Euro Area

Highlights One of the biggest mistakes in finance is to equate risk with volatility. The correct measure of risk is the negative skew in payoff distributions. If 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. This would be the point at which to scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Feature It is the crucial question that all investors should ask at all times. What is the relative risk of the two major asset classes - bonds and equities - and are their relative return prospects commensurate with the relative risk? Chart of the WeekBelow A 2% Yield, 10-Year Bonds Are Riskier Than Equities But first, there is an even more fundamental question: what do we mean by risk? Conventional wisdom says that the risk of an investment is captured by its volatility. Indeed, through instruments such as the VIX futures and currency volatility options, volatility has become a multi-trillion dollar asset-class in its own right. Therefore, volatility must measure the risk of an investment, right? Wrong. The Biggest Mistake In Finance As a measure of risk, volatility is clearly wrong. Volatility regards price gains in exactly the same way as it regards price losses. But investors don't mind gains, they only mind losses! Consider an investment whose price moves alternately sideways and sharply higher. The maths would say that the returns have high volatility, implying that the investment is very risky. In truth though, the investment is highly desirable and 'risk-free' - because its price never declines. At our recent New York conference, Nobel Laureate Daniel Kahneman warned that one of the biggest mistakes in finance is to equate risk with volatility. After decades of empirical and theoretical studies - which culminated in the 2002 Nobel Prize for Economics - Kahneman proved that investors are not concerned about the symmetrical fluctuations in investment returns. Instead, they are concerned about the asymmetry - or skew - in payoff distributions. Kahneman explained the underlying psychology. "People are limited in their ability to comprehend and evaluate extreme probabilities, so highly unlikely events are overweighted." If the payoff distribution is symmetric, the overweighting of unlikely events in the loss tail and the gain tail exactly cancels out. But if the distribution is asymmetric, the longer tail determines the perceived attractiveness of the payoff. Where the longer tail is on the gain side, the distribution is said to have positive skew (Figure I-1). The classic example is a lottery. When people play the lottery, their loss is limited to the ticket price, but their gain could be tens of millions. People perceive the positive skew as attractive because they overweight the minuscule probability of becoming a millionaire. As a result, they overpay for the lottery ticket versus its expected value. Where the longer tail is on the loss side, the distribution is said to have negative skew (Figure I-2). This is like a lottery in reverse. The gain size is relatively limited, but the loss could be very large. People perceive the negative skew as unattractive because they overweight the probability of a large loss. As a result, they demand overpayment to take it on. Figure I-1People Like Positive Skew Figure I-2People Dislike Negative Skew For investments with negative skew, this overpayment takes the form of an excess return demanded from the market - a 'risk premium' - versus investments with less negative skew. Are Bonds A Greater Risk Than Equities? We are now in a position to tackle the question in the title. To determine whether bonds are riskier than equities or vice-versa, we must compare the skews of their return profiles.1 The important point is that for a bond, the skew of its return profile changes with its yield. At yields above 2.5%, 10-year bond returns show no skew. Worst losses broadly equal best gains. However, when yields drop below 2%, returns start to exhibit negative skew (Chart I-2). And at yields below 1%, the negative skew becomes extreme. Chart I-2Bond Risk Increases At ##br##Low Bond Yields Chart I-3Equity Risk Does Not Increase At##br## Low Bond Yields The reason is obvious. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Close to this lower bound for yields, bond mathematics necessarily creates a negatively skewed return profile. Simply put, prices have little upside, but they have a lot of downside! Chart I-4A 40Bps Rise In Yields Would Make Global ##br##Bonds Riskier Than Equities Turning to equities, the empirical evidence shows that equity returns always exhibit negative skew. Worst losses are typically around 1.5 times the size of best gains (Chart I-3). But the negative skew of equity returns is largely independent of the bond yield. The upshot is that there is a crossover bond yield below which the negative skew on 10-year bonds exceeds that on equities. This crossover bond yield is around 2%. In negative skew terms, we can say that at a 10-year bond yield below 2%, 10-year bonds are riskier than equities. And at a yield above 2%, equities are riskier than 10-year bonds (Chart of the Week). So in negative skew terms, 10-year bonds are riskier investments than equities in Europe and in Japan. But equities are riskier investments than 10-year bonds in the United States. Still, given that developed financial markets tend to move en masse, the relationship that is most significant is the aggregate one. At a global level, 10-year bond yields are 40bps below the crossover yield at which equities become riskier than bonds (Chart I-4). QE Distorted The Relative Valuation Of Equities Versus Bonds Which segues us neatly to today's ECB monetary policy meeting. Many people, worried about the end of QE, point out that the $10 trillion of bonds that the 'big four'2 central banks have bought is not far short of the size of the euro area economy. However, in the context of a global fixed income market of $220 trillion,3 $10 trillion of buying is small change. For the $220 trillion global bond and bank loan complex, the much more significant driver of yields has been the expected path of policy interest rates. As ECB Chief Economist Peter Praet put it, serial QE has been nothing more than "a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates." Chart I-5A Promise To Keep The Policy Rate Ultra-Low ##br##Pulls Down Bond Yields Central bankers know that QE depressed bond yields by signalling an extended period of ultra-low interest rates (Chart I-5). They also know that if the prospective return on bonds drops, so must the prospective return on competing investments such as equities. Thereby, the absolute valuations of bonds and equities both rise. However, one largely overlooked impact of QE - even by central bankers - has been the effect on the relative valuation of equities versus bonds. To repeat, when 10-year bond yields drop below 2%, their return distribution becomes more negatively skewed than that for equities. But if bonds become riskier investments, the 'risk premium' (excess return) on equities must disappear. Meaning equity valuations and prices get a second boost, compressing the prospective 10-year equity return to become 'bond-like'. Is this the case? Unlike for 10-year bonds, we do not know the 10-year prospective return from equities with certainty. However, we can get a good estimate from today's starting valuation. But which valuation metric to use? We are cautious of using profit based metrics as these will be flattered by the advanced position in the business cycle as well as the structural uptrend in profit margins. Instead, at an aggregate level, world equity market capitalisation to world GDP has been an excellent predictor of the prospective 10-year return on world equities. Today, this valuation metric is at the same level as in 2000 and 2007, and implies a prospective return of less than 2% a year (Chart I-6). Chart I-6World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Nevertheless, while the global 10-year bond yield stays below 2%, this is a sustainable valuation for equities. Effectively, equities and bonds are offering broadly similar negative skews, and therefore should offer broadly similar prospective returns. However, if 10-year bond yields should rise another 40 bps, equities would become riskier than bonds and elevated equity valuations would become much harder to sustain. Though not there yet, this would be the point when we would scale back equity exposure. The corollary for bonds is that 10-year yields cannot sustainably rise more than 40bps before experiencing a tradeable reversal. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 One simple way to quantify this skew is to find an extended period of time in which the price ended where it started, and then to calculate the period's worst 3-month loss as a multiple of the best 3-month gain. We define skew = -ln(worst 3-month loss / best 3-month gain) using log returns for 3-month loss and 3-month gain. 2 The Federal Reserve, ECB, Bank of Japan and Bank of England. 3 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. Fractal Trading Model* This week's trade is to position for an underperformance of the Japanese energy sector (led by JXTG Holdings And Inpex) versus the overall Japanese market. This is a longer trade than normal with a maximum duration of 26 weeks. Set a profit-target at 8% with a symmetrical stop-loss. 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-7 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 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 Trade #1: Go Short The December 2018 Fed Funds Futures Contract. The trade has gained 64 bps since we initiated it. We are lifting the stop to 60 bps and targeting a profit of 75 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities. The trade is up 13.1%. We are targeting a profit of 15%, and are tightening the stop further to 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts. The trade is up 0.7%. We see this as a multi-year trade with significant upside potential. The unwinding of heavy short positions could cause the yen to strengthen temporarily. The euro is vulnerable to negative growth surprises. A retracement of some of its recent gains is likely. Feature Looking Back, Thinking Forward I had the pleasure of speaking at BCA's Annual Investment Conference held in New York on September 27th of last year where I offered three "tantalizing" trade ideas. Chart 1 reviews their performance. They were the following: Trade #1: Go Short The December 2018 Fed Funds Futures Contract We argued last summer that U.S. growth was likely to accelerate, taking rate expectations higher. That has indeed happened. Aggregate hours worked rose by 2.5% in Q4 over the previous quarter. Assuming that productivity increased by 1.5% in Q4 - equal to the pace recorded in Q3 - real GDP probably increased by nearly 4%. A variety of leading indicators point to continued above-trend growth in the months ahead (Chart 2). Chart 1Three Tantalizing Trades: ##br##An Update Chart 2Leading Indicators Pointing ##br##To Above-Trend U.S. Growth We think the Fed will raise rates four times this year, one more hike than projected by the dots and roughly 35 bps more in tightening than implied by current market expectations. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. We have been saying for a while that above-trend growth will take the unemployment rate down to a 49-year low of 3.5% by the end of this year. If the unemployment rate falls this much, the Fed will probably turn more hawkish. Stronger inflation numbers should also give the Fed confidence to keep raising rates once per quarter. Core inflation surprised on the upside in December. We expect this trend to continue in the coming months, as the ISM manufacturing index, the New York Fed's Inflation Gauge, and our own proprietary pipeline inflation index are already foreshadowing (Chart 3). Chart 3U.S. Inflation ##br##Should Accelerate Chart 4A Pick-Up In Wage Growth ##br##Would Put Upward Pressure On Service Inflation As we noted two weeks ago,1 service sector inflation should get a lift from faster wage growth this year (Chart 4). Goods inflation should also rise on the back of higher oil prices and the lagged effects of a weaker dollar (Chart 5). In addition, health care inflation is likely to pick up from its current depressed level, especially if the Congressional Budget Office is correct that insurance premiums will rise due to the elimination of the individual mandate (Chart 6). Housing inflation will moderate, but this is unlikely to stymie the Fed's tightening plans since excessively low interest rates could lead to even more overbuilding in the increasingly vulnerable commercial real estate sector. Chart 5Higher Oil Prices And A Weaker Dollar ##br##Are A Tailwind For Inflation Chart 6Health Care Inflation ##br##Should Move Higher Granted, four rate hikes equal four opportunities to defer raising rates. It is easy to imagine scenarios where the Fed stands pat, but hard to conjure scenarios where the Fed has to raise rates five times or more this year. Thus, the risk to our four-hike view is to the downside. As such, we will be looking to take profits of 75 bps on the trade, and are putting in a stop of 60 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities Capital spending tends to accelerate in the late innings of business-cycle expansions. We are in such a phase now, as evidenced by capital goods orders, capex intention surveys, and our global capex model (Chart 7). Increased capital spending will benefit industrial companies. Conversely, rising bond yields will hurt rate-sensitive utilities. Valuations in the industrial sector have gotten stretched, but are not at extreme levels (Chart 8). Based on enterprise value-to-EBITDA, industrials are still only slightly more expensive than utilities compared to their post-1990 average. Chart 7Capex Is Shifting Into ##br##Higher Gear Chart 8Industrial Stocks: Valuations Are Stretched, ##br## But Not Yet Extreme While we do think global growth will slow this year from the heady pace of 2017, it should remain firmly above-trend. A bigger-than-expected slowdown - especially if it is concentrated in China - would undoubtedly hurt industrials. A stronger dollar could also be a headwind. Thus, we are keeping this trade on a short leash, with a target of 15% and a stop of 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The Japanese economy is on fire. Growth almost reached 2% in 2017 and leading indicators suggest a solid start to 2018 (Chart 9). The unemployment rate has fallen to 2.7%, a full point below 2007 levels. The ratio of job openings-to-applicants has surpassed its bubble peak. The Tankan Employment Conditions Index is pointing to an exceptionally tight labor market. Wages excluding overtime pay are rising at the fastest pace in twenty years (Chart 10). Chart 9Japanese Growth Momentum Is Positive Chart 10Signs Of A Tight Labor Market Inflation is low but is starting to edge up. The most recent release surprised on the upside. Inflation expectations moved higher on the news, benefiting our long Japanese 10-year CPI swap trade recommendation (Chart 11). A simple scatterplot between the unemployment rate and core inflation suggests the Phillips curve remains intact in Japan -- amazingly, it even looks like Japan (Chart 12)! Chart 11Inflation Expectations Have Edged Higher Chart 12The Phillips Curve In Japan Looks Like Japan Still, with core inflation excluding food and energy running at only 0.3%, there is a long way to go before inflation reaches the BoJ's target -- and even longer if the BoJ honours its promise to generate a meaningful overshoot to compensate for the below-target inflation of prior years. This suggests the BoJ will not meaningfully water down its Yield Curve Control regime anytime soon. As such, five-year yields are likely to stay put while yields with maturities in excess of ten years should move higher. Our "tantalizing trade" being short 20-year JGBs versus their 5-year counterparts still has a long way to run. Too Risky To Short The Yen The exceptionally strong correlation between USD/JPY and U.S. Treasury yields has broken down this year (Chart 13). Had the relationship held, the yen would have actually weakened against the dollar. Still, we are reluctant to get too bearish on the yen (Chart 14). The yen real effective exchange rate is close to multi-decade lows. Positioning on the currency is heavily short. The current account surplus has mushroomed from close to zero in 2014 to 4% of GDP at present. And even if the BoJ keeps the Yield Curve Control regime in place, investors may still anticipate its demise, leading to a temporary bout of yen strength. Chart 13Strong Correlation Is Broken Chart 14Too Risky To Short The Yen What's Propping Up The Euro? The euro has been on a tear since last week, egged on by the ECB minutes, which hinted at a faster pace of monetary normalization. Growing confidence that Angela Merkel will be able to form a grand coalition also helped the common currency, along with hopes that the new government will loosen the fiscal purse strings. The euro is often thought of as the "anti-dollar." And sure enough, the euro's strength has been reflected in a broad-based decline in the dollar index in recent days. BCA's Global Investment Strategy service went long the dollar on October 31, 2014. We "doubled up" on this call in the fall of 2016, controversially arguing that "Trump will win and the dollar will rally." Obviously, in retrospect, I should have rung the register and declared victory on our long dollar view when I had the chance. EUR/USD fell to 1.04 on December 2016, within striking distance of our parity target. Bullish dollar sentiment had reached unsustainably lofty levels. That was the time to sell the greenback. But hubris got the best of me. While our other currency trade recommendations have delivered net gains of 11% since the start of 2017, the long DXY trade has stuck out like a sore thumb. Hindsight is 20/20. The key question is what to do today. EUR/USD is still trading below the level it was at when we went long the DXY. Relative to the IMF's Purchasing Power Parity exchange rate of 1.32, the euro is 7% undervalued. That said, PPP exchange rates may not be a reliable benchmark in this case. Given current market expectations, EUR/USD would need to strengthen to 1.41 over the next ten years just to cover the carry cost of being short the dollar. Even assuming lower inflation in the euro area, that would still leave the euro trading above its long-term fair value. It is possible, of course, that rate differentials will narrow further, but the scope for this is more limited than it might appear. The market currently expects policy rates ten years out to be 95 basis points higher in the U.S., down from a spread of nearly 180 basis points in late December (Chart 15). Given that euro area inflation expectations are 40-to-50 bps lower than in the U.S., this implies a real spread of about 50 bps - broadly in line with our estimate of the real neutral rate gap between the two regions. Ultimately, the fate of the euro in 2018 will rest on the same question that drove the currency in 2017: Will euro area growth surprise on the upside, prompting investors to price in a faster pace of monetary normalization? The bar for success is certainly higher at present. Chart 16 shows that euro area consensus growth estimates have risen significantly since the start of last year. The expected lift-off date for policy rates has also shifted in by more than a year to mid-2019. Considering that Jens Weidmann stated earlier this week that he thinks current market pricing is broadly consistent with when the ECB expects to hike rates, there is little scope for the lift-off date to move forward. Chart 15Little Scope For Rate Differentials ##br## To Narrow Further Chart 16Euro Area Growth Estimates Have Been Revised Up ##br##Since The Start Of 2017 Meanwhile, financial conditions have tightened significantly in the euro area relative to the U.S., the euro area credit impulse has turned negative, and the U.S. economic surprise index has jumped above that of the euro area (Chart 17). Euro area inflation has also dipped. Especially worrying is that core inflation in Italy has fallen back to a near record-low of 0.4% (Chart 18). How is Italy supposed to navigate its way out of its debt trap if nominal growth stays this weak? On top of all that, long speculative euro positions have soared to record-high levels (Chart 19). Given the choice of betting whether EUR/USD will first hit 1.30 or 1.15, we would go with the latter. If our bet turns out to be correct, we will use that opportunity to shift to neutral on the dollar. Chart 17The Euro Is Vulnerable ##br##To Negative Growth Surprises Chart 18Euro Area Core Inflation ##br##Has Dipped Chart 19Euro Positioning: From Deeply Short ##br##To Record Long Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The euro is in a cyclical bull market. It is supported by attractive valuations, improving balance of payments dynamics, declining political risk, potential shifts in reserves preferences, and a re-rating of the European terminal rate. This positive cyclical backdrop hides a more treacherous short-term outlook. EUR/USD is vulnerable because ECB members are increasingly worried, the European periphery is displaying early strains, European inflation will slow versus the U.S., global industrial activity may experience a mini down cycle, and sentiment measures are massively stretched. Short EUR/JPY for now, and use any move in EUR/USD to 1.15 or lower to buy this pair. Feature The euro has undergone a major paradigm shift over the course of the past 16 months. In December 2016, the euro was trading near parity, and expectations were uniform that it would fall well below that threshold. The narrative was simple: Europe was turning Japanese, with inflation forever moribund; also, Europe was succumbing to the siren call of nationalism and populism, which meant the euro was bound to break up within the next five years. Meanwhile, the U.S. was on the rebound. Core consumer price inflation was above 2.2%, and U.S. President Donald Trump was set to massively stimulate the American economy, giving a free hand for the Federal Reserve to hike to its heart's content. Today, the picture could not be more different. Investors expect the European Central Bank's first hike to materialize in the summer of 2019, European growth is stellar, and European inflation is not low enough to warrant emergency-level policy rates. As a result, not only is EUR/USD trading above 1.20, but consensus forecasts increasingly see the euro trading into the 1.25 to 1.30 zone by year end. Is EUR/USD at 1.22 a buying or a selling opportunity? Short-term risks are currently elevated for the euro, but a move toward 1.15 would represent a buying opportunity, as the cyclical bear market in the euro is over. The Long-Term Bull Case A crucial long-term positive factor for the euro is that it is cheap. EUR/USD currently trades at a 10% discount to its purchasing-power-parity equilibrium, even after a nearly 17% rally since its December 2016 low. Encapsulating this concept, the real effective exchange rate for the euro remains well below equilibrium (Chart I-1). Additionally, our fundamental long-term fair value model pegs the euro as being almost 1-sigma undervalued. The euro area's balance of payment is also very favorable. It is well known among the investment community that the euro area sports a surplus of 3.5% of GDP, but significant changes are also materializing in the capital account. Portfolios outflows out of the euro area have begun to decrease, as equity inflows are rising and bond outflows are becoming smaller. Moreover, the euro area basic balance is moving into positive territory, which historically has been a precursor to sustainable euro rallies (Chart I-2). The supply of euro for international markets is therefore decreasing. Additionally, the euro area's net international investment position (NIIP), which was as low as -17% of GDP in 2014, will likely move into positive territory toward the end of the year. The NIIP has historically been a strong driver of long-term exchange rate moves.1 Chart I-1The Euro Is Still Cheap Chart I-2The European Balance Of Payments Has Improved Politics too have been moving in the right direction. Euro skepticism is not taking hold in the euro area: Last year's French election was a vivid demonstration that "more Europe" is not electoral poison. Even the Italian elections this coming March may not land much of a blow to the European project: The Five Star Movement is rapidly softening its anti-euro rhetoric, and support for centrist parties is strengthening (Chart I-3). Moreover, a German move toward a grand coalition means Angela Merkel's CDU is very likely to be governing along with a pro-euro SPD, whose campaign theme was "MEGA": Make Europe Great Again. Already, Germany is lending a listening ear to some of Macron's integrationist proposals, and fiscal stimulus could well be in the pipeline. Long-term reserves diversification is also in the euro's favor. A headline last week suggested that China would unload some of its vast holdings of Treasurys. This leak was soon condemned as "Fake News" by China's State Administration of Foreign Exchange. However, while the news clearly lacked substance, the reality remains that despite the euro area and the U.S. being similarly sized economies, the euro only represents 20% of allocated global reserves, compared to 65% for the greenback. The greater depth and liquidity of U.S. bond markets contributes to this discrepancy, but the ECB's bond buying, by creating a scarcity of euro denominated securities, has exacerbated the disparity. This latter handicap for the euro will end sometime next fall, and if Europe's integrates further, European bond markets will increasingly become alternatives to U.S. ones. A rebalancing of reserves would principally help the euro by hurting the U.S. dollar: It will become more tenuous for the U.S. to achieve a positive international income balance while sporting a NIIP of -40% of GDP if official international demand for dollars falls (Chart I-4). Chart I-3Italian Centrists Are Gaining Ground Chart I-4The USD Needs Its Reserve Status Finally, the terminal rates differential between the U.S. and the euro area remains well above its long-term average of 110 basis points. Thus, there is scope for a normalization of European terminal rates relative to the U.S. on a long-term basis (Chart I-5). However, an average is only a number. What forces could cause the terminal rate spread between the euro area and the U.S. to normalize over the coming years? European policy is currently very loose when compared to the U.S., which will enable the ECB to play catchup over the coming years. To make this judgment, we look at broad money supply in excess of money demand. Because money demand is an unobserved variable, we have to estimate it. Economic theory argues it should be a positive function of economic activity, wealth and uncertainty. Therefore, to get a sense of what money demand may be, we regress the real broad money aggregates of various countries on uncertainty indices and real wealth.2 The difference between real broad money supply numbers and these estimates represent excess money supply. If a country's excess money is being generated today, it ends up stimulating future economic activity and inflation. This increase in expected nominal growth should contribute to lifting expected interest rates at the long end of the yield curve - i.e. expected terminal rates. As Chart I-6 shows, the stock of excess money supply in the U.S. has stopped growing since 2015. However, it is currently exploding in the euro area as European commercial banks are regaining their health and lending again. The money supply dynamics in Europe signal that the easy policy of the ECB is finally bearing fruit. And as the bottom panel of Chart I-6 illustrates, when European excess money supply increases relative to the U.S., as is currently the case, EUR/USD experiences cyclical rallies.3 This counterinituitive result exists because previous ECB easing is bearing fruits, European asset returns are rising, and economic activity is increasing. As a result, the European terminal rate now has more scope to rise vis-à-vis the U.S. The steepening of the German yield curve relative to the Treasury curve only confirms this message (Chart I-7). Chart I-5The U.S. Terminal Rate Has Room To Fall##br## Against That Of Europe Chart I-6European Excess##br## Money Is Surging Chart I-7Listen To Yield ##br##Curves The five forces described above imply that the euro's move from 1.03 to 1.21 was the first salvo in what is likely to be a long cyclical bull market that could end up driving the euro above 1.40 over many years. However, these factors provide little insight regarding the euro's path over the next three to six months. Bottom Line: The euro is likely to have embarked on a cyclical bull market at the beginning of 2017. Five factors support this judgment: The euro is cheap, the European balance-of-payment backdrop is favorable, political winds in the euro area remain favorable to further European integration, global foreign exchange reserves are very underweight the euro, and the spread between U.S. and euro area expected terminal rates remains well above its long-term average, and has scope to narrow. Murkier Short-Term Outlook While the long-term outlook is very favorable for the euro, the shorter-term outlook is much more clouded. First, the chorus of complaints against the euro's strength is growing among European central bankers. In recent days, not only have Vitor Constâncio and Francois Villeroy voiced concerns over the euro's recent strength, but so has Ewald Nowotny, the rather hawkish Austrian central banker. Additionally, Bundesbank President Jens Weidmann stated that the market should not anticipate a rate hike before the summer of 2019, suggesting he would not want to see a more aggressive rate pricing than what is currently at play (Chart I-8). Second, the less competitive and more fragile European periphery is already showing early signs that the sharp appreciation in the euro is causing some pain. Peripheral equities have begun to underperform the stocks of core euro area nations, and are also sharply underperforming U.S. equities. This phenomenon tends to be associated with a weakening euro. Moreover, peripheral inflation excluding food and energy has already weakened to 1.3% from a high of 2% in February last year, the consequence of a tightening in financial conditions (Chart I-9). Chart I-8ECB Doesn't Want This To Change Chart I-9Peripheral Core Inflation In Free Fall Third, the economic environment points to underperformance of aggregate European inflation relative to the U.S. A fall in the gap between euro area and U.S. inflation tends to be associated with short-term gyrations in EUR/USD (Chart I-10). This is because a fall in relative inflation against the euro area causes investors to temporarily tweak the perceived path of future policy differentials. Over the course of 2018, U.S. inflation is set to increase. A simple model based on U.S. capacity utilization and the velocity of money shows that U.S. core CPI could hit 2.1% (Chart I-11). While this model has done a good job picking the turning points in U.S. core inflation, it has consistently overestimated inflation since 2013. Correcting for this bias, the model still forecasts a significant pick-up in inflation to 1.8% (Chart I-11, bottom panel). Chart I-10Higher European Inflation Equals Higher Euro Chart I-11A U.S. Inflation Pick Up Is Coming The same cannot be said for euro area inflation. Not only is the European periphery already feeling the pain caused by the euro's strength, but also we have entered the window of time where the previous tightening in euro area financial conditions vis-à-vis the U.S. puts a brake on euro area relative inflation.4 Moreover, the diffusion index of the components of the euro area core CPI index has been below 50% for four months in a row now. Historically, this has been associated with a fall in core CPI. Fourth, over the past year or so, EUR/USD has traded in line with risk assets. The euro area has benefited from EM growth improvement, which has lifted all corners of the global economy levered to the global industrial cycle. As a result, as investors become increasingly bullish on industrial metals, EM assets or momentum plays, so they have of the euro.5 However, clouds are slowly forming over the global economy, at the very least pointing to a mini-cycle downturn. For one, Chinese producer prices have rolled over, and Chinese import growth has significantly underperformed expectations in recent months, slowing to a 5% pace from a 20% pace as recently as September 2017. Essentially, industrial activity has slowed in response to a tightening in Chinese monetary conditions. This slowdown is already beginning to impact various corners of the globe: Korean and Taiwanese export growth continues to decelerate; BCA's Global LEIs Diffusion Index is well below the 50% mark, which normally precedes slowdowns in the global LEI itself; Our boom/bust and global growth indicators have slowed further - two precursors to global industrial production decelerations. Our global economic and financial A/D line, which tallies 100 pro-cyclical variables, has also rolled over sharply, another early warning sign for the global economy (Chart I-12). Finally, as we highlighted in December, EM/JPY carry trades, a canary for the global economy, have lost momentum - a signal that has normally preceded a slowdown in global industrial activity.6 All these signals only confirm the "Yellow Flags" we highlighted last October.7 In an environment where complacency is rampant and assets levered to growth are priced for perfection, this is worrisome. The euro's recent elevated correlation to such risk assets, along with the fact that the gap between European and U.S. core inflation is itself led by Chinese PPI, suggests that the euro is tactically vulnerable. Fifth, from a technical perspective speculators have never been this long the euro, which represents a significant danger as the euro is trading at a sharp premium to its short-term interest rate driver (Chart I-13). Moreover, risk-reversals for EUR/USD point to heightened susceptibility of a selloff if the bad omen on global growth and European inflation come to fruition (Chart I-14). Chart I-12Rising Risks For Global Growth Chart I-13The Euro Is Vulnerable Chart I-14Risk Reversals Point To Euro Downside This short-term picture suggests that the probability of a move in EUR/USD toward 1.15 is growing over the course of the next three to six months. Bottom Line: While the cyclical picture for the euro is bright, the short-term snapshot is much more dangerous. Not only are an increasing number of ECB officials weighing in on the impact of the euro's recent rally, but the European periphery is showing growing signs that the euro rally has indeed taken a bite. Additionally, European inflation is set to underperform U.S. inflation, and the global economic cycle could enter a short burst of disappointment. Finally, investors are not positioned for such developments, increasing the likelihood of a downward move in the euro. What To Do? Caught between a cyclically propitious backdrop and a tactically dangerous environment, EUR/USD presents a riddle for FX investors right now. The odds of a euro correction over the next three to six months are substantially greater than 50%. But as we highlighted last week, instead of taking a direct bet on EUR/USD, we recommend investors short EUR/JPY. Shorting EUR/JPY is an even cleaner way to take advantage of the cloudy weather building over the global economy.8 Moreover, in recent years, EUR/JPY has fallen when the 52-week rate-of-change of momentum trades began to weaken (Chart I-15). This highly mean-reverting indicator is currently in the 96th percentile of its distribution for the past 25 years, suggesting an imminent rollover. Additionally, EUR/JPY tends to perform well when the LIBOR-OIS spread widens. Today, the three-month FRA-OIS spread has been widening, even as the end-of-year dollar funding shortage has passed (Chart I-16). These kinds of dynamics point to a potential drying out in global liquidity, a phenomenon which historically hurts risk assets, especially when they are as frothy as they are now. This should once again hurt EUR/JPY. Chart I-15EUR/JPY And Momentum Stocks Chart I-16Funding Stresses Point To A Fall In EUR/JPY Thus, shorting EUR/JPY is our highest conviction trade for the next six months or so. If, as we foresee, EUR/USD weakens during the first half of 2018, we will look to buy this pair. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 2 We do not include real GDP in the models because since wealth is affected by GDP, they are two co-integrated variables, which creates strong multi-collinearity in the regressions. Of the two variables, real wealth was the stronger explanatory variable. 3 While the focus of this report is on the euro, the relationship between relative excess money supply and currency performances works across many exchange rates. We will develop this theme over the coming weeks. 4 Please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets" dated February 26, 2016 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Euro: Risk On Or Risk Off" dated November 17, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "A Cold Snap Doesn't Make A Winter" dated January 5, 2018 available at fes.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "The Best Of Possible Worlds?" dated October 6, 2017 available at fes.bcaresearch.com 8 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data out of the U.S. was strong this week: Industrial production increased by 0.9% on a monthly pace; Capacity utilization increased to 77.9% from 77.2%; Continuing jobless claims increased to 1.952 million from 1.876 million, beating expectations of 1.9 million; Initial jobless claims however decreased to 220K from 261K, beating expectations of 250K. We continue to expect the Fed to hike more than is priced by the market. A tightening labor market will eventually feed inflationary pressures, causing upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was decent: German CPI came in unchanged and at expectations, at 1.6%; European headline and core CPI also remained unchanged and at consensus, coming in at 1.4% and 1.1% respectively. However, the euro seems to be losing momentum his week. Comments by ECB board members such as Ewald Nowotny, Vitor Constâncio, and Francois Villeroy, all pointed to issues with the euro's sharp rise, and how they "don't reflect changes in fundamentals". Additionally, relapsing inflation data in the peripheries shows that the strength in the euro is beginning to cause strains and may even negatively affect the ECB's mandate. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Domestic corporate goods year on year inflation underperformed expectations, coming in at 3.1%. It also decreased substantially from November. Moreover, the Eco Watchers Survey for current conditions underperformed expectations, coming in at 53.9. It also decreased from the November reading. However, machinery orders yearly growth outperformed expectations substantially, coming in at 4.1%. USD/JPY is relatively flat from last week. Overall we expect upside to the yen to be limited against the U.S. dollar, given that bond yields are set to go up in the U.S. That being said, the yen has upside against the euro, as financial conditions have eased significantly in Japan relatively to the euro area. This should cause rate expectations in Japan to improve relative to those of Europe's, pushing EUR/JPY lower. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The DCLG House Price Index yearly growth outperformed expectations, coming in at 5.1%. However, core consumer price inflation underperformed expectations, coming in at 2.5%. It also decreased from the 2.7% reading of November. Moreover, headline inflation came in line with expectations at 3%. This also marks the first decrease in inflation in the U.K. since July 2017. Lifted by the USD's weakness, cable has now reached the pre-Brexit low 1.38 hit in February 2016. However, GBP has been experiencing a downtrend versus the euro since last September Overall, we continue to be skeptical of the ability of the BoE to raise interest rates meaningfully. Thus, we would fade any further rally from GBP/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was strong this week: Home loans grew at a 2.1% annual pace in November, higher than the expected -0.2%; Employment grew by 34.7K, beating expectations of 9K. The part-time component increased by 19.5K, while the full-time component grew by 15.1K; The participation rate increased to 65.7% from 65.5%; Unemployment rate increased to 5.5% from 5.4%. Foreign exchange traders lifted the AUD further this week. While the headline employment data remains stellar, the heavy concentration part-time job creation means that overall labor utilization measures is staying low. This will cap wage and inflationary pressures, especially as the AUD is once again expensive, further exacerbating deflationary pressures. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: The month-on-month growth of food prices declined from -0.4% to -0.8%. Moreover, Electronic Card retail sales yearly growth slowed from 4.3% to 3.3%. Finally the ANZ Commodity Price Index year on year growth declined from -0.9% to -2.2%. The New Zealand Dollar has surges by almost 3% year to data against the U.S. dollar. This has been largely due to the depreciation of the greenback itself, as global growth continues to beat forecast. On a short term basis we are positive on the NZD relative to the AUD, as Chinese tightening should weigh more on Australia than New Zealand. However, the new populist government in New Zealand worsens the outlook of the kiwi on a long term basis. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Movements in the petrocurrency were muted following the 'dovish hike' by the Bank of Canada. Numerous factors were highlighted to justify the rate hike to 1.25%, such as: strong employment growth; higher wages; robust consumption; and exceptional GDP growth in 2017. While the Bank's Business Outlook Survey suggests the labor market is tightening due to labor shortages, the BoC underplayed this factor, pointing to much more muted overall labor utilization metrics. The BoC also noted the expected decline in the contribution of housing and consumption to growth this year due to higher mortgage and borrowing rates. While the economy is firing on all fronts, the spread between the West Canada Select and West Texas Intermediate oil prices continues to widen due to a lack of pipeline capacity to ship the oil out of Canada. According to the Bank, these bottlenecks should be temporary, which means that the CAD could catch up to oil later. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 On Tuesday, Thomas Jordan, the president of the SNB once again reiterated that the franc is still "highly valued", and thus interest rates need to stay low so as to prevent the franc from appreciating. Moreover, he emphasized that while expansionary monetary policy was necessary, it was important to not wait too long to normalize rates. Overall, we believe that the SNB will want to see sustained inflation at relatively high levels to justify an exit from their radical monetary policy. In the meantime the Swiss Central bank will stay accommodative, and thus, EUR/CHF is likely to have limited downside. If the mini down cycle takes hold of the global economy, this would temporarily weigh on EUR/CHF. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone continued to appreciate this week, and is now UP 3.3% year-to-date. The krone has been helped mostly by the surge in oil prices and by the fall in the dollar. Overall, we are bullish on this cross against the CAD, as there are 60 basis points of hiked priced in the Canadian curve, even after this week's hike. In the meantime, there are only 21 basis points in the Norwegian curve. We believe this spread is too high, and thus, that the krone should appreciate against the Canadian dollar. Moreover, further downside in EUR/NOK is limited, given that near 70 dollars, there is not much room for oil prices to go up. Thus, we are closing our EUR/NOK trade with a 3.40% gain but keep our long NOK/SEK call in place. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 In a recent speech in Uppsala, Sweden, Deputy Governor Henry Ohlsson reminded the audience of his view from the December meeting that it would have reasonable to hike rates in "early 2018". He pointed to Sweden's robust economic performance, highlighting population growth, migration into cities, and higher real wages. Inflation has also been on target since mid-2017. This assessment is in line with our view of the economy, however Governor Ingves consistently supported a strong dovish tone which undermined our view. Now that the ECB has begun tapering, the consensus within the Riksbank seems to also be shifting. Falling house prices need to be monitored closely, especially when one keeps in mind Governor Ingves dovish inclinations. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Our new pecking order for currencies is: yen first, euro second, pound third, dollar fourth. Long-term (real) interest rate differentials are the dominant driver of currencies right now. EUR/USD should continue to trend higher to around 1.30. Equity investors should prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50. Underweight Basic Materials equities versus Healthcare equities on a 6-9 month horizon. Feature Nine months ago, our report Euro First, Pound Second, Dollar Third 1 encapsulated our recommended pecking order for the three major currencies. Subsequent performance has fully justified the title. The euro has appreciated by 6% versus the pound, and by 13% versus the U.S. dollar (Chart I-2). Today we are tweaking our currency pecking order: yen first, euro second, pound third, dollar fourth. Chart of the WeekHigher Euro Area Inflation Has Strengthened The Euro Chart I-2Euro First, Pound Second, Dollar Third The Euro Has Moved The 'Right' Way, The Yen Has Moved The 'Wrong' Way The Chart of the Week illustrates an excellent explanation for the euro/dollar exchange rate. It shows euro area versus U.S. core inflation differentials, and provides a great rule of thumb. If the euro area's core inflation were underperforming by 2% vis-à-vis the U.S., EUR/USD should stand at 1.00. But thereafter, every half-percent of euro area inflation catch-up strengthens the euro by 10 cents. At the start of 2017, our thesis was that the underperformance of euro area inflation by almost 2% - and the associated EUR/USD rate near 1.00 - was an anomaly. And that core inflation in the euro area would converge with that in the U.S. Which it duly has. Still, if the euro area's inflation underperformance vis-à-vis the U.S. converges to its long run average of half a percent, EUR/USD should continue to trend higher to around 1.30. One equity market implication is to prefer the broader based 300-constituent Euro Stoxx over the 50-constituent Euro Stoxx 50 (Chart I-3). The puzzle is that for the yen, the same inflation relationship has worked the 'wrong' way. Through the past ten years, every half-percent of Japanese core inflation catch-up has weakened the yen by around 10 yen (Chart I-4). To complicate the puzzle, the relationship for the yen used to work the 'right' way. Through 1999-2008, every half-percent of Japanese inflation catch-up strengthened the yen by around 10 yen (Chart I-5). Chart I-3A Stronger Euro Favours The Euro Stoxx ##br##Over The Euro Stoxx 50 Chart I-4Through 2008-17 Higher Japanese##br## Inflation Weakened The Yen... Chart I-5...But Through 1999-2007 Higher Japanese##br## Inflation Strengthened The Yen! So higher relative inflation in the euro area has driven the euro up; whereas higher relative inflation in Japan has driven the yen down, but previously used to drive the yen up! How can we explain the puzzle? The answer is to think in terms of both inflation and its impact on long-term interest rate expectations. What Are The Drivers Of Currencies? Foreign exchange demand serves one of four broad purposes: To buy foreign exchange reserves. To buy foreign goods and services. To buy long-term investments denominated in a foreign currency, also known as foreign direct investment (FDI) To buy shorter-term financial investments like bonds and equities denominated in that currency, also known as portfolio flows.2 Of these four components, the demand for foreign exchange reserves tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.3 The net foreign demand for euro area goods and services and FDI are also not particularly volatile. Which means that the usual swing-factor in foreign exchange demand is portfolio flows (Chart I-6), and especially fixed income portfolio flows. Chart I-6Portfolio Flows Are The Swing Factor In Foreign Exchange Demand What causes swings in fixed income portfolio flows? The answer is expected changes in real interest rates. Fixed income investors gravitate to the bonds with the highest real yield adjusted for likely currency losses or hedging costs. So when the expected real interest rate in the euro area rises relative to that in the U.S., euro bonds becomes de facto relatively more attractive. Meaning that international fixed income investors will shift into euro bonds until the flow pushes up EUR/USD to make the currency valuation symmetrically less attractive. At this new higher level for EUR/USD, the fixed income portfolio flow will stop because a new equilibrium has been established. International investors now have more upside from the more attractive bonds, but symmetrically less upside from the less attractive currency valuation - and the two factors cancel out. Furthermore, at major turning points in monetary policy, the main issue for the largest fixed income investors is not the exact pattern of short-term interest rate changes. Whether the Fed hikes in March, June and December or whether the ECB hikes next year is largely irrelevant. The big issue centres on the so-called real terminal rate: the average real interest rate over the very long term. Solving The Currency Puzzle Let's now return to our currency puzzle. If core inflation increases, but the expected terminal interest rate increases more, it means that the expected real terminal rate will also increase - causing the exchange rate to rise. This is what tends to happen in the euro area versus U.S. comparison, and explains why the relationship between relative core inflation and EUR/USD movements works the 'right' way. In effect, the nominal terminal rate is the driving factor for the currency. It is also what tended to happen in Japan before 2008 (Chart I-7), and explains why the relationship between relative core inflation and the yen also used to work the 'right' way. However, if core inflation increases, and the expected terminal interest rate increases less, it means that the expected real terminal rate will decrease - causing the exchange rate to fall. Since 2008, this is what has happened in Japan (Chart I-8). The expected nominal terminal rate has gone into stasis, so higher core inflation has pulled down the real terminal rate. Which explains why the relationship between relative core inflation and the yen has worked the 'wrong' way. The key question is what happens next? Will the expected terminal rate in the euro area go into stasis, as it did in Japan? Almost certainly no. The euro area's expected terminal rate has already risen by over 0.5% in the past year (Chart I-9). Chart I-7Expectations For Japan's Terminal ##br##Rate Used To Fluctuate... Chart I-8...But After 2008, Expectations For Japan's ##br## Terminal Rate Have Gone Into Stasis Chart I-9The Terminal Interest Rate Differential##br## Is Driving EUR/USD More plausibly, the expected terminal rate in Japan could come out of its stasis. With every other major central bank backing away from ultra-accommodation, and Japanese growth and inflation now looking little different from other G10 economies, is it realistic - or indeed feasible - for the Bank of Japan to maintain its extreme policy? The slightest hint from the Bank of Japan that it is following other central banks out of its ultra-accommodation would cause the expected terminal rate - and the yen - to gap (up) sharply. On this basis, the one major currency that we would short the euro against is the Japanese yen. The Global Mini-Upswing Is Losing Steam Finally and briefly, an update to our 'mini-cycle' framework for global growth. Last week in The Cobweb Theory And Market Cycles, we explained the existence of these mini-cycles, and argued that the current mini-upswing - which started last May - is getting long in the tooth. Right on cue, the latest credit data out of both China and the U.S. show that their 6-month credit impulses are losing steam (Chart I-10). The implication is that global growth will experience a mini-downswing during the first half of 2018. In all of the last five such mini-downswings, cyclical sectors ended up underperforming defensive sectors (Chart I-11). Accordingly, on a 6-9 month horizon, equity investors should underweight Basic Materials versus Healthcare. Chart I-106-Month Credit Impulses Have Rolled##br## Over In The U.S. And China Chart I-11Expect A Mini-Downswing: Underweight ##br##Basic Materials Vs. Healthcare Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Euro First, Pound Second, Dollar Third' published on April 27 2017 and available at eis.bcaresearch.com 2 In this discussion, portfolio flows include short-term speculative flows. 