss People's Party Will Like This Up! Chart I-9A Healthy ##br##Rebalancing A Healthy Rebalancing A Healthy Rebalancing On a positive note, housing market speculation has been somewhat cleansed. Growth in rental housing units, which usually constitutes the bulk of investment homes, has grown to a standstill, and this is positively deviating from growth in owner-occupied homes. The message from this is clear: Macro-prudential measures such as a cap on second homes as well as stricter lending standards have helped (Chart I-9). Back in 2015, the SNB smartly surprised the market by abandoning the EUR/CHF floor. This helped rebalance the market as European investors who used the SNB put to speculate on properties in Zurich and Geneva were dis-incentivized once the euro collapsed. Demand for Swiss real estate has largely stabilized since then, eliminating this key source of risk for the SNB. The SVP’s curb on immigration has neutered a meaningful source of demand. Vacancy rates for rental properties have started to inflect meaningfully higher. More importantly, vacancy rates for rental properties have started to inflect meaningfully higher. This has usually led to lower housing prices, with a lag of about 12 months (Chart I-10). With the SVP unlikely to become more pro-immigration anytime soon, this will likely remain a headwind (Chart I-11). This suggests the political capital for the SNB to use stealth depreciation of the currency to stimulate the economy is high, especially as the global economy remains mired in a manufacturing downturn. A history of budget surpluses suggests that the SVP is unlikely to pass any significant pro-fiscal policies at any time soon. Chart I-10Slowing Migration Is Curbing Housing Demand Slowing Migration Is Curbing Housing Demand Slowing Migration Is Curbing Housing Demand Chart I-11A Slowing Workforce Is Curbing Housing Demand A Slowing Workforce Is Curbing Housing Demand A Slowing Workforce Is Curbing Housing Demand Claims on bank balance sheets from foreigners are relatively low, meaning the risk from an inflow of capital into the housing market on a lower exchange rate is low (Chart I-12). With bank lending margins likely to be depressed for the next few years, some foreign inflows into the real estate sector would help, alongside stricter macro prudential measures. Chart I-12Banks Have Low Foreign Mortgage Liabilities Banks Have Low Foreign Mortgage Liabilities Banks Have Low Foreign Mortgage Liabilities On EUR/CHF And USD/CHF Switzerland ticks off all the characteristics of a safe-haven currency. Its large net international investment position of 115% of GDP generates huge income inflows. Meanwhile, rising productivity over the years has led to a structural surplus in its trading balance and a rising fair value for the currency. Consequently, the franc has tended to have an upward bias over the years, supercharged during periods of risk aversion (Chart I-13). Meanwhile, hedging costs for short CHF trades are less attractive than a year ago. They might get more prohibitive but until then, we suggest prudence in going short the franc versus the euro or USD (Chart I-14). Our bias however, is that the SNB will significantly start to lean against the franc at 1.06. Chart I-13Risk: Swiss Franc Tends ##br##To Appreciate Risk: Swiss Franc Tends To Appreciate Risk: Swiss Franc Tends To Appreciate Chart I-14Hedging Costs Are ##br##Prohibitive Hedging Costs Are Prohibitive Hedging Costs Are Prohibitive   Investment Conclusions Chart I-15Major Dollar Tailwinds Have Peaked Major Dollar Tailwinds Have Peaked Major Dollar Tailwinds Have Peaked We continue to focus on trades at the crosses, and holding portfolio insurance such as the Swiss franc remains what the doctor ordered. Our objective in this week’s report was to highlight that investors and traders may not want to overstay their welcome, and as such keep a watchful eye on tentative signs of a reversal. Typically, the growth divergence between the U.S. and the rest of the world has been a good explanatory variable for medium-term fluctuations in the dollar. Ergo, the deceleration in the U.S. manufacturing PMI usually foretells a bad omen for the dollar (Chart I-15). The franc tends to do well at the crosses during dollar bull markets and poorly during dollar bear markets. However, there are benign adjustments and malignant ones, and a drop in the U.S. manufacturing PMI, driven by much slower global growth, looks like the malignant type. What we will need to see, if the weak dollar narrative is to pan out, is stabilization in the U.S. manufacturing sector, as the rest of the world’s manufacturing sector inflects higher. This will also weaken the franc at the crosses. Stay tuned.   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 There was a flurry of U.S. data releases, the balance of which was negative: Headline PCE was unchanged at 1.4% year-on-year in August. Core PCE increased to 1.8% year-on-year. Chicago purchasing managers’ index fell to 47.1 in September from 50.4 in August. Dallas Fed manufacturing business index fell to 1.5 in September from 2.7 in August. ISM manufacturing PMI plunged to 47.8 in September, the second consecutive month below 50. Moreover, ISM non-manufacturing PMI fell to 52.6 in September from 56.4, well below expectations of 55. Admittedly, the Markit composite PMI was up at 51 versus 50.7 the prior month. ADP non-farm payrolls were below expectations at 135K in September, versus 157K in August. Durable goods orders monthly growth slowed to 0.2% in August. Factory orders contracted by 0.1% month-on-month in August. DXY index rose by 0.6% initially, then plunged, losing 0.4% this week. The deterioration in both ISM manufacturing and non-manufacturing PMIs spurred worry about an imminent recession. We get the jobs report this Friday, which is one of the last pillars of support for a relatively hawkish Fed policy. On the monetary policy front, the Fed will resume the balance sheet expansion. The increase in supply of dollars will add to the forces that might eventually pull the dollar lower. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 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 negative: Inflation remains subdued across euro area countries in August. Headline inflation in the euro area fell to 0.9% year-on-year from 1%. In France, the headline inflation declined to 1.1% year-on-year from 1.3%. In Spain, it fell to 0.1% year-on-year from 0.3%. In Germany, it also decreased to 1.2% year-on-year from 1.4%. The unemployment rate in the euro area marginally decreased to 7.4% in August from 7.5%. The economic sentiment indicator in the euro area fell to 101.7 in September from 103.1. Producer price index fell by 0.8% year-on-year in August. Retail sales growth was little changed at 2.1% year-on-year in August. EUR/USD increased by 0.6% this week. On the inflation front, the steeper drop in CPI for core countries rather than the peripheral ones suggests that the redistributive efforts needed to hold the euro area together are somewhat working. ECB president Mario Draghi called for an “investment-led stimulus at the euro area level” in a speech in Athens on Tuesday evening, but the reality is that the peripheral countries are already using lower rates to deploy capital. J.P. Morgan analysts have upgraded European equities this week. If equity fund flows start to rise, the euro is likely to rebound against the U.S. dollar. Report Links: A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 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 disappointing: The all-important Tankan survey came out this week. There was deterioration in both the manufacturer and service outlook in Q3, but it was admittedly above expectations. Plans for capex remained relatively elevated. Industrial production contracted by 4.7% year-on-year in August. Retail sales increased by 2% year-on-year in August, but we are downplaying this because of the consumption tax hike. Housing starts decreased by 7.1% year-on-year in August. Construction orders fell by 25.9% year-on-year (the latter being extremely volatile). The unemployment rate was unchanged at 2.2% in August. Jobs-to-applicants ratio was also unchanged at 1.59. Consumer confidence fell to 35.6 in August, from 37.1 in July. We have discussed in length the significance of this in a Ricardian equivalence framework. Services PMI fell to 52.8 in September, while still above the 50 expansionary territory. USD/JPY fell by 1% this week. In the recent Summary of Opinions, the BoJ highlighted risks of lower external demand due to delayed economic growth. On the positive side, various countermeasures are set to mitigate the negative effects of the tax hike. We remain positive on the safe-haven Japanese yen as a hedge with limited downside. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 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 U.K. have been mixed: GDP growth increased to 1.3% year-on-year in Q2. On a quarter-on-quarter basis however, GDP growth contracted by 0.2% in Q2. Current account deficit narrowed to £25.2 billion in Q2, from £33.1 billion in Q1. Nationwide house prices grew by 0.2% year-on-year in September, compared with 0.6% in August. Markit manufacturing PMI increased to 48.3 in September from 47.4; Construction PMI fell to 43.3 from 45; Services PMI fell below 50 to 49.5. GBP/USD increased by 0.8% this week. PM Boris Johnson gave a speech this week and introduced the details of a Brexit proposal that was an easy target for the firing squads in this imbroglio. Another Brexit delay and re-election seem highly likely. The improvement in the Markit manufacturing PMI reflects higher confidence over the lower probability of a hard Brexit in our view. We recently upgraded the outlook for U.K. and went long the GBP/JPY. Stay with it.  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 mixed: Headline inflation slowed from 1.7% to 1.5% year-on-year in September. Private sector credit grew by 2.9% year-on-year in August. AiG manufacturing PMI increased to 54.7 in September from 53.1 in August. AiG services PMI marginally increased to 51.5 from 51.4. Commonwealth manufacturing PMI fell slightly to 50.3, from an upward-adjusted 50.9 in August. Commonwealth services PMI was little changed at 52.4. Building permits keep contracting by 21.5% year-on-year in August. Exports fell by 3% month-on-month in August, while imports were unchanged. The trade surplus narrowed to A$5.9 billion from A$7.3 billion. AUD/USD fell by 1.3% initially post RBA, then recovered with broad U.S. dollar weakness, returning flat this week. The RBA lowered interest rates by another 25 basis points on Tuesday, and stated that “the Australian economy is at a gentle turning point.” Lower rates, though not fully transferred to mortgage rates, could help to stabilize the housing market to some extent, and lift wage growth. We maintain a pro-cyclical stance and remain positive on the Australian dollar. 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 mostly negative: Building permits increased by 0.8% month-on-month in August. Activity outlook fell by 1.8% month-on-month in September. Business confidence fell further to -53.5 in September, from -52.3 in August. NZD/USD increased by 0.3% this week. The latest Quarterly Survey of Business Opinion, conducted by the New Zealand Institute of Economic Research, has shown that business conditions point to further slowing in economic activity. The manufacturing sector remains the most problematic. Moreover, firms are cautious about expanding, due to the combination of intense cost pressures, and weak pricing power. Australia has lowered interest rates giving ammunition to their antipodean neighbors to follow suit. The probability of rate cuts by RBNZ in its next policy meeting on November 13th reached 100%: 90% for a 25 bps cut and 10% for 50 bps. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 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: On a month-on-month basis, the GDP stagnated in July. On a year-on-year basis, GDP growth slowed from 1.5% to 1.3% in July. Markit manufacturing PMI increased to 51 in September, from 49.1 in August. Bloomberg Nanos confidence increased to 57.8 for the week ended September 27th. Raw material prices fell by 1.8% month-on-month in August. USD/CAD increased by 0.5% this week. Canadian GDP growth in July was led by the services sector. The divergence was 2.5% year-on-year in July for services GDP, while goods GDP continued to deteriorate, contracting by 1.8% year-on-year. GDP in the energy sector, a focal industry in the country, fell by 3.4% year-on-year in July, affected by the fluctuations in oil prices. Moreover, as our colleagues in Commodity & Energy Strategy point out, the price differential between Canadian crude oil and WTI would likely to deepen further, possibly reaching a discount of $20/bbl into 1Q20, due to transportation constraints in the west. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 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 negative: KOF leading indicator fell to 93.2 in September. Real retail sales contracted by 1.4% year-on-year in August. Manufacturing PMI fell to 44.6 in September from 47.2 in August. Headline inflation decreased to 0.1% year-on-year in September, from 0.3%. USD/CHF increased by 0.7% this week. While the Swiss economy is highly linked to global developments, especially those in the euro area, the positive current account balance makes it less vulnerable on a relative basis. We continue to favor the franc as a safe-haven hedge. We discuss the franc in this week’s front section. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 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 are scant data from Norway this week: Retail sales were unchanged in August. USD/NOK appreciated by 0.3% this week. The recent decline in oil prices has pushed our petrocurrency basket trade offside, weighed by the quick oil facility recovery in Saudi and demand concerns over a possible recession. That said, we continue to overweight energy prices and the Norwegian krone. The looming tension in the Middle East could lead to further escalation, which will again disrupt oil supplies and lift oil prices.  Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 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: Retail sales grew by 2.7% year-on-year in August, compared to a 3.9% yearly growth in July. Manufacturing PMI plunged to 46.3 in September, from 52.4 in August. USD/SEK increased by 0.5% this week. While the PMI employment component increased to 52.4 from 51.9, the new orders index plunged below 50 to 45.8. The new orders-to-inventory ratio also continues to decrease, which usually leads the euro area manufacturing PMI by a few months. This is one of the key data points we follow, so are heeding to the message from this indicator. Report Links: Where To Next For The U.S. 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

Dear Client, Please note that there will be no regular Weekly Report next week, as we take a summer break. Our regular publication will resume September 6th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights Our PPP models show the DXY index to be overvalued by 10-15%. Within the G10 universe, the cheapest currencies are the Swedish krona, the British pound, the Japanese yen and the Norwegian krone. Look to go short CHF/GBP on valuation grounds. Feature Regular readers of our publication will notice that we tend to adhere to very simple and time-tested ideas. One such is the concept of purchasing power parity (PPP). The beauty comes from its simplicity. If the price of a good in Sweden is rising faster than in South Africa, then the krona should depreciate versus the rand to equalize prices across both borders. Otherwise, the krona becomes incrementally expensive, relative to the rand. In practice, various models have shown PPP to be a very poor tool for managing currencies. One roadblock comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. Second, there is less price discovery for services, than there is for tradable goods. For example, it is rather difficult to import a haircut from Mumbai into the U.S., and so arbitraging those prices away tends to be impractical. Tariffs, trade restrictions and transport costs also tend to dampen the explanatory power of PPP models, though those have had diminishing importance over time. In order to get closer to an apples-to-apples comparison across countries, we make two adjustments. First, we divide the consumer price index (CPI) baskets into five major groups. In most cases, this breakdown captures 90% of the national CPI basket: Food, restaurants and hotels Shelter Health, culture and recreation Energy and transportation Household goods 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 U.S. 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, compared to using the national CPI weights. The results were largely consistent: Both regressions were statistically significant, but more so for REG1. This makes intuitive sense, as the number of variables were higher in the first regression. The sign for household goods was negative for some countries. This could be due to some specter of multicollinearity, if the tradable goods price effect is captured in other categories. There is also the low value-to-weight ratio for many household goods such as refrigerators or air conditioners, which could make currency deviations from PPP persistent. The shelter sign was also negative for some countries, meaning rising shelter prices tended to be associated with an incrementally cheaper currency. This could be due to the Balassa-Samuelson effect. Rising incomes (one key determinant of rising house prices) usually reflect rising productivity levels, which tend to lift the fair value of the exchange rate. The results showed the U.S. dollar as overvalued, especially versus the Swedish krona, British pound and Norwegian krone. Commodity currencies were closer to fair value, and within the safe haven complex, the Japanese yen was more attractive than the Swiss franc. The euro was less undervalued than implied by the overvaluation in the DXY index. As a final note, PPP models are just an additional kit to our currency toolbox, and so should never be used in isolation, but in conjunction with other currency signals. This is just a first iteration in our PPP modelling work, which we intend to improve in the months to come. U.S. Dollar We reverse-engineered the fair value for the DXY index by aggregating the model results from its six constituents. This includes the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc, using the corresponding DXY weights. The message from the synthetic model is clear: the U.S dollar is above its fair value, in line with our fundamental view (Chart 1). Chart 1The Dollar is Slightly Expensive The Dollar is Slightly Expensive The Dollar is Slightly Expensive Americans spent 35% of their income in 2018 on goods and 65% on services. Shelter remains the single largest consumption item for American households, which makes up 33% of the consumption basket. However, the relative importance of shelter is dwarfed by much more rampant rent and house price increases in other developed countries. Medical care accounts for 8.7% of the CPI basket, and is the highest in the developed world on a per capita basis. Total spending on health care accounts for almost 20% of nominal GDP. Since the 1980s, the CPI for medical care has risen fivefold, far outpacing many developed countries. This makes the dollar incrementally expensive.  Core CPI edged higher to 2.2% in July, driven by medical care and shelter. While above the Federal Reserve’s 2% target, the risks to inflation remain asymmetric to the downside. That will keep the Fed on a dovish path near-term, which should help close overvaluation in the dollar. Euro We had limited data for the euro area, and so our regression results were less robust. REG1 shows the euro as cheap, while REG2 is more ambiguous (Chart 2). In short, a PPP model for the euro had one of lowest explanatory powers within the G10 universe. Food, restaurants and hotels are the largest consumption item in the euro CPI basket. Looking at the details, food and non-alcoholic beverages account for 14%, alcohol and tobacco make up 4%, and restaurant and hotels account for about 10% (Table). Relative price trends have moved to undermine the fair value of the euro. Chart 2The Euro Is Slightly Cheap The Euro Is Slightly Cheap The Euro Is Slightly Cheap Euro Area CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Shelter’s weight in the euro area CPI basket currently stands at 16.7%, the smallest among G10 countries. Since 2012, relative house and rent prices in the euro area have been decreasing compared with that in the U.S. Rampant rent controls, especially in places like Germany have subdued housing CPI, and tempered the fair value of the euro. This makes sense to the extent that it represents a concomitant rise in the welfare state. It is well-known that the euro area is relatively open and so tradable goods prices are important for the fair value of the euro. Given that the epicenter of trade tensions is between the U.S. and China, this will act to boost the relative attractiveness of European goods, which will be a bullish underpinning for the euro. Inflation expectations have collapsed in the euro area. However, compared to the Federal Reserve, there is little the European Central Bank can do to boost inflation. This is relatively euro bullish. Once global growth eventually picks up, improved competitiveness in the periphery will allow for non-inflationary growth. Japanese Yen The yen benefits from being cheap, as well as being a safe-haven currency (Chart 3). The overarching theme for Japan is a falling (and rapidly aging) population, which means that deficient demand and falling prices are the norm. This makes the yen relatively attractive on a recurring basis. Most of the Heisei era in Japan has been characterized by deflation. Importantly, all categories in Japan have been in a relative price downtrend during this period (Table). Domestically, an aging population (that tends to be a large voting base), prefer falling prices. Meanwhile, the bursting of the asset bubble in the late 80s/early 90s led to a powerful deleveraging wave that undermined prices. Chart 3The Yen Is Quite Cheap The Yen Is Quite Cheap The Yen Is Quite Cheap Japan CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity The relative prices for most items have been decreasing, but culture and recreation inflation have experienced a meaningful rebound since 2013, largely due to a booming tourism industry in Japan.1 According to tourism statistics, the number of international visitors to Japan reached 31 million in 2018, almost five times the number ten years ago. But as long as the younger generation in Japan continues to save more and consume less, prices will remain under pressure. BoJ Governor Haruhiko Kuroda remains committed to achieving a 2% inflation target, but inflation expectations are falling to historical lows at a time when the BoJ is running out of policy bullets.2  That means inflation will likely lag that of other developed countries, lifting the fair value of the yen. British Pound Both regressions show the pound as undervalued. This supports our view that over the long term, the pound is a categorical buy (Chart 4). The consumption baskets in both the U.K. and the U.S. are roughly similar, which means traditional PPP models do a good job at capturing the true underlying picture of price differentials (Table). For example, OECD PPP models, based on national expenditure, show the pound as 15% undervalued. Chart 4The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap U.K. CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Housing is the largest item in the consumption basket, with a total weight close to 30% (including housing electricity and water supply). The shelter consumer price index in the U.K. started to fall relative to the U.S. in 2016, which has lowered the fair-value of the pound (in the Balassa-Samuelson framework). That said, the fall in the pound has been much more deep and violent than suggested by domestic price fundamentals. For example, food restaurants and hotels are 10% cheaper in the U.K. compared to the U.S. over the last half decade. However, rather than appreciating 10%, the pound has plummeted by about 30%. Brexit will continue to dictate the ebb and flow of sterling gyrations, but the reality is that the pound should be higher on a fundamental basis. Meanwhile, a pick up in the global economy will benefit the pound. Going short CHF/GBP on valuation grounds is an attractive bet today. Australian Dollar As a commodity currency, PPP models are less useful for the Australian dollar than terms of trade, or even interest rate differentials. That said, the Aussie dollar is still relatively cheap versus the USD on a PPP basis (Chart 5). The key driver for value in the AUD has been a drop in the currency, relative to what price differentials will dictate. Food, restaurants and hotels comprise 23% of the Australian CPI basket, with the alcohol and tobacco category alone making up 7.4% (Table). Given food price differentials have been stable versus the U.S. in over a decade, Aussie citizens have not been particularly worse off. Chart 5The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap Australia CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Shelter accounts for almost a quarter percent of the basket. Relative shelter prices in Australia have been rising since the late 1990s, but started to soften in the past few years, on the back of macro prudential measures. Meanwhile, holiday travel and accommodation have a total weight of 6%, of which domestic travel makes up 2.9%, and international travel 3.1%. The overall cost of tourism in Australia has been falling relative to the U.S., boosting the fair value of the Aussie. In the 1980s, inflation in Australia averaged around 8.3% year-on-year. This made the Aussie incrementally expensive, creating grounds for a subsequent 50% devaluation from 1980 to 1986. Inflation targeting was finally introduced and has realigned Aussie prices with the rest of the world. Our bias is that the Aussie will be less driven by price differentials going forward, but more by RBA policy and terms of trade. New Zealand Dollar The New Zealand dollar is at fair value according to both models (Chart 6).  Like the aussie, the kiwi is less driven by price differentials and more by terms of trade. Food and shelter account for the largest share of the consumption basket, and relative prices have not been moving in favor of the kiwi (Table). So, while the kiwi was overvalued earlier this decade, the overvaluation gap has been mostly closed via a higher dollar. Chart 6The Kiwi Is At Fair Value The Kiwi Is At Fair Value The Kiwi Is At Fair Value New Zealand CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Relative shelter prices in New Zealand have been soaring in recent decades compared to the U.S. Higher immigration, foreign purchases and a commodity boom helped. However, in August 2018, the ban on foreign property purchases came into effect, which helped cool down the housing market. Like in Australia, the inflation rate in New Zealand reached 18% year-on-year in the early 1980s, and was subsequently addressed via inflation targeting. This has realigned New Zealand prices somewhat with the rest of the world. Our bias is that going forward, the kiwi will underperform the aussie, mainly because of a negative terms of trade shock. Canadian Dollar The loonie is currently trading below its fair value, according to both of our models (Chart 7).  Shelter remains the largest budget item for Canadian households (Table). The average Canadian household spent C$18,637 on shelter per year, around 29.2% of the total consumption in 2017.3 Interestingly, the shelter consumer price index does not fully capture skyrocketing house prices in Canada over the last decade. Since 2005, Canadian house prices relative to U.S. have doubled, according to OECD. On the contrary, the relative shelter CPI has trended downwards. These crosscurrents have dampened the explanatory power of the exchange rate. Chart 7The Loonie Is Slightly Cheap The Loonie Is Slightly Cheap The Loonie Is Slightly Cheap Canada CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Canadians are avid users of private transportation. The average spending on transportation accounted for 20% of total consumption, the second-largest expenditure item. Relative prices in this category have been rising, which has lowered the fair value of the exchange rate. Canada stands as the sixth largest energy producer in the world, but due to heavy taxation, Canadian consumers are paying more for gas prices than their U.S. neighbors. That said, terms of trade have been more important than PPP concerns for the loonie. In the near term, we believe energy prices (and the Western Canadian Select price spread) will continue to be important for the loonie. Swiss Franc USD/CHF is trading slightly below fair value, despite structural appreciation in the franc in recent years (Chart 8). The largest consumption item in Switzerland is the food, restaurants and hotels category (Table). The second item is shelter. Social services have a higher weight in the CPI basket, compared to other developed nations. This has been a huge driver of relative prices between Switzerland and the rest of the world, with falling relative prices boosting the fair value of the franc. Chart 8The Swiss Franc Is At Fair Value The Swiss Franc Is At Fair Value The Swiss Franc Is At Fair Value Switzerland CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Healthcare notably accounts for 15.5% in the total CPI basket, of which patient services makes up 11.5%. The Swiss healthcare system is a combination of public, subsidized private, and entirely private systems. It is mandatory for a Swiss resident to purchase basic health insurance, which covers a range of treatments. The insured person then pays the insurance premium plus part of the treatment costs. Finally, as a small open economy, tradable goods prices are important for Switzerland. Given high levels of specialization, terms-of-trade in Switzerland are soaring to record highs. This makes the franc a core holding in a currency portfolio. Norwegian Krone The Norwegian krone is undervalued according to both models (Chart 9). Food and shelter account for the largest share of the Norwegian CPI basket (Table). While the share of shelter is lower than in the U.S., other categories share similar weights, allowing traditional PPP models to be adequate for USD/NOK. One difference is that in terms of social services, only 0.2% of the expenditures are allocated to education, since all schools are free in Norway, including universities. Chart 9The Norwegian Krone Is Cheap The Norwegian Krone Is Cheap The Norwegian Krone Is Cheap Norway CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity As a large energy producer, Norwegians pay less for electricity, gas, and other fuels. Norway is also a heavy producer of renewable energy, notably hydropower. This makes the domestic energy basket less susceptible to the ebbs and flows of energy prices. Going forward, the path of energy prices will continue to dictate ebbs and flows in the krone. Meanwhile, long NOK positions also benefit from an attractive valuation starting point.  Swedish Krona The krona is the cheapest currency in our universe by a wide margin (Chart 10). This stems less from fluctuations in relative prices and more from negative rates that have hammered the exchange rate. Like many countries, food and shelter is the largest component of the consumption basket (Table). Transportation is also important. However, an important driver for undervaluation in the currency has been a drop in the relative price of social services. Chart 10The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap Sweden CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Sweden experienced very high inflation rates in the 1980s, and since then, has been in a disinflationary regime. More recently, the inflation rate has edged down below the Riksbank’s target, mostly dragged down by recreation, culture, and healthcare. This makes Swedish real rates relatively attractive. We remain positive on the Swedish krona and believe that it will be one of the first to benefit, should global growth pick up.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com   Kelly Zhong, Research Analyst kellyz@bcaresearch.com Footnotes 1 We removed the shelter component in regression 1, since it was distorting results. 2 Please see Foreign Exchange Strategy Weekly Report, titled “Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much”, dated May 31, 2019, available at fes.bcaresearch.com 3 Please see “Survey of Household Spending, 2017,” Statistic Canada, December 12, 2018. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Our intermediate-term timing models are not sending any strong signals at the moment. That means the balance of forces could tilt the greenback in either way, in what appears to be a stalemate for the U.S. dollar so far.  We are maintaining a pro-cyclical currency stance, but have a few portfolio hedges in the event we are caught offside in what could be a volatile summer. Stay long petrocurrencies versus the euro. Remain short USD/JPY. Also hold a short basket of gold bullion versus the yen. Feature Chart 1Major Peak In The Bond-To-Gold Ratio Major Peak In The Bond-To-Gold Ratio Major Peak In The Bond-To-Gold Ratio Regular readers of our publication are well aware that we have maintained a pro-cyclical stance over the past few months, a view that has been underpinned by a few tectonic forces moving against the U.S. dollar. The reality is that the DXY index has been stuck in a broad range of 96 to 98 for most of this year, failing to decisively breakout or breakdown in what has largely been an extremely frustrating stalemate for traders. Our rationale for a breakdown in the dollar was outlined in a Special Report 1 we penned in March, and the arguments still hold true today (Chart 1).    Over the next few weeks, we will be going back to the drawing board to see if and where we could be offside in this view. We start this week with a review of our intermediate-term timing models. 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 U.S. dollar. Interest Rate Differentials: Under the lens of interest rate parity, if one country is expected to have lower interest rates versus another one, the incumbent’s currency will fall today so as to gradually appreciate in the future and nullify the interest rate advantage. This sounds vaguely familiar for the U.S. dollar. 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. This concept originated from the School Of Salamanca in 16th century Spain, and still applies to this day in the form of Purchasing Power Parity (PPP). 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. Gauging the balance of forces for this risk is important. For all countries, the variables are highly statistically significant and of the expected signs. These models help us understand in which direction fundamentals are pushing the currency. We hereto refer to these as Fundamental Intermediate-Term Models (FITM). Including the momentum variable helps fine-tune the models. Real rate differentials, junk spreads and commodity prices remain statistically significant and of the correct sign.  A final adjustment is one for momentum. Including a 52-week moving average for each cross helps fine-tune the models for trend. Real rate differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). 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 2001.2 Even in the very long run of 41 years – from August 1976 – a simple momentum-based dynamic hedging strategy outperforms static ones for investors with five home currencies, with only the AUD portfolio being worse off. These results give us confidence to continue running these models as a sanity check for our ever-shifting currency biases. The U.S. Dollar Chart 2No Major Mispricing In The U.S. Dollar No Major Mispricing In The U.S. Dollar No Major Mispricing In The U.S. Dollar Chart 3More Upside Is Possible More Upside Is Possible More Upside Is Possible The approach for modelling the U.S. dollar was twofold. First, we estimated the fair value of each of the DXY constituents, and reconstructed an index based on DXY weights – a bottom-up fair-value DXY, if you will. Second, we ran our three variables against the DXY index. Averaging both approaches gave us similar results to begin with. The dollar is currently sitting in a neutral zone, with two opposing forces holding it in stalemate. The Federal Reserve’s dovish shift is moving real interest rate differentials against the dollar, but budding risk aversion judging from the combination of junk bond spreads and commodity prices are keeping the dollar bid. The call on the dollar will be critical for currency strategy, and our bias is that a breakdown is imminent based on the bond-to-gold ratio. That said, the breakdown will require the final pillars of dollar support to crack, which would come from a nascent rebound in global growth and/or an easing in the dollar liquidity shortage. We will be watching these developments like hawks. The Euro Chart 4No Major Mispricing In The Euro No Major Mispricing In The Euro No Major Mispricing In The Euro Chart 5EUR/USD Is Not Particularly Cheap EUR/USD Is Not Particularly Cheap EUR/USD Is Not Particularly Cheap The model results for the euro are the mirror image of the dollar, with no evidence of mispricing. What is interesting about the euro, however, is that the biggest buy signal was generated in 2015, and since then the fair value has exhibited a series of higher-lows and higher-highs. In short, it appears the euro has been in a low-conviction bull market since 2015. The Treasury-bund spread is the widest it has been in decades, and it is fair to say that some measure of mean reversion is due. The standard dilemma for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others such as Spain and Italy. As such, the euro has typically been caught in a tug-of-war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The silver lining is that the European Central Bank has now finally lowered domestic interest rates and eased policy to the point where they are accommodative for almost all euro zone countries. The drop in the euro since 2018 has also eased financial conditions and made euro zone companies more competitive. This is a tailwind for European stocks. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Earlier this year, analysts began aggressively revising up their earnings estimates for euro zone equities relative to the U.S. If they are right, this could lead to powerful inflows into the euro over the next nine to 12 months.  The Japanese Yen Chart 6Rate Differentials Have Helped The Yen Rate Differentials Have Helped The Yen Rate Differentials Have Helped The Yen Chart 7JPY Is Slightly Expensive JPY Is Slightly Expensive JPY Is Slightly Expensive The yen’s fair value has benefitted tremendously from the plunge in global bond yields, which made rock-bottom Japanese rates relatively attractive from a momentum standpoint. That said, relatively subdued risk aversion has constrained upside in the fair value. The message from our ITTM is a moderate sell on the yen, which stands in contrast to our tactically short USD/JPY position. With the BoJ owning 46% of outstanding JGBs, about 75% of ETFs and almost 5% of JREITs, the supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. Total annual asset purchases by the Bank of Japan are currently running at under ¥30 trillion, while JGB purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon, given 10-year government bond yields are six points away from the 20 basis-point floor. It looks like the end of the Heisei era has brought forward a well-known quandary for the central bank, which is that additional monetary policy options are hard to come by, since there have been diminishing economic returns to additional stimulus. This puts short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position.  The British Pound Chart 8Cable Is At Equilibrium Cable Is At Equilibrium Cable Is At Equilibrium Chart 9Political Risk Could Lead To An Undershoot Political Risk Could Lead To An Undershoot Political Risk Could Lead To An Undershoot The selloff in the pound since 2015 has been quick and violent, and triggered our stop loss at 1.25 this week. Interestingly, our ITTM does not show any mispricing in the pound’s fair value at the moment, suggesting momentum could shift either way rather quickly. For longer-term investors, there is fundamental support for holding the pound. For one, the pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union. Yes, incoming data in the U.K. has softened, but employment growth has been holding up very well, wages are inflecting higher and the average U.K. consumer appears in decent shape. This suggests that gilt yields should be higher than current levels, solely on the basis of domestic fundamentals. Our bulletin last week3 provided an ERM roadmap for the pound, and the conclusion is that we could be quite close to a floor. That said, valuation confirmation from our ITTM would have been a nice catalyst, which is not currently the case. As such, we are standing aside on the pound for now. The Canadian Dollar Chart 10Loonie Is Trading At A Discount Loonie Is Trading At A Discount Loonie Is Trading At A Discount Chart 11A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish USD/CAD is slightly overvalued from a fundamental perspective, but our ITTM is squarely sitting close to neutral. Going forward, movements in the Canadian dollar will be largely dictated by interest rate differentials and crude oil prices, which for now remain supportive. Canadian data has been firing on all cylinders of late, so it was no surprise that Bank of Canada Governor Stephen Poloz decided to keep interest rates on hold this week. Risks from the slowdown in global trade remain elevated, but easier monetary policy around the world should help. Developments in the oil patch should also be increasingly favorable as mandatory production curtailments in Alberta are eased. Notably, Canadian exports to the U.S. are near record highs. Housing developments have been uneven, with Halifax, Montreal and Ottawa seeing robust housing markets versus softer data elsewhere. That said, solid gains in labor income should sustain housing investment and growth. As for the loonie, the tailwinds remain favorable because 1) the Fed is expected to be more dovish over the next 12 months, which should tilt interest rate differentials in favor of the loonie, and 2) crude oil prices should remain well anchored in the near term on the back of geopolitical tensions, which will favor the loonie. The caveat is of course that global (and Canadian) growth bounces back by 2020 into 2021 as the BoC expects. The Swiss Franc Chart 12The Franc Value Is Fair The Franc Value Is Fair The Franc Value Is Fair Chart 13The Franc Has Been A Dormant Currency The Franc Has Been A Dormant Currency The Franc Has Been A Dormant Currency For most of the past decade, the Swiss franc has tended to be a dormant currency, interspersed by short bouts of intense volatility. That is reflected in the ITTM, which has not deviated much from zero over this time. The current message is that USD/CHF is slightly undervalued, a deviation that remains within the margin of error. A unifying theme for the franc is that it has tended to stage big moves near market riot points. That makes it attractive as a portfolio hedge, given no major evidence of mispricing today. With Swiss bond yields at already low levels, any downward pressure on global rates will boost the franc’s fair value. Meanwhile, Swiss prices are rising at a 0.6% annual rate, while U.S. prices are rising at a 1.6% clip, suggesting the franc is getting incrementally cheaper relative to its fair value. The message from Swiss National Bank Chair Thomas Jordan has been very clear: Interest rates could be lowered further, along with powerful intervention in the foreign exchange market, if necessary. This suggests that in the near term, the preference for the SNB is for a stable exchange rate. The issue is that market forces have occasionally dictated otherwise, especially during riot points. With the S&P 500 at record highs and corporate spreads both in the U.S. and euro area historically low, we may be approaching such a riot point soon, which will support the franc.  The Australian Dollar Chart 14AUD Trading Tightly With Fundamentals AUD Trading Tightly With Fundamentals AUD Trading Tightly With Fundamentals Chart 15No Major Mispricing In AUD No Major Mispricing In AUD No Major Mispricing In AUD Our ITTM for the Australian dollar sits notoriously close to fair value at most times, making opportunistic buys or sells in the Aussie rather difficult. The current message is that the AUD/USD is sitting squarely at fair value, meaning a move in either direction is fair game.  On the surface, most data points appear negative for the Aussie dollar. Typical reflation indicators such as commodity prices and industrial share prices are soft after a nascent upturn earlier this year. This suggests that so far, policy stimulus in China has not been sufficient to lift global growth, and/or the transmission mechanism towards higher growth is not working. That said, the latest Reserve Bank of Australia interest rate cut might be the ultimate insurance backstop needed to jumpstart the Australian economy. More importantly, fiscal policy is set to become decisively loose this year. The new government introduced income tax cuts this month. This is skewed towards lower-income households, meaning the fiscal multiplier may be larger than what the Australian economy is normally accustomed to. Infrastructure spending will also remain high, which will be very stimulative for growth in the short term. One bright spot for the Aussie dollar has been rising terms of trade. In recent months, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both Chinese manufacturing data and the trend in prices that demand is also playing a role. We remain long AUD/USD with a tight stop at 68 cents.  The New Zealand Dollar Chart 16NZD Fair Value Has Been##br## Falling NZD Fair Value Has Been Falling NZD Fair Value Has Been Falling Chart 17NZD Cross Reflects Deteriorating Fundamentals NZD Cross Reflects Deteriorating Fundamentals NZD Cross Reflects Deteriorating Fundamentals Like the AUD, our ITTM for the NZD is sitting squarely at fair value. That said, we believe fundamentals are likely to shift against the NZD in the near-term. This warrants holding long AUD/NZD and SEK/NZD positions. Our bias is that failure to cut interest rates at the last policy meeting might have been a mistake by the Reserve Bank of New Zealand – one that will be reversed with more interest rate cuts down the line. Since 2015, the market has been significantly more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. We may now be entering a window where economic data in New Zealand converges to the downside relative to Australia, the catalyst being a foreign ban on domestic home purchases. The Norwegian Krone Chart 18NOK Is Cheap NOK Is Cheap NOK Is Cheap Chart 19A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish Our fundamental model for the Norwegian krone shows it as squarely undervalued. This favors long NOK positions, which we have implemented via multiple crosses in our bulletins. The Norges Bank is the most hawkish G10 central bank, which means interest rate differentials are likely to continue moving in favor of the krone. And with oil prices slated to rise towards year-end, this will also underpin NOK valuations. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher. Near $20/bbl, the discount between Western Canadian Select crude oil and Brent has narrowed, but remains wide. This has typically pinned the CAD/NOK lower. The NOK also tends to outperform the SEK when oil prices are rising, in addition to the benefit from a positive carry. The Swedish Krona Chart 20SEK Is Cheap SEK Is Cheap SEK Is Cheap Chart 21A Bounce In Global Growth Will Be Bullish A Bounce In Global Growth Will Be Bullish A Bounce In Global Growth Will Be Bullish Both our ITTM and FITM for the Swedish krona show the cross as cheap. Our high-conviction view is that the Swedish krona will be the biggest beneficiary from a rebound in global growth. For now, we are long SEK/NZD but are looking to add on to SEK positions once more evidence emerges that global growth has bottomed. The USD/SEK and NZD/SEK crosses tend to be highly correlated, since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% in New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD downside. Meanwhile, the carry cost of being short NZD is lower compared to being short the U.S. dollar.    Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled "Tug Of War, With Gold As Umpire", dated March 29, 2019, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy / Global Asset Allocation Strategy Special Report titled, "Currency Hedging: Dynamic Or Static? – A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Portfolio Tweaks Into Thin Summer Trading", dated July 5, 2019, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The rising spectre of global market volatility has reignited interest in the Swiss franc. In the current geopolitical game of brinksmanship between the U.S. and China, the risk of miscalculation is high, suggesting it pays to have insurance in place. The large net short positioning in the Swiss franc and cheap valuation make it attractive from a contrarian standpoint. That said, the Swiss National Bank (SNB) is unlikely to sit and watch the CHF catapult to new highs. We expect currency intervention will be actively and aggressively used as a policy tool. Over the longer term, high domestic savings, rising productivity and a chronic current account surplus are underlying sources of support for the Swiss franc. Hold on to CHF/NZD positions recommended on April 26. We expect the unofficial floor of EUR/CHF 1.08-1.12 to hold in the near term but will respect our stop-loss at 1.11 if it is breached. Feature For most of the past decade, the Swiss franc has tended to be a dormant currency, interspersed by short bouts of intense volatility. For example, the USD/CHF is sitting today exactly where it was in early 2008, yet during this period the franc has seen wild gyrations that have lasted anywhere from just a few days to a few months. Outside of these swings, both USD/CHF and EUR/CHF have been mostly stable (Chart I-1). Chart I-1On The Verge Of A Big Move? On The Verge Of A Big Move? On The Verge Of A Big Move? The first bout of volatility occurred during the Great Financial Crisis, when the franc appreciated by 13% versus the euro, from July to October 2008. The second adjustment was marked by the European debt crisis, with the drop in the euro putting tremendous upward pressure on the franc. From the beginning of 2010 until September 2011 (when the SNB eventually put a currency floor in place), the euro plummeted by almost 35% versus the franc. More importantly, two-thirds of this adjustment occurred in the short few months before the SNB took action. The most recent adjustment in the franc has been the most interesting, because it was the central bank itself – not market forces – that triggered volatility in the exchange rate. In January 2015, the SNB decided to abandon the EUR/CHF 1.20 floor. The euro instantaneously cratered by about 30% versus the franc before retracing half of those losses a few days after. Since then, the EUR/CHF has been slowly creeping back towards the levels that prevailed before the floor was abandoned. The unifying theme across all three episodes is that the franc has tended to stage big moves near market riot points. Over the past week, the Swiss franc has emerged as one of the best-performing currencies amid the rising spectre of global market volatility (Chart I-2). This brings forward a few interesting questions. Will the SNB abandon the unofficial floor of EUR/CHF 1.08-1.12, or does it have an incentive to vigorously defend the currency? Should market volatility intensify from current levels, what trading opportunities are available to investors? Finally, what is the medium- and long-term outlook for the Swiss franc? Chart I-2The Franc Loves Volatility The Franc Loves Volatility The Franc Loves Volatility The Case For An Unofficial Cap The irony of the Swiss currency cap is that both its inception in 2011 and eventual demise in 2015 were rooted in deep external deflationary shocks, but the rationale behind the SNB’s moves in both episodes was vastly different. Back in 2011, Switzerland was rapidly stepping back into deflation, having just barely escaped it a year earlier. More importantly, this was driven by tradeable goods prices, given the franc’s rampant appreciation. At its nadir in 2011, goods prices were deflating by 3%, and rapidly dragging down inflation expectations with them. The SNB quickly realized that for a small, open economy like Switzerland, the exchange rate becomes incrementally important if deflation is entrenched (Chart I-3). Ergo, sitting and watching the trade-weighted Swiss franc continue to appreciate, especially given the euro was in a cascading downdraft, appeared to be a recipe for disaster. The stakes were especially high, given recent memory of the Great Recession. The cap worked like a charm, and the authorities could not have hoped for a better result. Inflation expectations staged a V-shaped recovery, along with headline inflation. The economy entered into a meaningful economic rebound, with the PMI swiftly rising above 50 and real GDP growth accelerating from near standstill to a 2.5% pace by 2014. This set the stage for a stock market rally that more than doubled the SMI index, nudging it back to its pre-crisis highs. The SNB quickly realized that for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Since then, the inflation dynamics have improved even further, reinforcing the view that the SNB continues to manage the currency, even though the EUR/CHF floor was abandoned over four years ago. Inflation has risen almost uninterruptedly since it bottomed in 2015 (Chart I-4) – a feat that has not been replicated in major economies like the U.S. or euro area. During the same period, the EUR/CHF has trended higher, stabilizing during bouts of EUR/USD weakness but strengthening alongside gains in the euro. This has cheapened the trade-weighted franc, buffeting consumer prices. Chart I-3Exchange Rates Affect Tradeable Goods' Prices Exchange Rates Affect Tradeable Goods' Prices Exchange Rates Affect Tradeable Goods' Prices Chart I-4The SNB Has Done A Good ##br##Job So Far The SNB Has Done A Good Job So Far The SNB Has Done A Good Job So Far Our bias is that the whisper floor of 1.08-1.12 for EUR/CHF will continue to persist until the Swiss economy decisively exits deflation. In its latest monetary policy report, the SNB lowered its inflation target for 2019 and 2020 from 0.5% to 0.3% and 1% to 0.6% respectively. Meanwhile, three key factors suggest the inflation rate will continue to be anchored at low levels in the near term: Global trade has slowed meaningfully since the onset of 2018 and continues to drift downward. Given the complex nature of Swiss exports and their high-ranking in the value chain, they have been largely insulated from the slowdown (Chart I-5). It also helps that exporters have been able to cut prices to maintain volume sales. However, there is a natural limit as to how much exporters can cut prices to maintain demand, or how long exports can be insulated from a global slowdown, let alone a trade war. Falling exports will be a renewed powerful deflationary pulse for the domestic economy. While the franc has cheapened, our models suggest it still remains 5% overvalued versus the euro (Chart I-6). This explains in part why import prices remain under downward pressure, since it is just the mirror image of an expensive currency. In a world of still-low inflation, any adjustment in the real exchange rate can only occur very slowly. Swiss prices are rising at a 0.7% annual rate, while eurozone prices are rising at a 1.7% clip. This suggests it will take about five years just for the franc to close its overvaluation gap versus the euro. This suggests the SNB will be loath to tolerate any knee-jerk appreciation in the franc. Chart I-5Swiss Exports At Risk From A Trade War Swiss Exports At Risk From A Trade War Swiss Exports At Risk From A Trade War Chart I-6EUR/CHF Is Still 5% Cheap EUR/CHF Is Still 5% Cheap EUR/CHF Is Still 5% Cheap While the output gap has closed, it remains well below levels that have previously begun to generate meaningful inflationary pressures in the domestic economy. Domestic retail sales remain weak on the back of tepid wage growth. While the unemployment rate is at 2.4%, it usually takes the unemployment rate falling below 1% before it begins to generate any significant inflationary pressures. This is unlikely to happen over the next six to nine months. The Swiss labor market is extremely flexible and fluid, allowing for tremendous efficiency. Part-time employment continues to dominate job gains, meaning the need for precautionary savings will continue to restrain spending. Chart I-7Money Supply Growth Has Converged To GDP Growth Money Supply Growth Has Converged To GDP Growth Money Supply Growth Has Converged To GDP Growth Interestingly, the SNB has not had to ramp up its balance sheet significantly in recent years. Part of the reason is that the slowdown in global trade eased natural demand for francs, which meant the SNB was no longer accumulating foreign exchange reserves at a rampant pace. More importantly, the SNB has used the global slowdown to drain excess liquidity from the system and somewhat renormalize policy. Back in 2011 when the SNB put the cap in place, there was an explosion in domestic liquidity, with broad money supply rising at a 10% pace. As panicked investors were fleeing the European periphery, there were large inflows into the Swiss economy and into the haven of government bonds, driving up the franc in the process. The same pattern was repeated again in 2016 after the U.K. referendum to leave the EU. This time around, a lack of significant EU tail risks on the near-term horizon have curtailed safe-haven flows into the franc. This has allowed Swiss money supply growth to converge towards nominal GDP growth, effectively sterilizing excess liquidity (Chart I-7). The message from SNB Central Bank Chair Thomas Jordan has been very clear: Interest rates could be lowered further, along with powerful intervention in the foreign exchange market if necessary. This suggests that in the near term the preference for the SNB is for a stable exchange rate. The issue is that market forces have occasionally dictated otherwise, especially during riot points. With the S&P 500 off its highs, corporate spreads both in the U.S. and euro area inching higher, the VIX in an uptrend and government bond yields falling, we may be approaching such a point. Lessons From The 1990s And 2015 The natural questions that follow are that if the cap worked so perfectly, then why was it scrapped in the first place? And why not explicitly put it back on, given the rising specter of global asset volatility and Swiss franc strength? After all, if the risk for Switzerland is that it could abruptly step back into deflation, then the SNB can use the franc as a potent weapon to ease domestic financial conditions. Capping the franc at a cheap level to the euro, say back at 1.20, could be exactly what the doctor prescribed. The reality is that there are both political and economic constraints to such a commitment. While the decision to scrap the EUR/CHF floor was a puzzle to most investors back in 2015, a post-mortem analysis suggests the reasoning in hindsight was rather obvious. Back in 2015, the world economy was entering into a manufacturing recession as China closed off the credit spigots. This was particular acute in the Eurozone, which had just exited a double-dip recession but was facing credit growth falling at a 7% pace. Enter quantitative easing.  The deflationary backdrop back then had already led to an explosion of high-powered money as foreigners flocked into Swiss assets. Foreign exchange reserves were rapidly outpacing the monetary base and quickly closing in on nominal GDP (Chart I-8). The risk of course is that if surging money and credit growth cannot fuel consumer price inflation, it can only stimulate an asset price boom. A floor to a currency about to ride a wave of large-scale monetary stimulus was disconcerting to even the most Keynesian of Swiss central bankers. A floor to a currency about to ride a wave of large-scale monetary stimulus was disconcerting to even the most Keynesian of Swiss central bankers. Meanwhile, there had already been a rising chorus of discontent among right-wing politicians in 2014, specifically those within the Swiss People’s Party (SVP) who wanted the central bank to stop buying foreign currencies and significantly lift its gold holdings instead. As early as October of 2014, opinion polls suggested that support for the proposal was at 44%, with only 39% of Swiss citizens against.1 Memories from the 1990s asset burst in Switzerland were front and center among SVP members. The Plaza Accord had led to the proliferation of carry trades into Switzerland as the U.S. dollar fell. This was supercharged by strong migration into Switzerland ahead of the fall of the Berlin Wall. All of this lit a fire under the real estate market. The SNB was eventually forced to raise interest rates from 3.5% in 1998 to 9% in 1992, transforming a real estate bull market into a 20-year bust (Chart I-9). With the SVP currently ahead in opinion polls ahead of the October 2019 elections, this is likely to remain a constraint Chart I-8Still Lots Of High-Powered Money In Switzerland Still Lots Of High-Powered Money In Switzerland Still Lots Of High-Powered Money In Switzerland Chart I-9Macro-Prudential Measures Have Stymied A Housing Bubble Macro-Prudential Measures Have Stymied A Housing Bubble Macro-Prudential Measures Have Stymied A Housing Bubble Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland but a rising debt-to-GDP ratio that pins it among the highest in the G10 (Chart I-10). Too little stimulus, and the economy runs the risk of entering a debt-deflation spiral, as inflation expectations continue to be anchored strongly to the downside. Too much stimulus, and the result will be a build up of imbalances, leading to an eventual bust. This dilemma was the “raison d’ être” of the Swiss currency cap in 2011, but let to its eventual demise in 2015. Chart I-10The Swiss Have Lots Of Debt The Swiss Have Lots Of Debt The Swiss Have Lots Of Debt A final thought about the cap: It is different from a peg in that the former allows the franc to depreciate versus the euro, while the latter does not. This makes the cap an asymmetric mechanism: Only when the CHF is under upward pressure will the cap act as a QE mechanism, because the SNB has to buy euros while selling Swiss francs. Should the franc weaken against the euro, the SNB does not have to intervene, hence its balance sheet stops expanding and QE ends. The key risk is that the euro drops substantially, inviting speculation back into the Swiss economy. This risk is clearly unpalatable for both Swiss politicians and the SNB, which is why two-way asymmetry was reintroduced into the system. Trading Dynamics As A Safe Haven Switzerland ticks off all the characteristics of a safe-haven currency. Its large net international investment position of 125% of GDP generates huge income inflows. Meanwhile, rising productivity over the years has led to a structural surplus in its trading balance and a rising fair value for the currency. Consequently, the franc has tended to have an upward bias over the years, supercharged during periods of risk aversion (Chart I-11). Switzerland ticks off all the characteristics of a safe-haven currency. During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond with periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged positions become victim to short-covering flows. Given the negative yield from hedging trades funded in Swiss francs (Chart I-12), it is fair to assume a pronounced flight-to-safety will cause a knee-jerk appreciation in the franc, like in past episodes. Chart I-11The "Curse" Of The##br## SNB The "Curse" Of The SNB The "Curse" Of The SNB Chart I-12Hedging Against Franc Strength Is Expensive Hedging Against Franc Strength Is Expensive Hedging Against Franc Strength Is Expensive This is especially true, since the U.S. tax reforms have already driven foreign affiliates in Switzerland to liquidate investments (mostly real estate) and repatriate those funds back into Treasurys. Foreign direct investment in Switzerland is falling at a rate of 15% of GDP, causing the basic balance to hit -4% of GDP. These FDI outflows are unlikely to remain a headwind for the franc going forward, assuming the tax benefit was a one-time deal. Instead, a favorable balance-of-payments backdrop will continue to be a key underpinning behind the strong franc (Chart I-13). Chart I-13A One-Time Adjustment In The Basic Balance A One-Time Adjustment In The Basic Balance A One-Time Adjustment In The Basic Balance The message is that during rising periods of risk aversion, like now, speculators should accumulate francs as a portfolio hedge. We continue to favour the CHF/NZD, recommended on April 26. Aggressive investors can also sell the USD/CHF. Investment Conclusions Our long-term fair value models suggest the Swiss franc is currently cheap (Chart I-14). This makes it attractive both on a short- and longer-term basis versus a basket of currencies. The exception is versus the euro, given the EUR/CHF is still undervalued by 5%. Froth in the housing market has been eliminated. Stricter policies toward immigration, along with macro-prudential measures, such as a cap on second homes and stricter lending standards, have helped (Chart I-15). Meanwhile, the surprise move by the SNB to abandon the EUR/CHF floor has rebalanced the market. Back then, Swiss real estate became more expensive for investors in the euro area who used the SNB put to speculate on properties in Zurich and Geneva. Demand for Swiss real estate has largely decreased since then, eliminating this key source of risk for the SNB (Chart I-16) Chart I-14The Swiss Franc Is Cheap By Some Measures The Swiss Franc Is Cheap By Some Measures The Swiss Franc Is Cheap By Some Measures Chart I-15The Swiss People's Party ##br##Had Its Way The Swiss People's Party Had Its Way The Swiss People's Party Had Its Way Our bias is that over the next few years, the Swiss franc will be more of a dormant currency, gently appreciating towards its fair value but periodically interspersed by bouts of intense volatility. Interestingly, we may be entering such a riot point. German bund yields fell below Japanese levels this week. Historically, a falling bund yield has been a bad omen for EUR/CHF.  We will respect our 1.11 stop loss on long EUR/CHF if breached (Chart I-17). Chart I-16The SNB Had Its Way The SNB Had Its Way The SNB Had Its Way Chart I-17Where Next For Bund Yields? Where Next For Bund Yields? Where Next For Bund Yields?   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see www.reuters.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 from the U.S. have been positive: Headline inflation and core inflation increased to 2% and 2.1% year-on-year respectively in April. NFIB business optimism index increased to 103.5 in April. NY Empire State Manufacturing index increased to 17.8 in May. Retail sales fell by 0.2% month-on-month in April, but the Redbook retail sales clocked in a solid 5.4% growth year-on-year. Industrial production decreased by 0.5% month-on-month in April, but is still growing at 0.9% year-on-year. On the housing market front, MBA mortgage applications contracted by 0.6% in May. NAHB housing market index increased to 66 in May. Housing starts increased by 5.7% to 1.24 million month-on-month in April. Building permits increased by 0.6% to 1.3 million in April. DXY index increased by 0.4% this week. U.S. and Chinese negotiators failed to reach an agreement regarding tariffs. The increased tariffs on Chinese goods was followed by the inevitable retaliation by China this Monday. As the market gauges the net impact of the tariff from both sides, volatility will prevail. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 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 weaker-than-expected: Industrial production in the euro area fell by 0.6% year-on-year in March. The euro area ZEW economic sentiment fell to -1.6 in May. The German ZEW economic sentiment fell to -2.1 in May, while current situation improved to 8.2. Euro area GDP growth came in line at 1.2% year-on-year in Q1. German GDP growth increased to 0.4% quarter-on-quarter in Q1, while on a year-on-year measure, the growth rate fell from 0.9% to 0.6%. Trade balance in the euro area fell to 17.9 billion euros in March. German harmonized consumer price inflation was unchanged at 2.1% year-on-year in April. French industrial output contracted by 0.9% month-on-month in March, while non-farm payrolls increased to 0.3% quarter-on-quarter in Q1. EUR/USD fell by 0.4% this week. While signs are still pointing to a tentative recovery in the euro area, global trade war rhetoric and volatile incoming data continue to weigh on investor sentiment. Trump is poised to delay a decision to impose auto tariffs on EU and Japanese exports by up to six months, which suggests he might ramp up the trade war with China. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The 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 mixed: Leading economic index and coincident index fell to 96.3 and 99.6 respectively in March. Trade balance by the balance-of-payment measure increased to 700 billion yen in March. Adjusted current account balance fell to 1.27 trillion yen in March. On the housing market front, the construction orders increased by 66.1% year-on-year in March. Housing starts grew by 10% year-on-year in March. Reconstruction efforts following last year’s disasters appear well underway. Machine tool orders contracted by 33.4% year-on-year in April. Japanese producer price inflation decreased to 1.2% year-on-year in April, while still higher than expected. USD/JPY fell by 0.7% initially, then gradually recovered, returning flat this week. The ongoing trade disputes largely increased short-term volatility in the yen. We continue to recommend the yen as a portfolio hedge. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 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 U.K. have been solid, despite softer employment data: Nominal GDP growth increased to 1.8% year-on-year in Q1. Manufacturing production increased by 2.6% year-on-year in March. Industrial production increased by 1.3% year-on-year. Total trade balance came in at a deficit of 5.4 billion pounds in March. This was an improvement from the last reading of a 6.2 billion deficit in February. ILO unemployment rate fell to 3.8% in March, while the average earnings growth fell from 3.5% to 3.2%. Moreover, claimant count increased by 24.7K in April. GBP/USD fell by 1.6% this week. The pound remains one of our favorite currencies for the time being from a valuation perspective. Moreover, U.K. data continue to surprise positively. The catalyst for pound weakness this week was Theresa May’s announcement she will set out a timetable for her resignation next month, once the fourth iteration of Brexit is submitted for a vote. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 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: Home loans contracted by 2.5% in March. Crucially, this was driven by both owner-occupied and investor lending. National Australia Bank’s business conditions and business confidence indices both fell in April. Business conditions fell to 3, and business confidence decreased to 0. Westpac consumer confidence fell to 0.6% in May. Consumer inflation expectations fell to 3.3% in May. On the labor market front, the wage price index was unchanged at 2.3% year-on-year in Q1. Unemployment rate increased to 5.2%, while participation rate increased to 65.8%. 28.4 thousand new jobs were created in April. However, this is due to the creation of 34.7 thousand part-time jobs, while 6.3 thousand full-time jobs were lost. AUD/USD fell by 1% this week. We remain overweight the Australian dollar as it will be one of the first pro-cyclical currencies to benefit from Chinese stimulus. But we will respect our AUD/USD 0.68 stop loss if it is breached. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 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: Food price index fell by 0.1% month-on-month in April. Visitor arrivals contracted by 2.6% year-on-year in March. REINZ house sales continue to contract by 11.5% year-on-year in April. Net migration fell to 59 thousand in Q1. Migration has been an important source of demand for New Zealand. NZD/USD fell by 0.4% this week. The New Zealand dollar remains very vulnerable to external shocks, especially from the trade front. Meanwhile, terms of trade dynamics continue to favor AUD vis-à-vis NZD. The domestic environment, including reduced immigration also remains a headwind for the economy. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 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 from Canada have been promising: Building permits increased by 2.1% month-on-month in March.  On the labor market front, the unemployment rate fell to 5.7% in April, and 106.5 thousand new jobs were created. Participation rate increased to 65.9%, and average hourly earnings increased by 2.6% year-on-year in April. This was a blockbuster jobs report. Headline inflation increased to 2% year-on-year in April, while core inflation decreased to 1.5%. Manufacturing sales increased by 2.1% month-on-month in March. USD/CAD decreased by 0.1% this week. The good news from the Canadian housing sector and labor market has supported the loonie. On Wednesday, Canadian Foreign Affairs Minister Chrystia Freeland called again for the U.S. to lift steel and aluminum tariffs in order to create “true free trade” on the continent. On the U.S. side, Treasury Secretary Steven Mnuchin said that Washington was close to resolving its differences with Mexico and Canada over steel and aluminum tariffs. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 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 is little data from Switzerland this week: Producer and import prices fell by 0.6% in April. USD/CHF fell by 0.1% this week. The Swiss franc remains a safe-haven currency, and growing political uncertainty will increase demand for the franc. We discuss the outlook for the franc at length in the front section of this report. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 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 mixed: Core inflation fell to 2.6% year-on-year in April, while still higher than the expected 2.5%.  Headline inflation was unchanged at 2.9% year-on-year in April. Real GDP growth did slow down to a 0.3% quarter-on-quarter pace in Q1. However, seasonal factors were at play. Strong agricultural output in Q4 2018 was not repeated in Q1 following last year’s summer drought. There was also low power production in the months of February and March. The trade balance increased to 17.6 billion NOK in April. USD/NOK has been volatile but returned flat this week. Two Saudi oil-pumping stations were targeted in a drone attack this Tuesday. The tensions in the Middle East increased the risk of oil supply shortages, which is bullish for oil price, thus beneficial for the Norwegian krone. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 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: Swedish Public Employment Service (PES) unemployment rate fell to 3.5% in April. Headline consumer price inflation climbed to 2.1% year-on-year in April. Core consumer price inflation increased to 1.6% year-on-year in April. USD/SEK has been flat this week. As a pro-cyclical currency, the Swedish krona will soon benefit from a global growth recovery once political uncertainties and external shocks play out. We remain positive on the krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Open an equity market relative overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, the majority of this year’s absolute gains have already been made. Core euro area bond yields will edge modestly higher… …and EUR/USD will appreciate, as the backward-looking data on which the ECB depends catches up with the more perky real-time economic data.   Feature Vertical charts scare us, as we contemplate falling over the edge. But they also excite us, as we contemplate a lucrative investment opportunity. Right now, the vertical chart that is causing us palpitations is technology versus healthcare (Chart of the Week).  Chart of the WeekTechnology Versus Healthcare Has Gone Vertical! Technology Versus Healthcare Has Gone Vertical! Technology Versus Healthcare Has Gone Vertical! The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Meaning that the technology versus healthcare relative performance has unavoidable consequences for regional and country stock market allocation (Chart I-2 and Chart I-3). The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Chart I-2When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland Chart I-3When Technology Underperforms Healthcare, China Underperforms Switzerland When Technology Underperforms Healthcare, China Underperforms Switzerland When Technology Underperforms Healthcare, China Underperforms Switzerland Specifically, from a European stock market perspective, the Netherlands is overweight technology while Switzerland and Denmark are both overweight healthcare. Further afield, the U.S. is overweight technology while China is both overweight technology and underweight healthcare. Explaining Verticality And The Subsequent Fall What creates vertical charts? To answer the question, let’s turn it on its head: what prevents vertical charts? The answer is: the presence of value investors. In a healthy market, a cohort of value investors will sit on the side lines and only transact with the marginal seller when the price falls to a semblance of value. In other words, the value sensitive investors help to set the price, preventing verticality. But if the value sensitive cohort switches out of character to join a strong uptrend, the cohort will suddenly become value insensitive. In this case, the marginal seller will set the price higher and the formerly uninterested value sensitive buyer will now buy at the higher price. The market has morphed into a trend-following market. As more of the value cohort switch sides, the process adds rocket fuel to the rally. Driven by the ‘fear of missing out’ the marginal buyer will buy at larger and larger price increments, and the chart becomes vertical. What triggers the subsequent fall? When all of the value cohort have joined the uptrend, the fuel has run out: the marginal seller will no longer find a willing marginal buyer at the elevated price. At this critical point, one of two things will happen. Either: a completely new cohort of even deeper value investors will switch out of character and provide new fuel to the trend, allowing it to continue. Or: the deep value investors will stay true to character and will only deal with the marginal seller when the price falls, perhaps sharply, to a semblance of deep value. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased. Both the theoretical and empirical evidence suggests that at this critical point, the probability of trend-continuation decreases to about a third and the probability of a trend-reversal increases to about two-thirds. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased (Chart I-4). Chart I-4Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Therefore, on a tactical horizon, it is now appropriate to underweight technology versus healthcare – which, to reiterate, carries unavoidable consequences for country and regional stock market allocation: Open an overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. Distinguishing Between Valuation And Growth Is Extremely Difficult There is another problem for value investors. Over short periods – meaning less than a year – it is very difficult, if not impossible, to decompose a price return into its two components: the component coming from the change in valuation and the component coming from the change in earnings growth expectations. A stock market’s actual earnings are highly sensitive to small changes in economic growth. This is universally the case but is especially true in Europe, because the European stock market’s skew towards growth-sensitive cyclicals gives it a very high operational leverage to GDP growth: a seemingly minor 0.5 percent change in economic growth translates into a major 25 percent change in stock market earnings growth (Chart I-5). The slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Chart I-5A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth Given this very high operational leverage, the slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Which of course lifts the market’s price, P, very sharply. In contrast, equity analysts’ forecasts for earnings, which drive the market’s ‘official’ forward earnings, E, adjust much more slowly. As my colleague, Chris Bowes explains: “analysts get married to a view and usually require overwhelming evidence to materially change it.” The upshot is that the P rises very sharply but the official forward E does not, meaning that the official forward P/E also rises very sharply. This gives the impression that the move is mostly valuation driven, but the truth is that the move is mostly earnings growth driven. In a similar vein, when central banks guide interest rates lower, how much of the equity market’s move is due to a higher valuation, and how much is due to improved prospects for economic growth resulting from the central bank policy change? Over relatively short periods of time, it is extremely difficult to tell. All of which provides an important lesson: over short periods, do not focus on separately forecasting the valuation change and earnings growth change of a stock market. Much better to forecast the stock market price directly, by focussing on the two main things which will drive it: changes to central bank policy, and changes to short-term real-time economic growth. Focus On Central Banks And Short-Term Economic Growth Central bank policy now ‘depends’ on relatively longer-term changes (say, year-on-year) in backward-looking data, most notably the consumer price index. Whereas the stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators (Chart I-6). Chart I-6Quarter-On-Quarter Growth Is Rebounding Quarter-On-Quarter Growth Is Rebounding Quarter-On-Quarter Growth Is Rebounding Hence, the ‘sweet spot’ for equity markets is when, in simple terms, year-on-year CPI inflation is decelerating, implying central banks will become more dovish, while quarter-on-quarter economic growth is accelerating, implying the market will upgrade earnings growth (Chart I-7). The stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators. The ‘weak spot’ for equity markets is the exact opposite, when year-on-year CPI inflation is accelerating, implying central banks will become less dovish, while quarter-on-quarter economic growth is decelerating, implying the market will downgrade earnings growth. As 2019 progresses, our high-conviction prediction is that equity markets will move from a sweet spot to a weak spot. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, it implies that the majority of 2019’s gains have already been made in the first four months of the year – and the market is unlikely to be significantly higher at the end of the year. Compared to the equity market, the bond, interest rate, and currency markets are – almost by definition – much more dependent on central banks’ lagging reaction functions than on real-time growth. Which solves the mystery as to why bond yields are close to new lows while equity markets are close to new highs. It also solves the mystery as to why EUR/USD has lagged the very clear recovery in euro area real-time growth and in euro area stock markets (Chart I-8). Central banks are following lagging indicators. Chart I-7Stock Markets Take Their Cue from Real-Time Indicators Stock Markets Take Their Cue from Real-Time Indicators Stock Markets Take Their Cue from Real-Time Indicators Chart I-8Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators But as the backward-looking data, on which the ECB depends, catches up with the more perky real-time data, core euro area bond yields will edge modestly higher, and EUR/USD will gently appreciate. Next week, in lieu of the usual weekly report, I will be giving this quarter’s webcast titled ‘From Sweet Spot to Weak Spot?’ live on Wednesday May 8 at 10.00 AM EDT (3.00 PM BST, 4.00 PM CEST, 10.00 PM HKT). Through a series of key charts, the webcast will reveal the prospects and opportunities for all asset-classes through the remainder of 2019. At the end of the webcast, I will also unveil a brand new investment recommendation. So don’t miss it! Fractal Trading System* Supporting the arguments in the main body of this report, fractal analysis suggests that the recent rally in China’s stock market is at a technical point that has reliably signaled previous major reversals. Accordingly, this week’s recommended trade is a stock market pair trade, short China versus Japan. Set the profit target at 2.5 percent with a symmetrical stop-loss. We now have six 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-9Short China Vs. Japan Short China VS. Japan Short China VS. Japan   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 Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades 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 Central bankers appear to be in a rush to boost inflation expectations before the next economic downturn. This in practice should be stimulative for the global economy. Historically, currencies of small, open economies are typically the first to benefit from rebounding global growth. Ditto for those whose output gaps have fully closed. However, there appears to be a shift in the behavior of certain currency pairs in the current cycle. For example, the U.S. dollar has tended to perform better in a low-volatility environment in recent years, a shift from the past. Correspondingly, its safe-haven status may have been marginally eroded. The U.S. decision not to extend waivers on Iranian oil exports beyond the May 2 deadline is bullish for petrocurrencies such as the RUB and NOK. The Bank of Canada kept rates on hold but will be hard pressed to meet its inflation mandate before the next downturn. This suggests standing aside on USD/CAD. Rising net short positioning on the yen and Swiss franc is making them attractive from a contrarian standpoint. Place a limit-buy on CHF/NZD at 1.45. Feature Chart I-1Volatility Is Due For A Bounce Volatility Is Due For A Bounce Volatility Is Due For A Bounce The four most important financial variables that could give a near-complete snapshot of the world economy at any point in time are probably the level of the S&P 500, the U.S. 10-year Treasury yield, the trade-weighted dollar and a commodity bellwether, say, crude oil prices. Any permutation of these variables can identify what quadrant the world economy is operating in, with the two most important states being either boom or bust. Taking three of those variables today – the S&P 500 breaking to all-time highs, crude oil prices up 40% from their lows and U.S. 10-year Treasury yields off by almost 100 basis points from their October highs – it is hard to justify why the dollar has hardly budged, this week’s rally aside. Obviously, this is a very simplified view of an intricately complex world economy. But it highlights a point we have been making in recent bulletins: that extended periods of low currency volatility have been very unusual in the post-Bretton Woods world (Chart I-1). The typical narrative has been that as we enter a reflationary window, pro-cyclical currencies should outperform. The reason is simple enough: These economies are export-oriented and tied to the global cycle. So, a rising current account surplus as demand for their goods and services picks up provides underlying support for the currency. Should there be little slack in their domestic economies, this also raises the probability that the central bank tightens monetary policy to fend off future inflationary pressures. It does not hurt if these countries are also commodity producers, since rising terms of trade also provides an additional exchange-rate boost. The reality is that the world is not static, and some of these dynamics have been shifting. The evidence is in the counterfactual: At current levels, China’s credit injection should have lit a fire under pro-cyclical trades because they tend to work in real-time rather than with a lag. The foreign exchange market is one of the deepest and most liquid where new information tends to get digested and discounted instantaneously. As such, the lack of more pronounced strength in pro-cyclical currencies like the Australian, New Zealand and Canadian dollar exchange rates is genuine reason for concern and worth investigation. Why Is The Dollar Breaking Higher? Our Special Report1 on March 29th highlighted the fact that the dollar should be 5-10% higher simply based on measures of relative trends, and recent data corroborate this view. The growth differential between the U.S. and the rest of the world remains wide. Meanwhile, exports and industrial production from Southeast Asia continue to decelerate. Interbank rates in China are spiking higher, suggesting most of the monetary stimulus may have already been frontloaded. And on the earnings front, U.S. profit leadership also continues. It is unclear which of these catalysts was the actual trigger for dollar strength, since these have been in place for a while now, but confirmation from any and all of them was sufficient to reinvigorate the dollar bulls. That said, it is important to pay heed to shifting market forces, but it will be imprudent to change investment strategy on this week’s moves alone. Given these moves, a few observations are in order: Almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now (Chart I-2). This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked. Dollar technicals are also very unfavorable (Chart I-3). Speculators are holding near-record long positions, sentiment is stretched and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion. This time should be no different. Chart I-2Is It Time To Initiate Fresh Dollar Longs? Is It Time To Initiate Fresh Dollar Longs? Is It Time To Initiate Fresh Dollar Longs? Chart I-3Dollar Technicals Are Unfavourable Dollar Technicals Are Unfavourable Dollar Technicals Are Unfavourable A breakout in the dollar along with rising equity markets suggests that the correlation is once again shifting. The dollar has tended to trade as a counter-cyclical currency for most of the time, with a negative correlation even to global equities (Chart I-4). Importantly, given current low levels of volatility and elevated equity market valuations, the dollar would have been a great insurance policy for any stock market correction. But with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs (Table I-1). Chart I-4The Dollar Remains A 'Risk-Off' Currency The Dollar Remains A 'Risk-Off' Currency The Dollar Remains A 'Risk-Off' Currency Chart I- It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. For one, safe-haven assets tend to be lower-yielding but also during episodes of capital flight, investors choose to repatriate capital to pay down debt, with creditor nations having the upper hand. And given U.S. investors have already been repatriating close to $400 billion in assets over the past 12 months, it is unlikely this pace persists (Chart I-5). The bottom line is that investors who believe that the U.S. dollar has become a high-beta currency should be prepared to stampede out the door on any rise in volatility. Our bias remains that the U.S. dollar will ultimately weaken, given that the forces driving it higher are mostly behind us. Meanwhile, currencies such as the Japanese yen or even Swiss franc that have been used to fund carry trades are very ripe for short-covering flows. Putting everything together suggests at minimum building portfolio hedges. It will be difficult for the dollar to act as both a safe-haven and carry currency. One such hedge is going long CHF/NZD. This trade has a high negative carry, so we do not intend to hold it for longer than three months. But speculative positioning and relative economic trends also support this cross for the time being (Chart I-6). We are placing a limit-buy at 1.45. Chart I-5How Much More Will Repatriation Flows Help? How Much More Will Repatriation Flows Help? How Much More Will Repatriation Flows Help? Chart I-6CHF/NZD Is An Attractive ##br##Hedge CHF/NZD Is An Attractive Hedge CHF/NZD Is An Attractive Hedge A Shifting Landscape If the dollar eventually weakens, let’s consider the premise that the most export-dependent economies should benefit more from a rebound in global growth, and by extension, their currencies should appreciate the most. Within the G10 universe, this will be notably the European currencies led by the Swiss franc, the Swedish Krona, the euro and the pound (Chart I-7). However, from the trough in the global Purchasing Managers’ Index (PMI) in December 2008 until the peak in April 2010, it was the commodity currencies that outperformed. During that time frame, the Swiss franc actually fell. It is well known that Switzerland’s persistent trade surplus over the decades has been a key factor behind structural appreciation in the currency. However, at any point in time, other nuances such as whether the rebound is China or commodities driven, the starting point for valuations or even interest rate differentials take center stage in explaining currency moves. The lesson is that investors have to become nimble with currency investment strategy. The lesson is that investors have to become nimble with currency investment strategy. For pro-cyclical currencies, there have been dramatic shifts in the export share of GDP for various countries, according to World Bank data. Most euro area countries have massively expanded their export share of GDP as they have gained ground in value-added products and services. Meanwhile, the export share in Australian GDP has been stuck at 20% for many years, while that in Norway, New Zealand and Canada has seen a huge drop, even since 2009 (Chart I-8). At first blush, this suggests diminishing marginal returns to their currencies from global growth. Chart I-7 Chart I-8A Shifting Export ##br##Landscape A Shifting Export Landscape A Shifting Export Landscape Take the example of New Zealand, where commodities are over 75% of exports. Since the 2000s, the government has been actively trying to redistribute growth from net exports to domestic demand. This has been mainly via the skilled workers program. The result has been a collapse in the export share of GDP from 36% to about 26%. This means that the New Zealand dollar, which has typically been a higher-beta play on global growth, is giving way to other currencies such as the euro and the Swedish krone (Chart I-4). In addition to this, while global growth might eventually recover, part of the widespread deterioration since the global financial crisis may be structural. If the overarching theme over slowing global trade is a global economy that is trying to lift its precautionary savings and spend less, then the world may not see the high rates of trade growth registered in the 1990s anytime soon. This is because at a lower rate of potential GDP growth, trade elasticities also tend to fall.2 There are many reasons for this, including less willingness among creditor nations to finance current account deficits, the paradox of thrift or just outright saturation in the turnover of trade. All of this dampens marginal returns toward all pro-cyclical currency trades. Chart I-9Trade Volatility Has Fallen Trade Volatility Has Fallen Trade Volatility Has Fallen The bottom line is that the overall magnitude and volatility of trade relative to GDP has fallen, at least until the recent China – U.S. trade spat (Chart I-9). This has had the effect of dampening the volatility of the corresponding mediums of trade exchanges. Part of this is clearly cyclical, but a part may be structural as well. If we embrace confirmation that the Chinese economy has bottomed, it will be important to monitor if this cycle plays out like those in the past. Notes On Petrocurrencies, And The BoC The U.S. has decided not to extend waivers on Iranian oil exports beyond the May 2 deadline. Supposedly, a coalition with both Saudi Arabia and the United Arab Emirates would ensure that oil markets remain adequately supplied, though Saudi Arabia has since signaled they are in no rush to raise production. Overall, this increases the bullish narrative for oil. First, the Iranian response to a shutoff in their exports could be unpredictable. The U.S. threat of driving Iranian oil exports to zero increases the geopolitical risk premium in prices, as full implementation pushes Iran to a wall, raising the odds of retaliation. Chart I-10Iran Is A Meaningful Oil Supplier Iran Is A Meaningful Oil Supplier Iran Is A Meaningful Oil Supplier Second, oil production is being curtailed at a time when Venezuelan output is rapidly falling, conflict in Libya is reviving and OPEC spare capacity remains tight. This could nudge the oil market dangerously close to a negative supply shock (Chart I-10). Meanwhile, there is the non-negligible risk of unplanned outages which have been rising in 2019, which is another source of risk for oil supply Oil futures have responded positively to the news, with both Brent and WTI making fresh 2019 highs. However, while initially reacting favorably, petrocurrencies such as the Canadian dollar, Russian ruble and Norwegian krone are selling off amid dollar strength. We think Brent will continue to trade at a premium to WCS crude. This bodes well for currencies tied to North Sea production. Hold short CAD/NOK and long NOK/SEK positions, despite the selloff this week. As for Canada, we are neutral on the loonie both short and medium term. The dovish shift by the BoC and looser fiscal policy are likely to be growth tailwinds. So is the rise in oil prices. However, there appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts.  The key drivers for the CAD/USD exchange rate are interest rate differentials with the U.S. (which we think will compress further) and energy prices (which we think Canada benefits less from due to the discount Canadian oil sells for, and persistent infrastructure problems). As such, we think domestic conditions will continue to knock down whatever benefit comes from rising oil prices (Chart I-11). Chart I-11CAD/USD Will Benefit From##br## Rising Terms Of Trade CAD/USD Will Benefit From Rising Terms Of Trade CAD/USD Will Benefit From Rising Terms Of Trade Chart I-12Can The BoC Hike Given ##br##This Backdrop? (1) Can The BoC Hike Given This Backdrop? (1) Can The BoC Hike Given This Backdrop? (1) On the consumer side, real retail sales are deflating at the worst pace since the financial crisis, and demand for housing loans is falling off (Chart I-12). This is unlikely to improve if house prices continue to roll over (Chart I-13). A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is asymmetric with negative housing shocks, hurting consumption by more than the boost received from positive shocks. This asymmetry may be due to the fact that at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. There appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts. On the corporate side of the equation, the latest Canadian Business Outlook Survey is very telling. Firms’ expectations for sales have softened significantly, as businesses in several sectors are less optimistic about demand. This is driven by uncertainty in the oil patch, weak housing and weak external conditions. This in turn, has led to a steep drop in plans to increase capex (Chart I-14). For external investors, the large stock of debt in the Canadian private sector and overvaluation in the housing market are likely to continue leading to equity outflows on a rate-of-change basis. Chart I-13Can The BoC Hike Given This Backdrop? (2) Can The BoC Hike Given This Backdrop? (2) Can The BoC Hike Given This Backdrop? (2) Chart I-14Can The BoC Hike Given This Backdrop? (3) Can The BoC Hike Given This Backdrop? (3) Can The BoC Hike Given This Backdrop? (3) Technically, USD/CAD failed to break below the upward sloping trendline drawn from its 2017 lows. The next resistance zone is the 1.36-1.38 level. Our bias is that this zone will prove to be formidable resistance. We continue to recommend investors short the CAD, mainly via the euro. Housekeeping Our limit-buy on AUD/USD was triggered at 0.70. Place tight stops at 0.68 until further evidence that global growth has bottomed. Our short USD/SEK position garnered losses this week. The RiksBank’s dovish shift surprised the market, and triggered panic selling as important technical levels were broken. With a manufacturing PMI at 52.8, inflation at 1.8% and wages growing near 3%, this is not exactly the symptoms of an economy that needs more stimulus. We recommend holding onto positions, but will respect our stop loss a few hundred pips away. Finally, the dovish shift by the Bank of Japan does not change our thinking on the yen. The resilience in the currency might indicate the pool of yen bears has been exhausted.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “Tug Of War With Gold As Umpire,” dated March 29, 2019, available at fes.bcaresearch.com. 2 Cristina Constantinescu, Aaditya Mattoo, and Michele Ruta, “The Global Trade Slowdown: Cyclical Or Structural?” IMF working paper (2015). Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 ​​​​​ Recent data in the U.S. suggest a weaker housing market: In March, building permits contracted by 1.7% month-on-month, falling to 1.27 million; housing starts decreased by 0.3% month-on-month, coming in at 1.14 million. March new home sales grew by 4.5% month-on-month, coming in at 0.69 million. However, existing home sales contracted by 4.9% month-on-month, falling to 5.21 million. The house price index grew by 0.3% month-on-month in February, in line with expectations. MBA mortgage applications decreased by 7.3% in April. The Chicago Fed National Activity index fell to -0.15 in March, underperforming expectations. Durable goods orders increased by 2.7% in March, surprising to the upside. DXY index appreciated by 1% this week, hitting the highest level since June 2017. While a more accommodative monetary policy stance has been taken in China, global growth momentum remains weak, which is a cause for concern. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area continue to soften: Italian business confidence and consumer confidence in March fell to 100.6 and 110.5, respectively. April preliminary consumer confidence in the euro area fell to -7.9, below expectations. German IFO business climate fell to 99.2 in April; expectations and current assessment fell to 95.2 and 103.3, respectively. French business confidence improved to 105, while business climate decreased to 101 in April. Italian trade balance came in at a larger surplus of 3.42 billion euro in April. EUR/USD depreciated by 1% this week. The incoming data from the euro area and globally have been weaker than expected. The recent ECB Economic Bulletin remains positive for the growth outlook going forward, stating that “the supportive financing conditions, favorable labor market dynamics and rising wage growth should continue to underpin the euro area expansion.” Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Headline inflation and core inflation were unchanged at 0.5% and 0.4% year-on-year in March, respectively. Machine tool orders in March contracted by -28.5% year-on-year. All industry activity index fell by 0.2% month-on-month in February, in line with expectations. USD/JPY surged initially by 0.4% ahead of BoJ’s rate decision, then fell sharply, returning flat this week. The BoJ has decided to keep the interest rate on hold at -0.1%. The shift to a calendar-based form of forward guidance is unlikely to be a game-changer on its own. Moreover, the BoJ expects the Japanese economy to pick up through 2021 supported by highly accommodative financial conditions and government spending, despite the weakness of global growth and scheduled consumption tax hike. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been positive: Public sector net borrowing increased to 0.84 billion pounds in March. In April, the CBI retailing reported sales increased to 13. The CBI business optimism came in at -16 in April, an improvement compared to the last reading of -23. GBP/USD fell by 1% this week, mostly affected by the U.S. dollar’s broad strength. The pound is likely to rebound once we see more signs confirming the strength in global growth, given Brexit has been kicked down the road. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: Headline inflation fell to 1.3% year-on-year in Q1, missing expectations. Trimmed mean inflation in Q1 fell to 1.6% year-on-year. AUD/USD fell by 2.3% this week, which triggered our limit buy order at 0.7 on Wednesday. Inflation is a lagging indicator. While the Q1 inflation number missed expectations, the Australian dollar is likely to bottom as Chinese stimulus plays out and global growth starts to pick up. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: Credit card spending contracted by 5.1% year-on-year in March, underperforming expectations. NZD/USD fell by 1.36% this week. We remain bearish on the New Zealand dollar due to the Achilles’ heel of an overvalued housing market. Moreover, the Kiwi is still expensive compared to its fair value. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Wholesale sales grew by 0.3% month-in-month in February, surprising to the upside. CFIB business barometer increased to 56.7 in April. USD/CAD surged by 0.95% this week. The Canadian dollar seems to be less responsive to the energy prices this week due to lots of concerns regarding the pipeline issue in Alberta. The Bank of Canada maintained its overnight interest rate target at 1.75% on Wednesday. In the April Monetary Policy Report, the BoC projects real GDP growth of 1.2% in 2019, and around 2% in 2020 and 2021. Given the current developments in household spending, energy investment, and trade conditions, a dovish stance by BoC is warranted. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly positive: Money supply M3 grew by 3.5% year-on-year in March, same as last month. ZEW survey expectations increased to -7.7 from the previous reading of -26.9. USD/CHF increased by 0.66% this week. While global growth is set to rebound, the uncertainties regarding geopolitical risks, trade conditions, and oil prices will weigh on the growth pace. We remain neutral on the Swiss franc against U.S. dollar, but acknowledge that the large short positioning is attractive from a contrarian standpoint. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 There is no significant data from Norway this week. USD/NOK appreciated by 2.2% this week. We remain overweight the NOK based on our bullish outlook for oil. The Trump administration said they would not renew the waivers for Iranian oil exports, a move that roiled the energy market. The spike in oil prices will eventually benefit the Norwegian krone once global growth stabilizes. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden suggest a more positive sentiment: Consumer confidence increased to 95.8 in April, surprising to the upside. Economic tendency survey increased to 102.7 in April. Moreover, the manufacturing confidence also improved to 108.4 in April. USD/SEK appreciated by 2.64% this week. The Riksbank has kept its interest rate unchanged at -0.25% this week, as widely expected. The dovish shift of central banks worldwide is likely to help the global economy, which will benefit the Swedish krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. basic balance is the strongest it’s been in decades. However, the White House’s profligacy threatens this positive. The euro area basic balance is also healthy. Now that the European Central Bank has ended its asset purchasing program, aggregate portfolio flows in Europe have much scope to improve, creating long-term support for the euro. Australia, Canada and New Zealand are likely to suffer deteriorating balance-of-payments trends, which will hamper their performance. Norway is the commodity driven economy that is likely to buck this trend. Stay positive the NOK against the SEK and the EUR as well as against other commodity currencies. Feature Balance-of-payments dynamics can often be overplayed when forecasting G10 FX. While their capacity to forecast FX moves is small on a 12-month horizon, the state of the balance of payments can occasionally take primacy over any other consideration. This is particularly true when global liquidity conditions deteriorate, as it makes financing current account deficits more expensive, often requiring sharp adjustment in currency valuations. Since we have experienced a period of rising financial market volatility and global liquidity has deteriorated, this gives us a momentous occasion to review balance-of-payments conditions across the G10. While the balance-of-payments situation for the U.S. is not as dire as is often argued, the deteriorating fiscal balance suggests that this situation is temporary. This means that balance-of-payments risks are likely to grow for the dollar over the coming years. Meanwhile, depressed portfolio flows into the euro area have a lot of scope to improve, which point to a bullish long-term outcome for the euro. Finally, other than Norway, the commodity currency complex sports tenuous balance-of-payments dynamics, which are likely to deteriorate. This suggests that the CAD, AUD and NZD have downside. As a long-term allocation, selling these currencies against the NOK makes sense as well. The U.S. Despite a strong economy that is lifting import growth, the U.S. trade and current account balances have remained stable since 2014, hovering near -3% of GDP and -2.3% of GDP, respectively. This stability is a consequence of the shale revolution, which has curtailed U.S. oil imports by 3.3 million bpd since 2006. However, thanks to robust growth due in large part to the Trump administration’s deregulatory push as well as last year’s tax cut, the U.S. has been the recipient of large FDI inflows, amounting to 1.4% of GDP, the highest level since 2006. Consequently, the U.S.’s basic balance of payments has rebounded, hitting a record high (Chart 1). Chart 1U.S. Balance Of Payments U.S. Balance Of Payments U.S. Balance Of Payments A strong basic balance of payments has been an important factor behind the greenback’s strength this cycle as net portfolio flows in the U.S. have not been particularly strong, having mostly been driven by weaker official purchases. In this context, the current M&A wave bodes well for the dollar as the U.S. has historically been the recipient of such flows. The U.S. equity market’s overweight towards tech and healthcare stocks strengthens this view. From a balance-of-payments perspective, the biggest risk for the dollar is Washington’s profligacy, which is forcing the world to digest a large stock of USD-denominated liabilities. However, if history is any guide, this risk is likely to drive the dollar lower only once U.S. real rates begin to become less appealing compared to their peers. Since BCA expects U.S. real rates to increase more, widening real rate differentials in the process, the dollar should continue to remain supported this year, especially as investors continue to expect a shallower path for rates than we do. The Euro Area After peaking at 2.4% of GDP, the euro area trade balance has softened to 1.8% of GDP. Rebounding economic activity in the European periphery explains this small deterioration as rising domestic demand tends to lift imports growth, hurting trade balances in the process. Despite this worsening trade balance, the euro area current account surplus remains as wide as ever, clocking in at 3.4% of GDP. This reflects both recent improvements in the European net international investment position as well as the fact that low European rates are curtailing the costs of liabilities. Poor FDI performance mitigates the benefits of the large European current account surplus. Hampered by low rates of return, lingering worries about European cohesion and banks’ health, long-term investors have flown out of the euro area – not in. Nonetheless, despite this negative, the euro area basic balance remains in surplus, creating a small positive for the euro (Chart 2). Chart 2Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments The biggest problem for the euro in recent years has been portfolio outflows, especially in the fixed income sphere. While the weakness in portfolio flows has been a crucial factor preventing the good value in the euro – EUR/USD trades at a 12% discount to its purchasing-power parity equilibrium – from realizing itself, the outlook on this front is improving. The European Central Bank’s negative interest rate policy coupled with its Asset Purchase Program have created a powerful repellent for private fixed-income investors. However, the APP is now over, and European policy rates should move back above zero by year-end 2020. As a result, euro area portfolio flows have room to improve considerably. Once this happens, since the basic balance is already in surplus, the euro will have scope to rally significantly. Japan Burdened by slowing exports to both China and emerging markets, the Japanese trade balance is vanishing quickly. However, it still remains at a wide 3.8% of GDP. This is a direct artefact of Japan’s extraordinarily large net international investment position of 60% of GDP, which generates such large net investment income that even when Japan runs a trade deficit of more than 2% of GDP, as it did in 2014, the current account remains balanced (Chart 3). Chart 3Japanese Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments The flipside of Japan’s structural current account surplus is an FDI balance constantly in deficit. The Japanese private sector generates more savings than the country can use, even after the profligacy of the government is satiated. Essentially, Japanese firms are reluctant to expand capacity in ageing, expensive and deflationary Japan. They prefer to do so outside of the national borders, closer to potential new customers. As a result of this dichotomy between the current account surplus and FDI deficit, Japan’s basic balance of payments is a much more modest 1.1% of GDP. Thus, the long-term and stable components of the Japanese balance of payments are mildly positive for the yen. In terms of stock and bond flows, Japan is currently experiencing significant outflows, driven by Japanese investors moving funds outside the country. Historically, these portfolio flows have been a poor indicator for the yen’s direction, often moving into deficit territory as the yen strengthens. This is because Japanese investors are often hedging their foreign asset purchases. Consequently, money market flows will likely once again determine the yen’s fate. For now, the Bank of Japan remains firmly on hold and U.S. rates are rising, suggesting USD/JPY has room to rally this year. However, the JPY’s cheapness and the favorable balance-of-payments picture of Japan argue that the yen’s weakness is in its final innings. The next big structural move in the yen is higher. The U.K. Despite the post-referendum cheapening of the pound, the U.K. continues to run a massive trade deficit of 6.7% of GDP. The current account looks a bit better but remains at a large deficit of 3.9% of GDP. A current account deficit is not a problem for a currency so long as it can be financed cheaply. Historically, the U.K. has been attractive to long-term foreign investors, with a widening current account deficit often met with a growing net FDI balance, leaving only a small basic balance to finance through other channels (Chart 4). Chart 4U.K. Balance Of Payments U.K. Balance Of Payments U.K. Balance Of Payments This time around, the current account remains wide but net FDI flows have collapsed, from 8% of GDP in 2017 to 1.8% of GDP today. The uncertainty surrounding Brexit explains this deterioration. The financial services sector accounts for more than 50% of the stock of inward foreign investments in Great Britain. As financial services will suffer the brunt of Brexit, those investments have also melted. This means the U.K. will have to depend on portfolio flows to finance its current account deficit. Portfolio investments in the U.K. have grown since mid-2017, explaining the stability in the pound. However, this masks some heightened short-term volatility for the GBP against both the dollar and the euro. In the short-term, as the Brexit deadline quickly approaches, this volatility in both flows and the currency will remain high. On a long-term basis, we expect a benign resolution to Brexit. While large FDIs into the financial sector are forever something of the past, flows into British market securities are likely to improve, as the Bank of England will have room to increase rates once economic activity picks up again after the Brexit fog lifts. Canada The Canadian trade balance never recovered from its pre-Great Financial Crisis health. The rebound in oil prices since January 2016 has done little to help the Canadian trade balance, as Canadian oil trades at a large discount to global benchmarks – a consequence of a lack of pipeline capacity that has trapped Canadian oil where it is not needed. The Canadian current account balance offers little solace, and at -2.7% of GDP is in even worse shape than the trade balance (Chart 5). However, the Canadian basic balance is currently in better condition, as Canada continues to attract net FDIs equal to 2% of GDP. The problem for the country is that FDI inflows have become much more limited by the fact that Canadian oil sands generate little profits at current oil prices – a problem amplified by the lack of exporting capacity. This trend is unlikely to change anytime soon. Chart 5Canadian Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments Portfolio flows remain positive, but at 1.1% of GDP, they are falling sharply. The poor profitability of Canadian resources stocks is obviously a problem there, but the growing risks to the Canadian housing market are also likely to hurt banks’ profitability as well as the aggregate financial sector, which accounts for nearly 40% of the country’s stock market capitalization. As a result, with Canadian yields still lagging the U.S., portfolio flows could also deteriorate further. This combination implies that the balance-of-payments picture for Canada is becoming a growing headwind. Australia Two factors are lifting the Australian trade balance, which stands at a surplus of 0.6% of GDP. As the exploitation of Australia’s large mineral deposits mature, the need for mining capex has declined, which has been limiting the growth of Australian machinery imports. On the other hand, this same maturity means that more minerals are being exported out of Australia. Consequently, since iron ore prices have rebounded 88% since their December 2015 lows, representing a generous boost to Australian terms of trade, the country’s trade balance has significantly improved. The current account balance has mimicked this improvement; however, it remains at a deficit of 2.6% of GDP (Chart 6). Much of the investment required to develop the mineral deposits present in the country came from outside Australia’s borders. As a result, foreign investors are receiving large amounts of income from their investment, generating a negative income balance for the country. Nonetheless, the Australian basic balance is now positive as net FDI flows represent more than 3% of GDP. Chart 6Australian Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Going forward, we worry that China’s slowdown has not fully played out. This means that Australia’s nominal exports could suffer under the weight of falling metals prices, generating a deterioration in the trade balance, the current account and the basic balance. Worryingly, portfolio inflows into the country would also suffer. Finally, Australian households’ high indebtedness, coupled with pronounced overvaluation evident in key cities like Sydney and Melbourne, could further impede capital inflows into the country. This suggests that from a balance-of-payments perspective, the AUD could witness further depreciation, especially as AUD/USD still trades 10% above its purchasing-power-parity fair value. New Zealand The New Zealand trade balance has fallen to -1.8% of GDP, its lowest level in 10 years. This principally reflects stronger imports growth, as exports are currently growing at a 11% annual rate. A consequence of this worsening trade balance has been a widening current account deficit, which now stands at 3.6% of GDP. New Zealand has not been able to attract enough FDI to compensate for its structural current account deficit. As a result, its perennially negative basic balance currently stands at 2.6% of GDP (Chart 7). This lack of structural funding for its current account deficit is linked to its interest rates, which always stand above the G10 average. Thanks to immigration, New Zealand has an economy with an elevated potential growth rate, and thus a higher neutral rate. This means that on average it tends to run a capital account surplus that is matched by a current account deficit. Inversely, the perennial current account deficit requires higher interest rates in order to be financed via capital inflows. Chart 7New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments The problem facing the NZD is that kiwi rates, both at the long and short end of the curve, currently stand below U.S. rates. With a negative basic balance of payments, this creates a natural downward bias to the NZD. The kiwi needs to cheapen enough today that its future returns will be expected to be large enough to compensate for the lower yields offered by domestic securities. Since the real trade-weighted NZD currently trades at a 7% premium to its long-term fair value, so long as the interest rate handicap remains, the path of least resistance points south. Only a sustained rebound in global activity will be able to revert this trend in a durable manner. So far, a sustained rebound in global growth is not in the cards. Consequently, any tactical rally in the kiwi will be temporary. Switzerland The Swiss trade surplus may have declined, but it still remains at a very healthy 4.2% of GDP. This deterioration reflects a pick-up in imports, which have been boosted by a rebound in domestic activity in place since late 2015, as well as the expensive nature of the CHF. The Swiss current account surplus is even larger, standing at 10% of GDP. This large surplus is mainly the consequence of Switzerland’s extremely large net international investment position, which stands at almost 120% of GDP. Such a large pool of foreign assets yields a large income balance, which boosts the current account. After a sudden pickup in net FDI flows last year to 10% of GDP, these flows have violently morphed into a net outflow of 8.3% of GDP. Last year’s positive FDI balance was odd, as countries like Switzerland, which run persistent large positive current account balances, tend to export capital, not import it. A consequence of this sudden reversal was to push the basic balance from a surplus of 17% of GDP to a small surplus of 1.5% of GDP (Chart 8). Chart 8Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments In contrast, Swiss portfolio flows have moved back into a very small surplus, reflecting investors’ desire for safety in a 2018 year full of volatility and global growth disappointments. These flows suggest that generally, investors have been parking their funds in Switzerland, explaining the strengthening of the CHF last year against the EUR. Now that global financial conditions are easing, setting the stage for stabilization in global growth, the expensive CHF is likely to depreciate. The more dovish tone of the Swiss National Bank is likely to catalyze this change. Sweden Since 2016, the Swedish trade balance has been in negative territory, currently standing at 0.6% of GDP. This is a phenomenon not experienced in this country for more than three decades. Two forces have hurt the trade balance. On one hand, boosted by negative interest rates, Swedish consumers have taken on debt and consumed aggressively. This has lifted domestic demand, propping up imports in the process. On the other hand, Sweden is very sensitive to global trade and industrial activity. The slowdown witnessed at the end of last year has dampened Swedish exports. In response to these developments, the Swedish current account balance has declined meaningfully, from 8.3% of GDP in 2007 to 2.2% today. Since Sweden’s net FDI balance is at zero, the basic balance stands at 1.8% of GDP. However, this is toward the low end of its historical distribution (Chart 9). If the deterioration in the current account continues, something we expect as the Riksbank is keeping interest rates at extraordinarily accommodative levels of -0.25%, thus ensuring that import growth will remain robust, the krona will face an increasingly onerous balance-of-payments backdrop. Chart 9Swedish Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The saving grace for the SEK is likely to come from portfolio flows into securities. The trade-weighted krona is cheap, trading at a nearly 2-sigma discount to its long-term fair value, implicitly boosting expected returns from holding SEK-denominated assets. Moreover, the combination of a Riksbank having finally abandoned its efforts to dampen the krona, and some signs of rebound in economic domestic economic activity such as strong PMI readings, points to a high probability of funds flowing into the country. Norway Thanks to rebounding oil prices since 2016, the Norwegian trade balance has also recovered, having moved from a low of 3.8% of GDP to 6.9% of GDP today. This is still well below the levels that prevailed from 2001 to 2013, when the trade balance averaged 14% of GDP. Meanwhile, the Norwegian current account has followed the trend in the trade balance. However, since Norway sports a massive net international investment position equal to 207% of GDP, the current account stands at 7.9% of GDP, boosted by a large income stream from foreign investments. As a country sporting a structural current account surplus, Norway is also an exporter of capital, which means its FDI balance is normally negative. Even though net FDIs today are -4.6% of GDP, the basic balance is nonetheless in surplus at 3% of GDP (Chart 10). This is still a much smaller basic balance than what prevailed from 2001 to 2013. This means that the long-term component of the balance of payments is not as supportive to the NOK as it once was. Chart 10Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Norway also tends to suffer from portfolio outflows. This again is a consequence of the country’s large current account surplus, which is a channel outward via Norway’s massive sovereign wealth fund. Today, the portfolio balance is quite narrow, a consequence of declining oil receipts. However, Norwegian oil production is expected to increase by 50% by 2022. This means that the Norwegian current account will rebound, and portfolio outflows will once again grow. But since portfolios outflows are the mirror image of the current account dynamics, this is likely to be a neutral force for the NOK. Ultimately, we like the NOK because it is very cheap: the real trade-weighted NOK enjoys a one-sigma discount to its long-term fair value. Due to trade-weights, this means the NOK is cheap versus both the EUR and the SEK. Hence, with BCA’s positive view on oil prices and the positive outlook for Norwegian oil production, we would anticipate the NOK performing well against these two currencies on a 12- to 18-month basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth Chart I-1 Chart I-2 The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. Chart I-3 Chart I-4 When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Chart I-5 Chart I-6 Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation Chart I-7 Chart I-8 When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8). Chart I-9 Chart I-10   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions Chart I-11 Chart I-12 The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors Chart I-13   Chart I-14 We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates Chart I-15 Chart I-16   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions Chart I-17 Chart I-18   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 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 has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 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 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2   Recent data in Switzerland has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 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 has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The dollar will continue to rally despite the trade truce agreed upon last weekend between U.S. President Donald Trump and China President Xi Jinping. Not only is this truce far from a permanent deal, but global growth continues to slow. Moreover, if the truce were to generate a genuine improvement in global growth conditions, this would likely result in a much more hawkish Federal Reserve than the market is currently pricing in. This would lead to a further deterioration in global liquidity conditions, causing additional growth problems for the world. Buy EUR/CHF, as the Swiss National Bank will soon have to intervene in the market. Sell AUD/NOK, as oil should outperform metals and the Norges Bank is better placed to tighten policy than the Reserve Bank of Australia. Feature Presidents Donald Trump and Xi Jinping have agreed to freeze additional new tariffs on Chinese exports to the U.S. for three months. This means that as of January 1, 2019, U.S. tariffs on US$200 billion of Chinese exports to the U.S. will remain at 10%, and will not jump to 25%. Meanwhile, China has agreed to immediately resume its imports of soybeans and LNG from the U.S. Moreover, China has also agreed to begin talks to open up Chinese markets to U.S. exports as well as to address U.S. worries regarding intellectual property theft. The world has let out a collective sigh of relief. A potent narrative exists that fears of a trade war have been the root cause of the slowdown in global growth witnessed this year. Consequently, since the dollar performs well when global industrial activity slows, this also means that ending the trade war could be key to abort the dollar’s bull market. We are doubtful this narrative will pan out, and we do not think that the Buenos Aires truce will lead to the end of the dollar rally. This also means that the G-20 armistice is also unlikely to reverse the underperformance of commodity and Scandinavian currencies. First, this truce does not mark the end of the trade war. It is only an agreement to delay the implementation of U.S. tariffs. Come March, the Trump administration may well sing a very different tune. The U.S. domestic political climate has not changed one iota, and protectionism, particularly when directed at China, still wins votes (Chart I-1). Meanwhile, the concessions China is willing to give are long-term in nature; however, Trump wants visible wins well ahead of the 2020 elections. This mismatch creates a real danger that the White House imposes new tariffs again beyond the three-month armistice agreed at the G-20. The news yesterday afternoon that the CFO of Huawei was indicted in Vancouver already casts doubts on the deal. Chart I-1Americans Will Remain Tough On China Waiting For A Real Deal Waiting For A Real Deal Second, the dollar has been strong, and risk assets have been weak for more reasons than the trade war alone. As shown by the slowdown in Japanese or Taiwanese exports, as well as by the contraction in German foreign orders and in the CRB Raw Industrial Index’s inflation, global trade and global growth are slowing (Chart I-2). This development is likely to last until mid-2019, as our global leading economic indicator continues to fall. This deterioration in the global LEI does not look set to stop soon, as normally any improvement in the global LEI is first telegraphed by a stabilization in the Global LEI Diffusion Index – an indicator that is still falling (Chart I-3). Chart I-2Global Growth Continues To Slow Global Growth Continues To Slow Global Growth Continues To Slow Chart I-3No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI China is not yet coming to the rescue either. The slowdown in Chinese economic activity continues, and in fact, the paucity of a rebound in Chinese credit growth despite injections of liquidity by Beijing suggests that a bottom is not yet in sight (Chart I-4). Hopes that were raised by increased bond issuance from local governments have also been dashed as this proved to be a very temporary phenomenon (Chart I-5). What is more worrisome is that so far Chinese exports have held their ground; however, the decline in the new export orders of the Chinese PMI suggests that this support to growth is likely to taper sharply in the coming months (Chart I-6). Chart I-4Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus   Chart I-5Chinese Infrastructure Push Looks Transitory Waiting For A Real Deal Waiting For A Real Deal   Chart I-6Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Finally, despite the cloudy outlook for global growth that built up this year, U.S. yields had risen 80 basis points by November 8, adding stress to economies already negatively impacted by weakening manufacturing activity. This increase in global borrowing costs has worsened the already noticeable decline in U.S.-dollar based liquidity (Chart I-7). This decline in liquidity has been a great source of concern as EM economies, the source of marginal growth in the global economy, have large dollar-denominated debt loads, and thus need abundant dollar liquidity in order to support their economies (Chart I-8). Chart I-7Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Chart I-8...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated This last point is especially unlikely to change in response to the Buenos Aires truce. Since November, 10-year U.S. yields have fallen around 25 basis points, and now fed funds rate futures are only pricing in 45 basis points of rate hikes over the coming two years, including the December hike. If business sentiment improves because of a trade truce, and consequently U.S. capex proves more resilient than anticipated by market participants, the Federal Reserve will increase rates by much more than what is currently priced into the futures curve (Chart I-9). Chart I-9U.S. Rates Have Plenty Of Upside, Even More So If The Trade Truce Becomes A Peace Treaty Waiting For A Real Deal Waiting For A Real Deal This will lift yields, resuscitating one of the first reasons why markets have been weak this fall. This risk is even greater than the market appreciates. After Fed Chair Jerome Powell gave what was perceived as a dovish speech last week, markets were further emboldened to bet on a Fed pause. However, Fed Vice-Chairman Richard Clarida and New York Fed President John Williams have both argued since that the U.S. economy will continue to run above trend and warrants further gradual increases in interest rates. A truce in Buenos Aires may only provide them with more ammunition to implement those hikes. Global liquidity conditions are unlikely to improve significantly anytime soon. Moreover, the truce could also change the calculus in Beijing. Much of the stimulus implemented since last summer in China has been to limit the negative impact of a trade war. However, if a trade war is not in the cards, Beijing has fewer reasons to abandon its deleveraging campaign. It thus raises the possibility that with a risk to China evaporating, the Xi Jinping administration would instead not do anything to limit the slowdown in credit. This implies that Chinese capex would stay weak and that China’s intake of raw materials and machinery would not pick up. This means that the euro area and countries like Australia will continue to lag behind the U.S.  Ultimately, the market speaks louder than anything else. The incapacity for risk assets to catch a bid in the wake of what was good news is disconcerting. It suggests that the combined assault of slowing global growth and a tightening Fed remains the main problem for global financial markets. Hence, in this kind of deflationary environment, the dollar reign supreme – even if U.S. growth were to slow (Chart I-10). Chart I-10A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth Bottom Line: A trade truce in Buenos Aires could have aborted the bull market in the dollar. So far, it has not, and we do not think it will be able to end the dollar’s rally. First, this truce remains flimsy, and does not guarantee an end of the trade war between China and the U.S. Second, global growth continues to exhibit downside. Finally, the Fed is unlikely to change its course and pause its hiking campaign. In fact, if a trade truce is so good for trade, it will give more reasons for the Fed to hike and may even incentivize Chinese authorities to abandon their efforts to cushion the Chinese economy against slowing global trade. Stay long the dollar and keep a defensive exposure in the FX market, one that favors the yen and the greenback at the expense of Scandinavian and commodity currencies. Buy EUR/CHF Despite our view that global growth is set to slow, we are inclined to buy EUR/CHF this week. We expect the Swiss National Bank to stop sitting on its hands as a stronger CHF is becoming too painful. First, as we highlighted last week, aggregate Swiss economic activity is slowing sharply.1 What is more concerning is that consumer spending is also suffering, as shown by the contraction in real retail sales (Chart I-11). This implies that despite record-low interest rates, Swiss households are feeling the pinch of the tightening in Swiss monetary conditions created by the stronger CHF. Chart I-11Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Second, the franc remains a problem for Swiss competitiveness. As Chart I-12 shows, Swiss labor costs are completely out of line with its competitors. This phenomenon worsened significantly after 2008 due to the Franc’s strength vis-à-vis the euro. Despite the weakness in the franc from mid-January 2015 to April 2018, Swiss unit labor costs remain uncompetitive. This means that going forward, either the SNB will have to tolerate a further contraction in wages, something unpalatable as Swiss households have a debt load equal to 212% of disposable income, or the franc will have to fall. Chart I-12The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive Third, the franc’s recent strength is only accentuating the deflationary impact of softer global growth on the local economy. As Chart I-13 illustrates, the recent strengthening in the trade-weighted CHF portends to a potentially painful contraction in import prices, while core inflation is already well off the SNB’s 2% objective. Moreover, as the second panel of Chart I-13 shows, our CPI model suggests that Swiss inflation is about to fall into negative territory again. This would imply that not only will the Swiss economy suffer from the recent strengthening in the franc, but also that Swiss real interest rates are about to increase by 100 basis points, the last thing a slowing economy needs. Chart I-13Swiss Deflation Will Return Swiss Deflation Will Return Swiss Deflation Will Return This economic backdrop suggests to us that after 16 months where the SNB played nearly no active role in managing the CHF exchange rate, the Swiss central bank is about to come back to the market in order to limit the downside in EUR/CHF. This makes buying this cross attractive, as it offers a favorable asymmetric payoff. EUR/CHF generates a small positive carry, has limited downside and offers ample upside if the SNB intervenes – all while offering low volatility. Meanwhile, if global growth picks up, EUR/CHF should also rebound. In fact, the pro-cyclical behavior of EUR/CHF, as well as its asymmetric payoff, increases the attractiveness of this trade within our broadly defensive portfolio stance: It hedges us against being wrong on the global growth outlook and the importance of the trade truce. Furthermore, any resolution to Italy’s battle with Brussels will also boost this cross. Bottom Line: EUR/CHF normally depreciates when global growth slows. While this pattern materialized in 2018, we anticipate EUR/CHF to stabilize and potentially rally, even if global growth slows. The strong CHF is now causing serious pain to the Swiss economy, and the SNB will have to prevent any deepening of the malaise. The SNB is thus set to begin intervening in the market. Additionally, if we are wrong and global growth does not slow further, being long EUR/CHF provides a hedge to our defensive market stance. AUD/NOK To Be Knocked Down An attractive opportunity to sell AUD/NOK has emerged. First, on the back of the weakness in oil prices relative to metals prices, AUD/NOK has caught a furious bid in recent weeks (Chart I-14). However, we expect the underperformance of oil relative to metals to peter off. The main factor that has weighed on petroleum prices is that Saudi Arabia has kept extracting oil at full speed, expecting a shortage of oil in global markets once U.S. sanctions on Iran kicked in. Chart I-14AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices However, with President Trump greatly softening his stance and allowing exemptions for some countries to import Iranian oil, the crude market instead has experienced a mini unforeseen oil glut. OPEC 2.0, just agreed to essentially remedy this problem by limiting their oil output. This should boost oil prices. Meanwhile, slowing global growth centered on slowing Chinese capex will have a much deeper impact on industrial metals prices than on oil. This represents a negative terms-of-trade shock for Australia vis-à-vis Norway. Second, domestic economic conditions also favor betting on a weaker AUD/NOK. Australian nominal GDP growth often weakens when compared to Norway’s ahead of periods of depreciation in AUD/NOK. Today, Australia’s nominal GDP growth is sagging relative to Norway’s, and the contraction in Australia’s LEI relative to Norway suggests that this trend will deepen (Chart I-15). A rebound in oil prices relative to metals prices will only reinforce this process. Chart I-15Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Third, AUD/NOK seems expensive relative to the anticipated path of policy of the Reserve Bank of Australia relative the Norges Bank (Chart I-16). Moreover, the Norwegian central bank has begun lifting rates, and since real interest rates in Norway are still negative, it will continue to tighten policy next year. Meanwhile, the RBA remains reticent to increase interest rates as Australian inflation and wage growth are still tepid. The recent deceleration in Australian GDP growth as well as budding problems in the Aussie real estate market will only further cajole the RBA in its reluctance to lift the cash rate higher. Hence, the real interest rate differentials will continue to point toward a lower AUD/NOK. Chart I-16AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates Fourth, AUD/NOK is once again very expensive, trading at a 12% premium to it purchasing power parity equilibrium (Chart I-17). It only traded for an extended period of time at a richer premium when Brent was free-falling to US$25/bbl. Since we anticipate oil to rebound, such a premium in AUD/NOK is unwarranted. Chart I-17AUD/NOK Is Pricey AUD/NOK Is Pricey AUD/NOK Is Pricey Finally, all our technical indicators show that AUD/NOK is massively overbought (Chart I-18). The study on momentum we conducted last year showed that out of 45 G-10 FX pairs tested, after AUD/SEK, AUD/NOK was the second worst one to implement momentum-continuation trades.2 As a result, we would anticipate that the recent period of overbought conditions will lead to a period of oversold conditions. Chart I-18The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought Bottom Line: Selling AUD/NOK today makes sense. BCA anticipates oil prices to rebound relative to metals prices, the Australian economy is slowing relative to Norway’s, monetary policy is moving in a NOK-friendly fashion, AUD/NOK is expensive, and the cross is well-placed to experience a large episode of momentum reversal.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com  Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “2019 Key Views: The Xs And The Currency Market”, dated November 30, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: The price component of the ISM manufacturing survey underperformed expectations, coming in at 60.7. This measure also declines sharply from the previous month. However, the headline ISM Manufacturing survey surprised to the upside, coming in at 59.3. Total vehicle sales also outperformed expectations, coming in at 17.50 million. The DXY U.S. dollar Index was flat for the past two weeks. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and falling inflation has historically been very positive for this currency. Moreover, the fed will likely hike more than anticipated by the market, providing another tailwind for the dollar until at least the first quarter of 2019. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 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 Europe has been mixed: Retail sales growth underperformed expectations, coming in at 1.7%. Moreover, core inflation also surprised to the downside, coming in at 1%. However, market services and composite PMI surprised positively, coming in at 53.4 and 52.7 respectively. EUR/USD has been flat for the past two weeks. We are bearish on the euro, given that we expect Chinese tightening to continue to weigh on global growth. Furthermore, recent disappointment in euro area inflation confirms our view that it will be very difficult for the ECB to tighten policy. This means that rate differentials will continue to move against EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The Nikkei manufacturing PMI outperformed expectations, coming in at 52.2. Moreover, housing starts yearly growth came in line with expectations, at 0.3%. However, Markit Services PMI came in at 52.3, decreasing from last month’s number. USD/JPY has decreased by -0.4% these past two weeks. We are positive on the yen for the first quarter of 2019. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which should keep decreasing as markets continue to sell off. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Nationwide housing prices yearly growth came in at 1.9%, outperforming expectations. Moreover, Markit manufacturing PMI as well as construction PMI both surprised positively, coming in at 53.1 and 53.4 respectively. However, Markit Services PMI underperformed expectations, coming in at 50.4. GBP/USD has decreased by 0.7% these past two weeks. The pound continues to be a complex currency to forecast. While the pound is cheap and makes for a potentially attractive long-term buy, current political risk continue to make a shorter-term position very risky. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 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 has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.8%. Moreover, building permits month-on-month growth also surprised negatively, coming in at -1.5%. Finally, construction done also surprised to the downside, coming in at -2.8%. AUD/USD has decreased by -0.5% these past two weeks. We believe that the AUD is the currency with the most potential downside in the G10. After all, the Australian economy is the economy in the G10 most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Building permits month on month growth outperformed expectations, coming in at 1.5%. However, retail sales as well as retail sales ex-autos both declines from the previous quarter, coming in at 0% and 0.4%. NZD/USD has increased by 1% these past two weeks. After being bullish in the NZD for a couple of months, we have recently turned bearish, as we believe that this currency is very likely to suffer in the current environment of declining inflation and global growth. With that said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 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 has been positive: Retail sales month on month growth outperformed expectations, coming in at 0.2%. Moreover, headline inflation also surprised to the upside, coming in at 2.4%. Finally, the BOC core inflation measure increased from last month’s number, coming in at 1.6%. USD/CAD has risen by 1.7% these past two weeks. A lot of this weakness was caused by the dovish communication of the Bank of Canada following their announcement to keep rates on hold at 1.75%. This change in stance is likely a response to the collapse in oil prices in the past months. With that in mind, we are inclined to believe that the CAD might be reaching oversold levels, as oil is likely to stabilize and the economy continue to show signs of strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.4%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 99.1. Finally, headline inflation also surprised negatively, coming in at 0.9%. EUR/CHF has decreased by 0.5% these past two weeks. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover, registered unemployment also surprised negatively, coming in at 2.3%. Finally, the credit indicator came in line with expectations at 5.7%. USD/NOK has been flat these past two weeks. We are shorting AUD/NOK this week, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency shows one the most mean reverting tendencies in the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 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 has been negative: Consumer confidence underperformed expectations, coming in at 97.5. Moreover, retail sales growth also underperformed expectations, coming in at -0.1%. Finally, gross domestic product yearly growth also surprised negatively, coming in at 1.6%. USD/SEK has fallen by roughly 1% these past two weeks. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank continues to be too dovish given the current inflationary backdrop. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades