Euro Area

Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... Chart I-5Harder Brexit Means ##br##Retailers Underperform... Chart I-6...Travel And Leisure Underperforms... Chart I-7...And Real Estate Underperforms Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. 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 10 * 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 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. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper Chart 2European Inflation Is Stubbornly Low The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down Chart 4Inflation Expectations Will Stay Low Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields Chart 7ECB Needs To Keep The Monetary Base Growing As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit Chart 11Lowering The Yield Floor For QE Makes Sense Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 2016, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer Chart I-4Residential Investment Will Improve Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow Chart I-6Favorable Technical ##br##Backdrop For The Greenback Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-à-vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken Chart I-12Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil Chart I-16The BoC Is Looking The Other Way... The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So Chart I-18Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Chart I-20Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights When interest rates are ultra-low, central banks have no margin for policy error. A small loosening or tightening has the potential to produce either a stall or catastrophic turbulence. The analogy is flying a plane at high altitude. Bond investors should have a strong preference for U.S. T-bonds over German bunds (currency hedged). Currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere, once a sufficient equity risk premium is factored in. But a setback in the region of 5-10% could create a tactical entry point. Feature As the ECB Governing Council convenes for its October monetary policy meeting, an experience familiar to pilots1 provides a perfect analogy for central banks' very limited margin for error. Pilots call the experience "flying in coffin corner." Chart of the WeekUnusually High Turbulence For The German 30-Year Bund Next time you're in a plane climbing to 35,000 feet, here's something to think about; or perhaps, not to think about. As the plane gains altitude, its stall speed increases while its upper speed limit simultaneously decreases. For the pilot, this means less and less margin for error (Figure I-1). The plane's stall speed is the minimum speed to generate sufficient lift. At higher altitude, as the air gets thinner, the stall speed increases. Meanwhile, the plane's upper speed limit is set by the speed of sound. Airliners cannot fly too close to the speed of sound because the sonic shockwave produces violent and catastrophic turbulence. At higher altitude, as the air temperature drops, so does the speed of sound. Which means the plane's upper speed limit decreases. By the time the plane has reached the rarefied atmosphere of 35,000 feet, these lower and upper speed limits are barely 25 knots (30mph) apart,2 leaving almost no room for flight data misinterpretation or pilot error.3 Hence, at high altitude pilots morbidly say they are "flying in coffin corner." Analogously, in the rarefied atmosphere of zero or near-zero interest rates, central bank policy is also in coffin corner. When short-term and long-term interest rates approach the zero bound, there is no room for economic data misinterpretation or policy error. A small loosening or tightening of monetary policy has the potential to produce either a stall or catastrophic turbulence (Figure I-2 and Chart of the Week). Figure I-1Flying At High Altitude ##br## Has No Margin For Error Figure I-2Monetary Policy At Ultra-Low Rates ##br##Has No Margin For Error Avoiding A Stall At today's zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system, and thereby stalling the economy. A bank's core business is simple. Take in deposits, and lend them out at a higher interest rate than the deposit-rate - with the difference in the two defining the bank's net interest margin. A part of the net interest margin is a compensation for the risk of non-performing loans. This should be profit-neutral if correctly priced. The other large part of the net interest margin comes from the interest rate term-structure, as loans tend to be long-term while deposits are short-term. Hence, all else being equal, the bank's profitability suffers as the term-structure flattens. For a while, the bank can protect its profitability by cutting the interest rate paid on short-term deposits to well below the policy rate. However, once the policy rate hits zero, this profit-protection strategy hits a wall - because a negative deposit rate would risk an exodus of deposits into cash or cash-substitutes. Alternatively, the bank could charge a higher rate to borrowers, but this would tighten credit conditions. The third possibility is for the bank to suffer a hit to its already-thin net lending margin, but this would also tighten credit conditions. The pressure on the bank's profitability and share price would increase the cost of equity, making it harder to raise capital (Chart I-2). Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions. The paradox is that at the zero bound, the smallest additional monetary loosening - via interest rate cuts or QE - risks stalling euro area bank credit creation (Chart I-3). Thereby it risks stalling economic growth. Chart I-2The ECB's QE Has Hurt Bank Valuations Chart I-3The Interplay Between Bank Profits And Bank Credit Creation Avoiding Violent Turbulence An extended period of ultra-low interest rates, and a commitment to keep them structurally low, has compressed the yields on government bonds pushing up their prices. As competing asset classes, the prices of corporate bonds and equities have also increased. This phenomenon is called the Portfolio Balance Effect. The big problem is that the prices of riskier assets have increased by more than is justified by the portfolio balance effect alone. This distortion is the result of a behavioural finance phenomenon called Mental Accounting Bias. Mental Accounting Bias describes the irrational distinction between the return from an investment's yield and that from its capital growth. The distinction is irrational because the money that comes from yield and the money that comes from capital growth is perfectly fungible.4 Rationally, what should matter is an investment's total return. But psychologically, the distinction between yield and capital is very stark. Fears about self-control cause people to compartmentalise yield as spending money and capital as saving money. Hence, people who want their investments to generate spending money - say, retirees - have an irrational focus on yield. Traditionally, the safe income from cash and government bonds satiates the people who irrationally focus on yield. However, in recent years, central banks' extended experiments with ZIRP, NIRP and QE have forced these yield-focussed investors out of cash and government bonds into risky investments. And just like every distortion, this phenomenon has generated memes to justify the act: 'reach for yield', 'search for yield', and 'there is no alternative' (TINA). But the irrational focus on yield instead of total return has artificially bid up the prices of risky investments. To the point that they no longer offer a sufficient risk premium5 for the very real possibility of substantial losses over a 5-10 year horizon (Chart I-4 and Chart I-5). The unfortunate thing is that as central bankers have little expertise in psychology or behavioural finance, they have been blind to the very dangerous behavioural distortion that their monetary policy experiments have unwittingly unleashed. Chart I-4A Positive Yield On Equities##br## Can Produce A Negative 5-Year Return... Chart I-5...And Even A Negative ##br##10-Year Return The risk is that the smallest monetary tightening could trigger an aggressive unwinding of this behavioural distortion. Recall the violent turbulence in global financial markets at the start of the year after just one 25bps rate hike from the Federal Reserve. Now consider what might happen if the Fed hiked again and the ECB simultaneously announced a rapid tapering of its QE program. How Must The Pilots Fly? In a rarefied atmosphere, pilots have very little margin to alter speed without inducing a stall or violent turbulence. The same applies to central banks today. The ECB has the hardest piloting task. It is becoming difficult to justify the current aggressive pace of QE given the danger of stalling the euro area banking system; and given that the euro area's nominal GDP and nominal wage bill are both growing at a very respectable 3% (Chart I-6). But an abrupt end to the ECB's QE could create violent turbulence in QE-distorted financial markets. Chart I-6What Deflation Threat? Euro Area Nominal GDP And The Wage Bill Growing At 3% Hence, the ECB's best course of action is to hint at a very gradual deceleration of QE to start at some point in the second half of 2017. Turning to developed economy central banks in general, we remind readers of a very powerful observation. Since 2008, no major central bank has been able to hike interest rates by more than 1.75%. And every central bank that has hiked rates has had to start unwinding those hikes within a year, ultimately taking the policy rate to a new all-time low (Chart I-7 and Chart I-8). Chart I-7Since 2008, All Rate Hikes ##br##Have Been Quickly Reversed Chart I-8Will The U.S. Be ##br##Any Different? No Given the turbulence that rate hikes will generate in the financial markets and/or the economy, we fully expect the Federal Reserve to go through exactly the same experience. The important upshot is that global central bank policy through 2017-18 will be considerably less divergent than is discounted. Bond yields could creep higher in the short term. But on a 1-year horizon, bond investors should have a strong preference for U.S. T-bonds over euro area bonds, and especially over German bunds (currency hedged). Over the same horizon, currency investors should prefer the euro over the dollar. For equity investors, valuations do not appear structurally attractive anywhere once a sufficient equity risk premium is factored in. Moreover, the potential for ECB QE-tapering combined with expectations for a Fed rate hike could generate some near-term turbulence. That said, a setback in the region of 5-10% could create an excellent entry point for a 3-month trade. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. Last week's long silver/short lead pair trade has bounced sharply. And the short U.K. A-rated corporate bonds trade has achieved its 4% profit target. 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-9 * 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 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. 1 Your author is a former pilot in the Royal Air Force reserve. 2 For an Airbus A330. 3 Tragically, a combination of flight data misinterpretation and pilot error at 35,000 feet was disastrous for Air France flight AF447 flying from Rio de Janeiro to Paris in June 2009. Going through a storm, the airspeed indicator started giving a false reading and the pilot took the wrong corrective action, resulting in a catastrophic stall. 4 Assuming no difference in tax treatment of income and capital gains. 5 Please see the European Investment Strategy Weekly Report "The Great Distortion... And How It will End" dated September 15, 2016 available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

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

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