3 For example, when the Swiss National Bank broke the franc's peg to the euro, it just stopped buying euro reserves. Fractal Trading Model* There are no new trades this week, leaving two 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-12 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 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 The Japanese economy is booming. This is allowing the BoJ to move away from its QQE (Quantitive and Qualitative Easing) program. However, the YCC (Yield Curve Control) program will stay in place for the foreseeable future as inflation remains a direct function of financial conditions. Because yen positioning and valuations are so skewed, this could result in a yen rally, especially against the Euro. Short EUR/JPY. Like the Fed, the BoC will hike rates three times this year. However, the market already discounts more hikes in Canada than the U.S. We remain neutral USD/CAD. However, CAD will experience downside against the NOK. Short CAD/NOK. Feature Chart I-1JPY Vs. Bonds: The Divorce Something fascinating happened to USD/JPY in recent months: it began to decouple from U.S. bond yields (Chart I-1). To a large degree, this break in relationship reflected the dollar's own weakness, as the dollar index fell by 10% in 2017. But as weak as the dollar may have been last year, it has actually been flat since September 7. Another culprit behind the yen's decoupling from bond yields has been that as the European Central Bank announced the end of its own asset purchases program, the Bank of Japan has been seen as the next in line to diminish its purchases. On January 8th, the BoJ began moving in that direction, as it started to curtail its buying of long-dated JGBs. Since that day, not only have global bonds sold off, but the yen has regained vigor as well. We believe the yen bear market is not over, but a playable rally against the euro is likely to emerge. The Sun Is Rising The BoJ is justified in wanting to remove some policy stimulus. The Japanese economy is firing on all cylinders, and the improvement seems broad-based. Consumer confidence, buoyed by rising asset prices and an unemployment rate at 23-year lows, is hitting record highs (Chart I-2). This will continue to support real household spending, which is now growing at a nearly 2% pace after contracting steadily from 2015 to early 2017. Another support for household spending comes from the wage front. Contractual wages are already growing at their fastest pace since 2006, and wages excluding overtime pay are expanding at rates not seen since 1998 (Chart I-3). Moreover, the openings-to-applicant ratio is at its highest level since 1974. This increases the likelihood that Prime Minister Shinzo Abe's arm-wrestling with corporate Japan to increase wages will bear fruit, and that the upcoming spring wage negotiation will generate accelerating gains. Chart I-2Japanese Households Feel Ebullient Chart I-3Wage Growth Has Picked Up Business confidence is also surging. The Japanese manufacturing PMI number is elevated by Japanese standards, currently at 54, and small business confidence points toward an acceleration in industrial production (Chart I-4). Financial markets validate this picture as well. The surge in the Nikkei has grabbed the imagination of investors, but even more impressive has been the strength in small-cap equities, which have outperformed their large-cap counterparts by 17% since 2015 (Chart I-5). This development has coincided with a pick-up in credit growth, and is also normally associated with a robust growth outlook. The GDP model developed by our sister publication, The Bank Credit Analyst, encapsulates these various phenomena, and forecasts that Japanese real GDP growth could hit an annual rate of 3% in the first half of 2018 (Chart I-6). Thus, it would seem that the Japanese economy will continue to gain momentum. Chart I-4Japanese Companies Are Also##br## Feeling The Good Vibes Chart I-5Small Caps Point To##br## A Bright Outlook Chart I-6Japanese Growth ##br##Has Momentum But what underpins these improvements? First, the fiscal thrust in Japan has changed. Fiscal policy was a drag in Japan from 2012 to 2016, creating an average brake on economic activity of 0.6% of GDP per year. However, in 2017, fiscal policy eased to add 0.2% to GDP. Second, Japan has greatly benefited from the rebound in EM growth. According to the IMF, a 1% growth shock in EM affects Japanese growth by 50 basis points - nearly five times more than the effect of the same shock on the U.S. economy. This is because 43% of Japanese exports are shipped to EM economies. Third, the impact of EM activity on Japan is amplified by the countercyclical nature of the JPY. As global and EM growth expands more vigorous, the yen weakens, which eases Japanese financial conditions. This phenomenon was in full display last year, as financial conditions eased by a full standard deviation over the past 16 months. These developments are what have laid the ground for better growth and the change in the BoJ's tone. Bottom Line: Japan is doing very well. Consumers and businesses are upbeat, spending is on the rise and GDP is forecasted to accelerate even further. Easing fiscal belt-tightening, stronger EM economies, and the softening financial conditions are the factors behind these improvements. The BoJ is taking notice. How Far Can The BoJ Go? The BoJ had been itching to move policy for a few months now. In November 2017, BoJ Governor Haruhiko Kuroda was making noise about the concept of the "reversal rate." The reversal rate is the interest rate below which additional interest rate cuts become contractionary for economic activity. This is because below this level, lower rates hurt bank interest margins to such a degree that commercial banks start curtailing their lending to the private sector. The reason why the BoJ was getting more vocal about the reversal rate was because this rate is inversely related to the amount of securities held on commercial banks' balance sheets. If commercial banks hold plenty of government bonds, as interest rates fall to very low levels, the value of these securities increases, offsetting the negative impact of lower interest rate margins. The problem in Japan is that as the BoJ mopped up more JGBs than was issued by the government, and therefore the bond holdings of banks were dwindling at an alarming rate (Chart I-7). This meant that the reversal rate was rising, implying that the BoJ had less control over policy. When inflation surprised to the upside in December, financial markets reacted violently. While Japanese nominal yields did not budge much, Japanese inflation expectations surged, which prompted a collapse in Japanese real rates (Chart I-8). This produced a de facto easing in Japanese monetary conditions, creating the perfect cover for the BoJ to adjust its asset purchases: any negative impact from tweaking bond purchases would be mitigated and the BoJ, according to its view, would not lose control of financial conditions because of a falling reversal rate. Despite this shift in policy action and rhetoric, we do not yet foresee the end of the Yield Curve Control program. Inflation excluding food and energy only stands at a paltry 0.3%, still well below the BoJ's 2% target or even 1% - a level that is likely to result in a more real removal of easing. Additionally, the BoJ is in somewhat of a bind. It is true that the economy is doing much better, but this does not really help explain inflation dynamics. Japanese capacity utilization only explains 3% of the movements in Japanese core inflation; global utilization, only 10%; and inflation leads credit creation in Japan. Instead, the best factor to explain Japanese inflation has been financial conditions (FCIs). In no other country do FCIs explain inflation dynamics as much as they do in Japan. The recent movements in Japanese inflation are fully consistent with how Japanese FCIs have evolved since 2010. Based on this relationship, CPI excluding food and energy should likely peak at 0.7% in June 2018 (Chart I-9). Chart I-7Japanese Reversal Rate##br## Is Falling Because Of QQE Chart I-8Sudden Pick Up In##br## Inflation Expectations Chart I-9Inflation Is Picking Up Because##br## Financial Conditions Eased However, if the BoJ removes accommodation too fast, the yen would rally and financial conditions would tighten sharply. In all likelihood, inflation would weaken substantially, nullifying the very reason to tighten policy in the first place. These very dynamics point to a continuation of YCC for at least the next 12 to 18 months. Bottom Line: Japan will soon fully do away with its QQE program. However, this is not indicative of a removal of yield curve controls. This is not only because Japanese inflation is extremely far off from the BoJ's target, but also because Japan's inflation rate is hyper-sensitive to financial conditions. Therefore, any tightening in financial conditions created by a stronger yen - the likely market response of tighter policy - will cause inflation to collapse, nullifying the very need for tighter policy. Investment Implications USD/JPY is expensive, trading 16% above the fair value implied by purchasing power parity. Additionally, the yen is supported by a generous current account surplus of 4% of GDP. Moreover, global investors have been underweighting duration. This phenomenon tends to be negative for the yen. When investors are as underweight duration as they are currently, the yen becomes more likely to rally (Chart I-10). It is true that in 2014, investors were as negative on bonds as they are today, but USD/JPY sold off. This was because back then, the BoJ announced an increase to its asset purchase program. Today, the BoJ is moving toward ditching its QQE program, which is likely to prompt a short-covering rally. Now, the key question for investors is what currency should be sold against the yen. We posit the euro is an interesting alternative to the USD. EUR/JPY is exceptionally expensive at present. On a long-term basis, EUR/JPY is trading well outside its normal range on a purchasing-power-parity basis (Chart I-11). Moreover, while USD/JPY is mildly expensive according to metrics that incorporate rate differentials and risk appetite, EUR/USD is very dear based on a similar comparison. The implication is that EUR/JPY is trading at an exceptionally demanding level in terms of short-term valuations (Chart I-12). Hence, tactically, the timing is becoming increasingly ripe to short this cross Chart I-10Duration Positioning Points To Upside Risk For The Yen Chart I-11EUR/JPY Is Expensive Chart I-12Tactical Risk For EUR/JPY . Further arguing in favor of shorting EUR/JPY instead of USD/JPY are relative financial conditions. Euro area financial conditions have tightened much more than U.S. financial conditions relative to Japan's (Chart I-13). As a consequence, even when adjusting for sector biases, European stocks are currently underperforming Japanese equities by a greater margin than the underperformance of U.S. equities. This highlights that Japan's relative economic outlook burns brighter when compared to the euro area than when compared to the U.S. This also means that the yen has more room to rally against the euro than the USD. Finally, relative positioning between the euro and the yen is also exceptionally skewed. As Chart I-14 illustrates, when speculators are simultaneously long the euro and short the yen, EUR/JPY tends to experience subsequent corrections. Chart I-13Euro Area FCIs Tightened ##br##More Than U.S. Ones Chart I-14Skewed Positioning##br## In EUR The aforementioned factors point to a potentially large yen rally, but the durability of this rally is likely to be limited. The BoJ will only be dropping a QQE program that it had already only half-implemented in recent months, as bond purchases were well below its JPY80 trillion-yen objective. The BoJ is still committed to its YCC program for the foreseeable future. Only a rejection of this program will create a durable support for the yen. In the meanwhile, as any yen rally will tighten financial conditions and hurt inflation, any yen rally is to be rented rather than owned, as terminal policy rates in Japan still have little scope to rise. Bottom Line: Ditching QQE is likely to result in a yen rally. Such a rally is likely to be most pronounced against the euro as valuations, positioning, and financial conditions are especially exacerbated when compared to the European currency. To be clear, the yen rally is likely to be a countertrend move, as a strong yen will exert serious deflationary pressures on Japan, which means the BoJ's YCC program will remain firmly in place. We are shorting EUR/JPY at 133.79. CAD: Stuck Between The BoC And NAFTA Chart I-15Canada Will Experience Rising Wages Canada:##br## Inflationary Conditions Emerging The Bank of Canada (BoC) is meeting next week and the odds are rising that it will lift policy rates this month. The Canadian economy is very strong too, led by the domestic sector. Real consumer spending is growing at its fastest pace in nearly 10 years, the unemployment rate is at 40-year lows, and capex is recovering after having been decimated by the collapse in oil prices from 2014 to 2016. Thanks to this backdrop, the Canadian economy is hitting its own capacity constraints. The BoC estimates that the Canadian output gap has closed. Moreover, the recent Business Outlook Survey confirms this message: A record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints, and the growing number and intensity of labor shortages points to a tight labor market (Chart I-15). Tight capacity and higher wages will support the already-visible rebound in core inflation, which has already reached 1.8%. As a result, we expect the BoC to tighten rates as much as the Federal Reserve this year. However, the impact of this development on the CAD might be limited. Investors are already pricing in more hikes in Canada than in the U.S. over the next 12 months - 82 basis points versus 60 basis points, respectively. Moreover, speculators are once again very long the loonie, implying an elevated hurdle for strong economic data to actually lift CAD further. Moreover, NAFTA remains a major risk for Canada. As Marko Papic, our Chief Geopolitical Strategist, wrote in a November Special Report, President Trump does have uninhibited power when it comes to abrogating NAFTA (Table I-I).1 If NAFTA were to collapse, Canada would most likely ultimately revert to the still-preferential Canada-U.S. Free Trade Agreement. Thus, the impact on Canada-U.S. trade would likely be temporary. However, the brunt of the pain should be felt in Canadian capex spending. The high degree of uncertainty associated with unwinding NAFTA would cause companies to abandon expansion plans in Canada, and prompt them to expand their North American capacity directly in the U.S., thereby bypassing the regulatory risk created in the supply chain. This would dampen the future growth profile of Canada. Table I-1Trump Faces Few Constraints On Trade Oil is unlikely to fill the void for CAD. At near US$70/bbl, Brent has hit our Commodity and Energy strategists' target. OPEC 2.0 will be unwilling to accommodate much higher prices, as this would incentivize shale producers to expand capacity, recreating the supply glut dynamics that existed prior to the 2014 crash. Additionally, the West Canada Select benchmark, the oil price most relevant for Canada, remains at a substantial discount to WTI and Brent. This is because there is not enough pipeline capacity to ship oil outside of Alberta. Canada is drowning in its own oil. This situation is not about to change. Chart I-16CAD/NOK Is Stretched Based on this combination, we are neutral USD/CAD on a 12-month basis, even if a move back to 1.29 is likely over the coming weeks. However, while Canadian oil is trading at a discount, the CAD has performed better than the NOK, the other petrocurrency in the G10 space. This suggests that shorting CAD/NOK may be a cleaner way to play the risks inherent to the Canadian dollar. First, the Canadian dollar is very expensive relative to the Norwegian krone right now, trading 11% above its purchasing-power-parity rate (Chart I-16). Even when adjusting for other factors like productivity and commodity prices, CAD is trading at its largest premium to the NOK since 1994. This represents a risk for CAD/NOK as the loonie is exposed to trade policy risks, while the nokkie is not. Second, the balance-of-payments picture remains highly favorable for the NOK. Norway runs a current account surplus of 5.5% while Canada runs a deficit of 2.8%. Additionally, Norway sports a Net International Investment position (NIIPs) of 210% of GDP, the largest in the G10. Strong NIIPs are associated with rising real effective exchange rates. Third, while the Canadian economy's momentum is well known by investors - this is the reason why they are so long the CAD and expecting so many hikes from the BoC - the positives in Norway are being ignored. Norway's leading economic indicator is still rising, and Norwegian industrial production and real GDP growth are accelerating. Fourth, the Norges Bank is responding to weakness in the NOK. At its December meeting, it adjusted its tone, as the NOK is easing monetary conditions too much in the eyes of the Norwegian central bank. This suggests the 25-basis-point hike currently expected out of Norway could be too low. It also highlights that the exceptional 60-basis-point gap between Canada and Norway in terms of expected 12-month rate hikes is also likely to normalize. Finally, CAD/NOK is trading toward the top of both its long-term and near-term historical trading ranges. While positioning on the CAD is now quite extended on the long side, speculators are short the NOK, according to Norges Bank data. Thus, with NAFTA in question, a fully priced BoC outlook, and the unlikelihood that the WCS-Brent discount narrows, risks are skewed toward a lower CAD/NOK going forward. Bottom Line: The Canadian economy is booming. This means the BoC will keep pace with the Fed and increase rates at least thrice this year. However, markets are already discounting more hikes in Canada than they are in the U.S. Moreover, oil prices have limited upside from here, and the WCS benchmark will continue to trade at a deep discount to Brent. Thus, while USD/CAD has limited upside, it has limited downside as well. However, CAD/NOK faces plenty of downside risks from current levels. We are shorting this cross this week, with an entry point at 6.398. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism" dated November 10, 2017, available at gis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Nonfarm payrolls surprised to the downside, coming in at 148 thousand. Moreover, labor force participation rate surprised to the downside, coming in at 62.7%. ISM non-manufacturing PMI also underperformed expectations, coming in at 55.9. However, consumer credit change outperformed expectations, coming in at 27.95 billion dollars. The dollar began the week on a strong, which ultimately dissipated, on relatively hawkish ECB minutes and policy tweaks in Japan. Overall, we expect the market to continue to price the fed dot plot, putting upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been positive: Core inflation outperformed expectations, coming in at 1.1%. Moreover, the economic sentiment indicator also outperformed expectations, coming in at 116. Retail sale yearly growth also surprised to the upside, coming in at 2.8%. Finally, the unemployment rate declined from 8.8% to 8.7% In spite of the positive data the euro has fallen this weekThe Euro begun the week on the weak side but surged in the wake of the ECB's hawkish minutes. This has happened due to the surge in rate expectations in the U.S., as the market has continued to price in the fed. Overall, we expect to see downside in EUR/JPY as the BoJ has more room to back off its ultra-dovish policy than the ECB. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Labor Cash earnings yearly growth outperformed expectations, coming in at 0.9%. They also increased relative to October. However consumer confidence surprised to the downside, coming in at 44.7 and declining from the previous month. The yen has been surging this week, with USD/JPY falling by 1.7%. This was caused because the BoJ signaled that they would reduce their buying of long dated bonds. The market interpret this as a signal that the BoJ will start exiting from its ultra-dovish monetary policy. These developments should continue to provide upside to the JPY, particularly against the Euro. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production yearly growth outperformed expectations, coming in at 2.5%. Moreover, manufacturing production yearly growth also surprised to the upside, coming in at 3.5%. However, Halifax House Prices yearly growth underperformed expectations, coming in at 2.7% as the month-on-month growth contracted by 0.6%. The pound has been flat, this week against the dollar, while it has lost about 1% against the euro. Overall, the BoE is limited in the capacity to raise rates meaningfully. Moreover, inflation should start to ease following the rate hike and the rise in the pound. This will put downward pressure on the pound. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Building permits yearly growth outperformed expectations, coming in at 17.2%. However, the trade balance in November surprised to the downside, coming in at -628 million. It also decreased from -302 million one month earlier. AUD/USD has been flat this week, however AUD/NZD has fallen by roughly 1%. While it is true that global growth continues to be strong, key indicators like Korean and Taiwanese export growth have rolled over. Moreover money supply growth in China continues to decrease. All of this points to a temporary slowdown in Chinese industrial activity, which would lead to weakness in AUD/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has rallied by nearly 5% since the start of the year, as global growth continues to stay robust. Overall, we expect that the NZD will continue to outperform the AUD this year, as New Zealand is less sensitive to a tightening in financial conditions than Australia. However on a longer time horizon, the upside for the Kiwi is limited, as the new populist government has not only vowed to decrease immigration into the country, but also for the RBNZ to have a dual mandate. Both of these policies will depress the neutral rate in New Zealand, and consequently put downward pressure on the kiwi. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mostly positive: The unemployment rate surprised positively, as it declined to 5.7% from 5.9% Moreover, net change in employment also outperformed expectations, coming in at 78.6 thousand. Housing starts yearly growth also outperformed expectations, coming in at 217 thousand. However, the Ivey Purchasing Manager Index underperformed, coming in at 60.4. USD/CAD jumped on Tuesday following reports that Trump will exit the NAFTA accord. Overall we believe that the Canadian dollar will have limited upside from here on out, as the market is now pricing in more hikes in Canada than in the U.S. This weakness could be taken advantage of by shorting CAD/NOK, as this cross is much overvalued according to multiple metrics. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: Headline inflation came in line with expectations, at 0.8%, meanwhile month on month inflation surprised to the upside, coming in at 0%. The unemployment rate also came in line with expectations, at a very low level, coming in at 3%. Finally, retail sales yearly growth surprised to the upside substantially, coming in at -0.2%, compared to 2.6% last month. EUR/CHF has stayed relatively flat since last week. Overall, we expect limited upside in the franc. As the SNB will stay active in the foreign exchange market. In order for the SNB to change its policy, inflation in Switzerland will have to stay at a high level for a considerable amount of time. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Headline inflation outperformed expectations, coming in at 1.6%. Moreover core inflation also surprised to the upside, coming in at 1.4% However, manufacturing output growth underperformed expectations, coming in at 0.3% USD/NOK is down by roughly 0.7%, as oil prices continue to approach the 70 dollar mark. Nevertheless, we believe that the upside for USD/NOK is limited from here, as the market will start pricing in more rate hikes from the Fed. That being said, investors willing to bet on more oil strength could short EUR/NOK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 After falling precipitously at the end of 2017, USD/SEK has been relatively flat this year. Overall, while Stefan Ingves continues to be very dovish, he conceded in the latest minutes that a change in monetary policy is getting closer. Meanwhile, Deputy Governor Jansson stated that while he supports to continue with asset purchases, to keep the repo rate unchanged would be "difficult to digest". Investors willing to bet on a slowdown in the Euro area caused by tightening financial conditions could short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature The existence of 'mini-cycles' in economic and financial variables is an empirical fact. We encourage readers to plot for themselves the change in global bank credit flows, the global bond yield, global inflation, and metal price inflation. The very clear and regular mini-cycles should shout out at you (Chart I-2, Chart I-3, Chart I-4, Chart-5). Feature ChartThe Cobweb Theory Explains The Regular Mini-Cycles In Economic And Financial Variables Chart I-2Mini-Cycles In Global Credit Flows Chart I-3Mini-Cycles In The Global Bond Yield Chart I-4Mini-Cycles In Global Inflation Chart I-5Mini-Cycles In Metal Price Inflation Identifying these mini-cycles is very useful because it helps us to predict the future. Just as we know when the tide will go out and come back in, we can predict the mini-cycle's downswings and upswings. And if most market participants are unaware of the next turn in the mini-cycle, it will not be discounted in today's price - providing a compelling investment opportunity. The obvious question is: if the existence of mini-cycles is an empirical fact, what is its theoretical foundation? Dusting Down The Cobweb Theory A likely answer comes from an economic model called the Cobweb Theory, first proposed in the 1930s by several economists, among them Althus Hanau and Nicholas Kaldor. The Cobweb Theory is so called because when its predicted pattern of price and output mini-cycles is traced out on a standard price/quantity diagram, it resembles a cobweb (Chart I-6, Chart 7, Chart I-8). Chart I-6Cobweb Theory Case 1: ##br## Regular Mini-Cycles Chart I-7Cobweb Theory Case 2: ##br##Divergent Mini-Cycles Chart I-8Cobweb Theory Case 3: ##br##Convergent Mini-Cycles The Cobweb Theory is based on a simple premise: lagging supply. The demand for an item depends on its price in the current period, but the supply of the item depends on its price in the previous period. Or equivalently, the price in the current period influences the supply in the next period. In the 1930s, economists used the theory to explain the mini-cycles in agricultural output and prices. Most crops can be sown and reaped only once a year. Therefore, an unanticipated increase in demand will cause a sharp rise in price - because there can be no immediate increase in supply. This high price may lure farmers to increase their output more than is justified by future demand. So when this supply eventually comes on the market, it will cause a sharp fall in price. In turn this will result in a decrease in output for the next period to a greater extent than is justified. And so on. More generally, the Cobweb Theory applies in any market where supply lags demand. Under this simple premise, the market price will produce a two-period oscillation with the actual price being alternately above and below the equilibrium price. When the price is above equilibrium, it falls in the next period as supply adjusts upwards; and when the price is below equilibrium, it rises in the next period as supply adjusts downwards. But supply tends to over-adjust, causing both the quantity and price to overshoot and undershoot equilibrium repeatedly - effectively creating a mini-cycle (see Box I-1). Box I-1The Cobweb Theory Of Cycles The Cobweb Theory Of Credit Demand And Supply We now come to a key point: credit demand and supply often meet the conditions of the Cobweb Theory. Chart I-9 illustrates that the credit demand cycle is perfectly coincident with the bond yield cycle. Whereas Chart I-10 and Chart I-11 demonstrate that the credit supply cycle can often lag the credit demand cycle - and therefore the bond yield cycle - by several months. One obvious explanation is that unless you have an (unexpended) existing credit line to draw upon, there will be a lag between applying for credit and receiving it. Chart I-9The Credit Demand Cycle Is Coincident ##br##With The Bond Yield Cycle... Chart I-10...But The Credit Supply Cycle Lags ##br##The Credit Demand Cycle... Chart I-11...And The Bond ##br##Yield Cycle With credit demand and supply meeting the conditions of the Cobweb Theory, both the quantity and the price of credit (the bond yield) should exhibit mini-cycles. And as the charts in this report attest, they do. What about the mini-cycles in commodity inflation and broader CPI inflation? Given that these closely track the credit impulse mini-cycle (Feature Chart), we can deduce that they must be mostly a reflection of the mini-cycle in global demand growth. Still, could the commodity inflation mini-cycle also be impacted by the supply-side, as postulated for agricultural prices in the original Cobweb Theory? Interestingly, a recent paper, "The cobweb theorem and delays in adjusting supply in metals" markets,1 does "link the dynamics of raw material markets and commodity price fluctuations to a delayed adjustment of supply." However, the supply lags mentioned in the paper are too long to explain the half-cycle lengths typically observed in the commodity inflation mini-cycle. This would confirm that this mini-cycle is mostly a demand-side phenomenon. But the paper does also point out that speculation on futures markets may lead to higher volatility. This implies that while the phases of the mini-cycles should stay closely aligned, the amplitudes of the commodity inflation and credit impulse mini-cycles can deviate. Which is precisely what we observe in the data (Chart I-12). Chart I-12The Various Mini-Cycles Have Similar Periods But Different Amplitudes What Is The Current Message? Chart I-13The Bond Yield Cycle Explains##br## The Sector Selection Cycle To sum up, global credit flows, the global bond yield, global inflation, and metal price inflation exhibit clear and regular mini-cycles with a consistent half-cycle length averaging around 8 months, but not necessarily a consistent amplitude. We propose that all of these mini-cycles will continue indefinitely, and that they are manifestations of the lagging supply of credit and the Cobweb Theory. In the context of these clear and regular mini-cycles, the current mini-upswing in activity which started last May is getting long in the tooth, and we would expect it to end in early 2018. Having said that, given that the recent upswing in the global bond yield is quite modest, the next mini-downswing in the global credit impulse, and thereby activity, should be quite shallow. Nevertheless, in terms of investment implications, any mini-upswing in price since last May that has displayed an outsize amplitude would be more vulnerable to a setback. Industrial metal prices might be in this vulnerable category. Furthermore, the mini-cycle framework has been an important driver of cyclical versus defensive sector performance over the past few years (Chart I-13), and likely will continue to be an important driver. On a 6-9 month horizon, the current message would be to pare back exposure to cyclical sectors and to tilt towards defensive-biased equity markets such as Switzerland and Denmark. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 System Dynamics Review, April 2017: 'The cobweb theorem and delays in adjusting supply in metals' markets' by Glöser-Chahoud, Hartwig, Wheat and Faulstich. Fractal Trading Model* This week's trade is to expect a countertrend reversal in S&P500 versus Eurostoxx50 performance. Set a profit target of 2.0% with a symmetrical stop-loss. In other trades, long IBEX35 / short Eurostoxx50 closed in profit while short WTI crude closed at its stop-loss. 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 14 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 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 The dollar continues to suffer as global growth remains strong. The year-end performance of the dollar rarely heralds things to come for the next six to twelve months. Signs are slowly accumulating that global growth may soften, but it could take a quarter to happen. In the meanwhile, the dollar could continue to weaken. Already boosted by global growth, the euro received a further fillip as markets upgraded the anticipated terminal interest rate in Europe. The U.S. terminal rate will be upgraded too, but only when this happen will the dollar be able to rally. Stay cautious. Feature As a cold snap engulfed North America, the U.S. dollar finished 2017 falling as fast as the mercury. This move is worrisome, as it pushed the greenback to the edge of a cliff. If the DXY punches below 91, the low hit on September 7, the greenback could hit 88. For EUR/USD, a decisive break above 1.21 constitutes the same threshold, and would indicate that the euro will rally to 1.25. Vigilance is required. A December Signal? The performance of the dollar in the last two weeks of December rarely offers a reliable signal of things to come. As Table I-1 illustrates, based on more than 20 years of data, the performance of the dollar index in the last weeks of a year has been negatively correlated with the dollar's performance over the following six to 12 months. This would imply that investors fighting dominating trends over the course of the prior 12 months capitulate in the last two weeks of the year, cleaning the slate in the process. Table I-1A Cold Snap Doesn't Make A Winter When it comes to specific pairs, relationships vary. The correlation of EUR/USD's subsequent six-month and 12-month returns with its year-end performance is zero, thus there is little to glean from the euro's recent strength in terms of its implications for 2018. However, interestingly, there is a strong negative correlation between the AUD/USD's year-end performance and the Aussie's returns over the next six to 12 months. It would seem the AUD's blistering rally is to be sold, not bought. The weakness in the USD was supercharged by the greenback's countercyclical nature. Our global synchronicity indictor - which measures the proportion of DM economies with PMIs above 50 - displays a negative correlation with the dollar's returns. This indicator's extraordinarily strong performance elucidates why the dollar was so weak last year, and also why the euro performed so well (Chart I-1). Going forward, two key leading indicators of our global synchronicity measure are saying that the global upswing could lose power (Chart I-2). The performance of Swedish equities relative to U.S. stocks and the annual change in U.S. 10-year yields reveal that even if global growth remains above trend, it will decelerate from current elevated readings. This could support the dollar index. However, we should keep an eye on the performance of EM carry trades.1 EM carry trades had been indicating that the best days for global growth are also behind us (Chart I-3), but lately EM carry trades have regained some vigor. If this strength is maintained, the message from the relative performance of Swedish equities and of U.S. bond yields will be invalidated. Such a move could be associated with a DXY breaking down below 91, potentially hitting 88; and EUR/USD rallying above 1.21 to 1.25. Chart I-1Strong Global Growth Hurts The Dollar Chart I-2Will This Synchronized Boom Peter Off? Chart I-3EM Carry Trades And Growth When all these forces are taken together, the picture for the dollar remains murky. The recent weakness in the Baltic Dry Index as well as the outperformance of oil relative to metals prices suggests we are entering a late cycle environment where even if global growth remain above trend, it is likely to be peaking. Thus, even if the dollar were to sell off further in the coming weeks, the downside will be limited. Nonetheless, a rally in the USD will have to wait for clear signs that U.S. inflation is picking up. It is best to stay on the sidelines for now. Bottom Line: The performance of the dollar in the last weeks of the year is rarely a good gauge of the dollar trend for the next six to 12 months. However, the dollar has been suffering on the back of strong global growth. While important metrics are suggesting that global growth could lose some momentum, other essential indicators such as EM carry trades are regaining some vigor. For now, limiting directional dollar bets is a safer strategy. The dollar will only rally once U.S. inflation picks up. EUR/USD And Terminal Rates The recent strength in the euro is linked to strong global growth. However, EUR/USD has been supercharged by domestic factors. In December, the differential in expected terminal policy rates between the European Central Bank and the Federal Reserve moved violently in favor of the euro. This move reflected a forceful upgrade of the anticipated terminal policy rate in the euro area (Chart I-4). This sudden upgrade in Europe makes sense: the European economy is strong. Euro area PMIs are at record highs, German unemployment has hit post-unification lows and German inflation regained gumption. Moreover, Benoit Coeure, a member of the ECB's Executive Board, expressed some very hawkish views. The market is correct to upgrade the outlook for the ECB. However, interest rate markets continue to expect too-shy-a-Fed over the remainder of the cycle. This leaves room to upgrade the expected terminal interest rate for the U.S. The U.S. economy is also firing on all cylinders. The U.S. ISM came in at 59.7 this week, with the new order component standing at a very strong 69.4. Additionally, total hours worked have been accelerating (Chart I-5). Together, these point to very robust GDP growth. Already, the Atlanta Fed GDPNow tracker foresees growth of 3.2% for Q4. Chart I-4EM Carry Trades And Growth Chart I-5U.S. Growth Set To Accelerate Strong U.S. growth is materializing in an environment of increasingly significant capacity constraints, which has historically been associated with rising inflationary pressures (Chart I-6). The recent easing in U.S. financial conditions only reinforces this message, and argues that U.S. inflation has upside (Chart I-7). Moreover, U.S. compensation costs have been accelerating, from a low of 1.9% in 2016 to 2.5% today. Hence, U.S. inflation should perk up this year, letting the Fed increase rates more than what markets currently foresee. Chart I-6Inflationary Backdrop In The U.S. Chart I-7U.S. Financial Conditions Furthermore, the relative growth picture indicates that the increase in U.S. terminal rate should outpace the eurozone's. The Goldman Sachs Current Activity Indicator in the euro area has rolled over relative to the U.S., highlighting that the euro has tightened relative financial conditions enough to now harm the growth profile of Europe vis-à-vis the U.S. (Chart I-8). Moreover, European economic surprises are slowing sharply relative to the U.S. and the Euro Stoxx is re-testing its cycle low against the S&P 500, further corroborating the message from the Current Activity Indicator (Chart I-9). Chart I-8EUR/USD Starting To Hurt European ##br## Relative Growth Prospects Chart I-9Strains In The ##br##Eurozone Despite these dynamics, it is not clear that making a bet today on a weak euro is the proper tactic. At the time of writing, EUR/USD was flirting with its previous high of 2017; any break above 1.21 would likely push EUR/USD toward 1.25. Thus, we recommend investors continue to play pairs like short EUR/SEK to take advantage of the tightening in euro area financial conditions rather than bet outright on EUR/USD. To make this latter bet, investors will need either a marked failure of EUR/USD to break out, thus invalidating previous bullish technical signals, or a pick-up in U.S. inflation, whose timing remains unclear. Bottom Line: The euro's rally has been supercharged by an upgrade of the market's expected terminal policy rates in Europe relative to the U.S. While upgrading the ECB makes sense, markets should also upgrade the U.S. policy path as the American economy is just as strong and closer to capacity constraints, thus more likely to generate inflation. However, fighting the momentum in EUR/USD is currently dangerous. Thus, we recommend investors to wait for U.S. inflation to pick up before selling the euro. Instead, sell EUR/SEK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been positive: Personal consumption expenditure and core personal expenditure grew at 1.8% YoY and 1.5% YoY respectively. Both measures increased from last month's reading. ISM manufacturing PMI came in at 59.7, surprising significantly to the upside. This measure also increased from last month. Meanwhile, ISM prices paid came in at 69, smashing expectations. The dollar ended 2017 on a free fall, as the enigma of low inflation in an environment of very low unemployment continues to puzzle investors. Meanwhile global growth continues to be very strong, adding an additional handicap to the dollar. We continue to believe that the Fed will hike more than expected, pushing the dollar upwards. However for this process to star, inflation must first emerge in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in Europe has been positive: M3 Money supply yearly growth surprised to the upside, coming in at 4.9%. Moreover, Europe's Markit manufacturing PMI, came in line with expectations at 60.6. Finally, Germany's headline inflation also outperformed expectations, coming in at 1.6%. However this number did decline from the previous month. EUR/USD has rallied by almost 2% since Christmas. This has been mainly due to the rhetoric by ECB members, who appear to be much less dovish than before. Indeed, ECB board member Mersch warned that the ECB "must be careful not to act too timidly and too late and to fall behind the curve". Overall, we continue to believe that the Fed will surprise the market more than the ECB will. However to have an outright bullish dollar view inflation will have to pick up in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Retail trade yearly growth came in at 2.2%, exceeding expectations by a wide margin. Meanwhile, housing starts also surprised to the upside, as they contracted by only 0.4%. Tokyo CPI ex fresh food yearly growth also beat expectations, coming in at 0.8%. Finally, the unemployment rate declined to 2.7%. The yen has appreciated against the U.S. dollar, with USD/JPY falling by about 0.7%. Meanwhile, Kuroda continued to assert that no change is needed to the BoJ's yield curve control program. Overall, in spite of the improved global outlook which is benefiting the Japanese economy, it is unlikely that Japan will abandon its extremely dovish monetary policy unless inflation rises much further. This is unlikely to happen in the near future. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Gross domestic product growth surprised to the upside, coming in at 1.7%. However this number did decline from the previous quarter. Additionally, total business investment yearly growth also outperformed expectations, coming in at 1.7%. However, Markit manufacturing PMI underperformed expectations, coming in at 56.3. Moreover, construction PMI also surprised to the downside, coming in at 52.2. Since Christmas, cable has gone up by roughly 1.5%. Overall we believe that the BoE is unlikely to raise rates meaningfully, as they will be more cautious than otherwise as the U.K. muddles through the Brexit negotiations. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Private sector credit yearly growth increased relatively to last month, coming in at 5.4%. However the AiG Performance of Manufacturing Index declined relatively to last month, coming in at 56.2 in December versus 57.3 in November. Finally, the RBA Commodity SDR Index, which in an early indicator of export price changes, contracted by 5.9%, a decline from last month's 4% contractions. The Australian dollar has rallied by more than 2.6% since Christmas, as multiple indicators point to continued strength in global growth. However we expect a temporary slowdown, as a result of tightening financial conditions in China. This will be negative for the AUD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has increased by roughly 1.2% since Christmas, partly because of the decline of the U.S. dollar. However the New Zealand dollar has depreciated against almost every single G10 currency. Overall, we expect the NZD to appreciate relative to the AUD, given that the Australian dollar is much more sensitive to Chinese tightening financial conditions. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Gross Domestic Product month-on-month growth underperformed expectations, coming in at 0%. However, Markit manufacturing PMI surprised to the upside, coming in at 54.7. This measure also increased relatively to last month's. USD/CAD has plunged by nearly 2.8%. We expect the Canadian dollar to outperform the AUD and the NZD, as oil should outperform metals in the commodity space. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator surprised to the upside, coming in at 111.3 in December. This measure also increased relative to November's reading. Meanwhile, the SVME Purchasing Manager's Index also outperformed expectations, coming in at 65.2. Finally, the ZEW survey expectations component increased relatively to last month, coming in at 52. EUR/CHF has continued its appreciation into the New Year. This is good news for the SNB, as this will provide an easing in financial conditions. Overall, we expect the franc to have limited downside against the euro, as the still low inflation in Switzerland will keep the SNB intervening in currency markets. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth for November increased relatively to last month's number, coming in at 2.1%. However, registered unemployment surprised negatively, as it increased from 2.3% to 2.4%. Since Christmas, USD/NOK has plunged by nearly 3%, as it has been battered by very strong oil prices. Overall, we expect USD/NOK to find upside, however this will happen only when rate expectations in the U.S. rise meaningfully. In order for this to happen, inflation must once again accelerate. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2.8%. This measure also increased from last month's reading. Producer price inflation also increased from last month's number, coming in at 2.7%. However, Manufacturing PMI declined in December relatively to November, coming in at 60.4. In line with multiple indicators signaling that global growth continues to improve, USD/SEK has plunged by more than 2.5% since Christmas. Investors willing to bet on a temporary slowdown in the euro area, caused by tightening financial conditions should short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Question #1: Will global growth remain above trend? Yes. Question #2: Will growth continue to outperform outside the U.S.? No. Question #3: Will productivity growth pick up? Yes, but only cyclically. The structural outlook remains bleak. Question #4: Will continued strong global growth finally deliver higher inflation? Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Feature Global Growth In Focus We wish all our readers a joyous and prosperous 2018. As the new year begins, four questions about the global growth outlook loom large. Question #1: Will global growth remain above trend? Our answer: Yes. It is likely that global growth will come down a notch from its current elevated pace. However, it should remain firmly above trend. For one thing, the global economy continues to exhibit a lot of positive momentum. Real-time measures of economic activity, such as the Goldman Sachs Current Activity Indicator (CAI), highlight that global real GDP is rising at a robust pace (Chart 1). Our global leading indicator, as well as a wide swath of PMI data, suggest that this trend has legs (Chart 2). Chart 1APositive Global Growth Momentum Can Be Seen Here Chart 1BPositive Global Growth Momentum Can Be Seen Here Since 1980, above-trend global growth in one year has been accompanied by above-trend growth in the following year nearly three-quarters of the time. This bodes well for 2018. Chart 2... And Here Too Chart 3Financial Conditions Tend To Lead Growth By Six-To-Nine Months Global financial conditions eased significantly in 2017, thanks mainly to higher equity prices and narrower credit spreads. Easier financial conditions tend to benefit growth with a 6-to-9 month lag (Chart 3). The 6-month global credit impulse, which tends to lead activity, is also positive (Chart 4). Fiscal policy should remain stimulative. The fiscal thrust moved into positive territory in advanced economies in 2016-17 and this should remain the case in 2018 (Chart 5). Tax cuts will add about 0.3 percentage points to U.S. growth, while hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending will add another 0.2 points. Chart 4Positive Credit Impulse Is Another Tailwind For Growth Chart 5Fiscal Policy Has Turned More Stimulative Our political strategists expect further fiscal easing in Japan this year. They also believe that German coalition talks will produce more government spending, with the SDP extracting concessions from Merkel on public investment and the CSU securing a commitment for more defense expenditure. On the flipside, our strategists expect some fiscal tightening in France as President Macron takes steps to trim France's bloated welfare state. Question #2: Will growth continue to outperform outside the U.S.? Our answer: No. Global revisions were more favorable outside the U.S. in the first nine months of 2017, which helps explain why the dollar came under downward pressure (Chart 6). More recently, U.S. growth estimates have begun to drift higher. As a result, the U.S. surprise index has surged relative to those of other economies (Chart 7). Chart 6U.S. Growth Expectations Were Lagging... ##br## But Not Anymore Chart 7U.S. Economic Surprise Index Increased ##br## Relative To Those Of Other Countries We expect the data to continue to favor the U.S. Aggregate U.S. hours worked in November was up 3.4% at an annualized rate over Q3 levels. If we add in productivity growth, Q4 GDP growth was probably in excess of 4% - well above current consensus estimates. Financial conditions have eased a lot more in the U.S. than in the rest of the world. Fiscal policy is also set to loosen relatively more in the U.S. Euro area growth is likely to tick lower next year from its current stellar pace, as the impact of a stronger euro begins to bite. The 6-month credit impulse has already turned negative there. Japanese growth should also cool somewhat from the heady pace of 2.7% seen over the past two quarters. The Chinese economy will decelerate modestly in 2018. The authorities are tightening the screws on the shadow banking system, expediting efforts to reduce excess capacity in the industrial sector, and clamping down on corruption. All of these reforms will pay off in the long run, but they could dent growth in the short run. Question #3: Will productivity growth pick up? Our Answer: Yes, but only cyclically. The structural outlook remains bleak. U.S. nonfarm productivity rose by 1.5% over the prior year in Q3, well above the post-2010 average of 0.8%. This improvement occurred despite the fact that low-skilled workers continue to re-enter the labor market - dragging down output-per-hour in the process - a phenomenon that is not well captured by the official productivity data. Productivity growth elsewhere in the world also appears to be on the upswing (Chart 8). Increased business investment should support productivity in 2018. Corporate surveys indicate that a rising percentage of companies anticipate boosting capital budgets (Chart 9). This often happens in the last few innings of business-cycle expansions, as more companies begin to experience capacity constraints. Chart 8Productivity Growth Showing Signs Of ##br## A Tentative Recovery Chart 9Surveys Are Signaling Acceleration ##br## In Capex Unfortunately, while the cyclical outlook for productivity is improving, the structural backdrop remains downbeat. As we have discussed in the past, flagging educational achievement, decreased creative destruction, and a shift in technological innovation towards consumers and away from businesses all augur poorly for future productivity trends.1 The much-hyped Amazon effect makes for good news stories, but is not borne out by the data.2 Question #4: Will continued strong global growth finally deliver higher inflation? Our answer: Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Chart 10A Pick-Up In Wage Growth Would Put Upward Pressure ##br## On Service Inflation Going into 2017, the Fed had expected core PCE inflation to end the year at 1.9%. It is likely to have finished the year at only 1.5%. We expect core PCE inflation to move toward 2% by the end of 2018. Wage growth should accelerate as the labor market continues to tighten. This should put upward pressure on service inflation (Chart 10). Goods price inflation should also recover due to the lagged effects of a weaker dollar and the bleed-through of higher energy prices into several core components of the CPI (airline fares being a notable example). Slower rent growth will dampen inflation. However, this will be partially offset by higher health care prices. The cost control measures introduced in the Affordable Care Act helped push down PCE health care services inflation from 3% in late 2010 to less than 0.5% in early 2016 (Chart 11). Many of these measures have been realized, and as a consequence, health care inflation has begun to revert to its long-term trend (though in level terms, the savings to consumers remain). The Republican tax bill could put some upward pressure on health care costs. The Congressional Budget Office estimates that the repeal of the Individual Mandate will raise premiums on health care exchanges by 10% because a larger share of healthy individuals will decide to forgo buying health insurance.3 Japanese inflation should move modestly higher in 2018, but from extremely depressed levels. The Japanese unemployment rate is now a full percentage point lower than in 2007 and the ratio of job opening-to-applicants has reached the highest level since 1974 (Chart 12). Chart 11U.S. Inflation Breakdown Chart 12Japan's Tightening Labor Market Euro area inflation will be held down by the lagged effects of a stronger euro and continued high levels of slack across southern Europe. Outside Germany, labor market underutilization is still 6.3 percentage points higher than it was in 2008 (Chart 13). U.K. inflation should edge lower as the spike in import prices stemming from the post-Brexit pound depreciation dissipates. Chart 13There Is Still Labor Market Slack Outside Of Germany Investment Conclusions A shift in global growth leadership back towards the U.S. would benefit the beleaguered U.S. dollar. Higher U.S. inflation will prompt the Fed to raise rates four times in 2018, one more hike than implied by the dots and two more hikes than implied by current market expectations. Rising inflation should also keep Treasury yields on an upward trajectory. We expect the 10-year yield to finish 2018 at around 3%. As long as inflation is rising in response to stronger growth, and from below-target levels, both U.S. and global risk assets should continue to rally. Only once U.S. inflation rises above 2% in 2019, and growth begins to slow on the back of binding supply-side constraints, will equities flounder. Stay long stocks for now, but look to significantly trim exposure towards the end of the year. Regionally, we favor euro area and Japanese equities over U.S. stocks for the next 12 months on a currency-hedged basis. Both the euro area and Japanese stock markets are dominated by large multinational companies whose prospects are geared more towards global growth than demand in their own regions. Above-trend global growth and rising capital spending should disproportionately benefit European and Japanese bourses, given that they have a greater tilt towards cyclically-sensitive companies. Valuations also tend to favor non-U.S. stocks. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?," dated May 31, 2017; Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 3 Please see "Repealing the Individual Health Insurance Mandate: An Updated Estimate," Congressional Budget Office, dated November 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades