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Feature Chart 1Global Growth Pick Up As a whole, G10 economies have been in expansion for more than seven years now. Moreover, after a near-recessionary episode in late 2015 / early 2016, the global economy is on a renewed upswing, with global trade and capex having regained vigor (Chart 1). Similar upswings in aged economic expansions have historically been the ideal breeding ground for global monetary tightening. However, the world economy is still dealing with two deflationary anchors: two decades of over-investment in emerging markets that have led to chronic overcapacity globally, and a strong preference for savings - a legacy of the great financial crisis (GFC) in the West and of financial repression in China. Thanks to this confluence of forces, global central banks have been fearful of tightening policy, hence, global policy rates continue to hover near multi-generational lows. Yet, now that the Federal Reserve has opened Pandora's box and raised rates four times, the question on every investor's mind is who is next. In this piece, we examine a few key domestic indicators for each G10 central bank (CB), and try to categorize CBs according to their likelihood of being the next one to tighten policy. We find three groups. The first one with the highest likelihood of hiking includes New Zealand, Sweden, and Canada. We place Australia, the U.K., and the Euro Area in the somewhat-likely-to-tighten camp. Finally, among the economies where we see little scope for tighter policy are Norway, Switzerland, and Japan. Using this ranking, we examine the implications for these countries' respective currencies and equity markets' relative performance. In this optic, it is important to remember that while conventional wisdom dictates that the stock market needs a depreciating currency in order to advance, empirically, countries with appreciating exchange rates have tended to outperform the global equity benchmark, reflecting the effect of international flows into these economies and markets.1 Finally, we look forward to publish in the coming months a quantitative model based on the indicators used in this report. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com Most Likely To Increase Rates First: 1) New Zealand Chart 2New Zealand The real Official Cash Rate has never been at such a discount to trend real GDP growth (Chart 2). As a result, nominal GDP is growing at a strong 6% a year, and core inflation is moving back toward 2%. Additionally, nominal retail sales are expanding at nearly 8% per year, the highest pace since 2007. According to the OECD, GDP is now nearly 2% above trend, which highlights the inflationary nature of New Zealand's economy. Supporting that, capacity constraints are becoming rampant, despite strong immigration into the country, unemployment is now nearly 1% below equilibrium, further confirming that the Reserve Bank of New Zealand is keeping policy at too-stimulative levels. This time around, hiking rates will not be a policy mistake as it was in both 2010 and 2014. In 2010, the difference between real rates and trend real GDP growth was much narrower than today, and the output gap was still very negative. In 2014, measures of slack were also not supportive of higher rates, and a rollover in core inflation as well as muted retail sales growth created additional headwinds. Most Likely To Increase Rates First: 2) Sweden Chart 3Sweden The Riksbank's repo rate has been driven lower in response to the European Central Bank's own bias, resulting in a Swedish repo rate of -0.5%. The gap between the real policy rate in Sweden and trend GDP growth is hovering around record-low levels (Chart 3). Supported by such a stimulative policy setting, Swedish non-financial private credit has expanded massively, hitting 230% of GDP. Today, the output gap is in positive territory and the unemployment gap indicates that the labor market has tightened considerably. In fact, both measures are congruent with the levels recorded during prior rate-tightening cycles. Core inflation is still below the central bank's 2% target, but is accelerating higher. The Riksbank's resource utilization indicator is further confirming this trend and points toward much higher inflation in the second half of 2017.2 Retail sales have been soggy, but they are picking up anew, clearing the way for a rate hike. Crucially, under the tutelage of Stefan Ingves, the Riksbank has been extremely dovish, but his second term as head of the institution ends this year. For now, he does not look set to be re-appointed. His re-appointment constitutes the greatest risk to our Riksbank view. Most Likely To Increase Rates First: 3) Canada Chart 4Canada The gap between the real policy rate and trend real GDP growth is still very negative, much more so in fact than was the case in 2010, the last time the Bank of Canada (BoC) tried to hike interest rates. The output gap and the unemployment gap continue to point toward a small degree of slack in the Canadian economy (Chart 4). Nonetheless, the BoC expects the output gap to close in 2018. However, the amount of slack in the economy remains very low compared to what prevailed in 2010. Like in the U.S., core inflation has recently sagged, but retail sales continue to grow at a healthy pace. Canadian policy rates have rarely diverged from those in the U.S. for long as the Canadian economy is deeply integrated in the U.S. supply chain. This means that economic impulses in the U.S. are often transferred to Canada. The Fed increasing rates in the U.S. puts pressure on the BoC. If rates diverge for too long, the Loonie will weaken considerably, exacerbating inflationary pressures in Canada. Recent communications of the BoC's most senior staff indicate a very sharp move away from dovishness. Middle Of The Pack: 1) Australia Chart 5Australia The gap between real policy rates and trend real GDP growth is in stimulative territory, but it is not at the level seen in New Zealand, Sweden or Canada. While the unemployment gap suggests the labor market is becoming increasingly tight, the OECD's measure of the output gap still stands near record lows, suggesting that in aggregate there remains substantial slack in Australia (Chart 5). This paints a mixed picture rather than an indubitably good or bad one. Core inflation remains in a downtrend and nominal retail sales are growing at very low rates, further highlighting that monetary policy is not as accommodative as in New Zealand or Canada. Improvement in global trade continues to support the Australian economy, and strong real estate activity suggests that policy is too easy for domestic asset prices. These two forces are critical in preventing Australia from falling into the bottom basket of central banks. Even if a small deceleration in global activity emerges, so long as it does not degenerate into the kind of vicious commodity selloff experienced in the second half of 2015 and early 2016, the Australian economy will be able to avoid another deceleration. Middle Of The Pack: 2) The U.K. Chart 6U.K. On many fronts, the U.K. looks ripe for an imminent rate hike. The gap between the real policy rate and trend real GDP growth is as depressed as the levels recorded in the countries in the first bucket, suggesting that the Bank of England's policy stance is extremely accommodative (Chart 6). However, like in Australia, measures of economic slack paint a mixed picture. The unemployment gap points to an absence of slack, while the output gap remains negative and indicative of some slack in the U.K. Retail sales have been lifted by the recent surge in inflation, with core consumer prices now growing at a 2.6% annual rate. However, this picture is distorted. Real retail sales have massively decelerated, and the surge in inflation has had nothing to do with domestic conditions but has been entirely due to the pass-through associated with the near-20% collapse in the trade-weighted pound since November 2015. Beyond the negative output gap, the key reason why the BoE is not at the top of the list of potential hikers is because U.K. household inflation expectations remain well behaved, and the economy could continue to decelerate in the face of uncertainty associated with Brexit. This could even prompt Mark Carney to keep an even more dovish stance that we or the market currently anticipate. Middle Of The Pack: 3) The Euro Area Chart 7Euro Area The gap between the real policy rate and trend real GDP growth in the euro area is actually also at extremely stimulative levels (Chart 7), partly explaining why the European economy has been able to generate so many positive data surprises. However, the euro area economy still needs easy policy. The output gap remains very negative and unemployment is still below equilibrium. In fact, as we have argued, this latter indicator may even underestimate the amount of labor market slack in Europe, as measures of labor underutilization remain very elevated. Euro area core inflation has been moving up, but at around 1% remains well shy of the ECB's objective of close to but below 2%. True, officially the ECB targets headline inflation, but Draghi's emphasis on underlying domestic inflation trends belies a focus on core inflation. Ultimately, the combination of labor underutilization, simmering political risk in Italy and a still-negative output gap suggests the ECB in unlikely to lift interest rates until at least late 2018. The biggest risk to our view would be for the ECB to tighten policy more than we or even the market anticipate. This would put the ECB ahead of the BoE. The Laggards: 1) Norway Chart 8Norway The gap between Norway's real policy rate and trend real GDP growth is still indicative of an easy policy stance. However, the recent dip in core inflation has caused an inadvertent policy tightening, as illustrated by the gap's sharp narrowing (Chart 8). The OECD's measure of Norway's output gap is very negative, and the unemployment rate has not been this deeply above equilibrium in more than 20 years. As such, there seems to remain large amounts of slack in the Norwegian economy. Corroborating this assessment, Norwegian wages are contracting at a 4% annual pace. Norwegian retail sales have been very weak, and core inflation has collapsed from 4% to 1.5%. This easing in inflation is a blessing for the Norges Bank as this allows it to focus on the large amount of slack still present in the economy. The Laggards: 2) Switzerland Chart 9Switzerland Despite a deeply negative nominal policy rate and a continuously expanding central bank balance sheet, Switzerland monetary policy does not seem to be very easy, as the gap between the real policy rate and the trend real GDP growth rate is in neutral territory (Chart 9). The OECD's output gap and the difference between the headline unemployment rate and equilibrium unemployment rate both point toward plentiful slack in the Swiss economy. Swiss wage growth also remains quite tame, only hitting 0.1% last quarter. Core inflation remains well below target as it only modestly moved back into positive territory three months ago. The confluence of not-so-easy monetary policy and plentiful excess capacity suggests that despite the challenging conditions for Swiss pension plans and insurance companies created by deeply negative rates the Swiss economy is not yet ready to handle tighter monetary policy. The Laggards: 3) Japan Chart 10Japan Japan might be the most perplexing economy in the G10 right now, and the Bank of Japan is in the toughest position of all the major central banks in the advanced economies. Like Switzerland, despite negative nominal short-term interest rates and large asset purchases by the BoJ, the gap between Japan's real policy rates and trend real GDP growth suggests that policy is only at a neutral setting (Chart 10). This would seem appropriate given that both the output gap and the unemployment gap point to little spare capacity in Japan. However, this does not square with core inflation moving back into negative territory and barely expanding retail sales. Ultimately, Japan's problem is two-fold. First, the unemployment gap underestimates the amount of labor underutilization in Japan, as output per hour worked remains 11% and 34% behind that of the OECD and the U.S, respectively. Second, extremely depressed Japanese inflation expectations continue to result in an extraordinarily flat Philips curve. Due to these dynamics, we expect that it will take continued sustained efforts by the BoJ to overheat the economy before any signs of inflation emerge. FX Implications Based on our assessments, we would expect the RBNZ, the Riksbank and the BoC to be the first central banks to hike now that the Fed has blazed the trail. Within this group, the RBNZ is potentially the cleanest story, as all factors are aligned. We would expect the RBNZ to hike late summer / early fall 2017. Technically, the Riksbank seems in a better place to hike rates than the BoC. However, the leadership of the BoC is already preparing the market for higher rates. Canadian rates could also rise as soon as late summer / early fall 2017. Meanwhile, so long as Ingves remains head of the Riksbank, the Swedish central bank will likely stand pat. Thus, we would expect the first hike to materialize early next year, as soon as a new governor takes the helm, although, we believe markets will begin pricing in such a hike as soon as his replacement is announced. In the second group of central banks, we expect the RBA to be the first to increase rates. The BoE does face a much more inflationary environment than the RBA, but the U.K.'s economic uncertainty remains such that the BoE is likely to tread carefully and wait to see how the economy handles the new wave of political trauma unleashed by this month's election. The ECB is likely to begin tapering its own purchases at the end of 2017, but our base case anticipates that it will not touch policy rates until well into 2018. Among the laggards, the Norges Bank will most likely be the first to push up rates - something we do not anticipate until late 2018. While BCA expects oil prices to rebound, this is unlikely to boost the economy fast enough to close the output gap for at least 18 months. Switzerland and Japan need to do a lot of work before their respective economies generate any kind of inflationary pressures. We do not anticipate any tightening for Switzerland until well after the ECB has moved. The BoJ may not tighten policy for the remainder of this decade. This means that the CAD and the NZD are likely to prove to be the best-performing currencies in the dollar bloc. Investors should stay short AUD/NZD and AUD/CAD. CAD/NOK also possesses more upside. The SEK could prove to be the best performing European currency. Swedish money markets are pricing in only 40 basis points of hikes over the next 12 months, something that seems too low considering the inflationary risk in that country. Stay short EUR/SEK. The EUR/USD rebounded this week on the back of seemingly hawkish comments by Draghi. Even when the ECB somewhat backtracked and communicated that the market had misinterpreted the speech, EUR/USD looked the other way. This confirms our fear that the momentum in this pair is too strong to fight. EUR/USD should retest 1.15-1.16, the upper bound of its trading range put in place since March 2015. Based on our economics work, any move above 1.15 should be used to short the euro. The pound will continue to suffer from a political discount, however, because our base case expects the BoE to tighten policy before the ECB, we continue to recommend that investors use moves above 0.88 to begin shorting EUR/GBP. The SNB is unlikely to remove its cap on the Swiss franc, which means the natural upward pull created by the large net international position of Switzerland will be of little solace for investors. Finally, the JPY should be the worst performing currency in the G10 as the BoJ will not be able to lift rates - a great handicap when, as BCA expects, global bond yields are likely to enjoy more upside than downside over the next 12 months. Equity Implications U.S. Equities Chart 11U.S. Contrary to popular belief equities and the currency are joined at the hip especially during currency bull markets. A rising currency tends to attract flows and equities outperform in common and local currency terms. Keep in mind that domestic equity exposure dominates stock market weightings, further solidifying the positive currency and equity correlation. The top panel of Chart 11 shows that this relationship is extremely tight in the U.S. with equities outperforming the MSCI ACWI when the dollar advances and suffering a setback when the greenback depreciates. The Fed has raised rates three times since December 2015 and is slated to tighten monetary policy one more time later this year. This is well telegraphed to the markets, and thus the U.S. dollar has been in sell off mode for the past 6 months, weighing on relative equity performance. The relative economic surprise indexes also have an excellent track record in forecasting relative equity momentum, and the current message is grim for relative share prices. We expect the U.S. to continue to trail other G10 bourses in the coming months and the MSCI ACWI as other CBs have more scope to tighten monetary policy, and recommend an underweight stance in global equity portfolios. Bank/financials performance is also closely linked to monetary policy. While the yield curve flattening tends to suppress net interest margins (NIM), the recovery in loan volumes and drop in NPLs owing to a pickup in economic growth more than offsets the fall in NIMs. We continue to recommend overweight exposure in U.S. banks/financials both in global and U.S. only portfolios.3 New Zealand Equities Chart 12New Zealand The positive stock and currency correlation exists in New Zealand. Currently, the Kiwi has been rising, but relative equities have not followed suit. If our analysis proves prescient and the RBNZ becomes the next G10 CB to hike, then a playable relative equity catch up phase will materialize (Chart 12). The relative surprise index is firing on all cylinders and corroborates the bullish economic message from our macro analysis and hints that New Zealand equities are a buy. We recommend an overweight stance in New Zealand stocks in global equity portfolios. While all the rest of the G10 have a domestic banking sector, New Zealand is the exception. Australian banks dominate the banking scene in New Zealand, and thus serve as a good proxy. We are comfortable to have a modest Australian banks/financials exposure in New Zealand only portfolios. However, there is one caveat: the housing market is bubbly. While excesses are well documented, we doubt that the housing markets would burst either in Australia or in New Zealand in the coming 6-12 months and bring down the Australian banking sector. In such a time frame, both CBs will still be early in their respective tightening cycles. Swedish Equities Chart 13Sweden The Swedish krona moves in lockstep with relative share prices, a relationship that has been in place for the better part of the past two decades (Chart 13). Were the Riksbank to raise the policy rate from deeply negative territory, as our macroeconomic analysis pegs it as second most likely, then equities will outperform the MSCI ACWI, and we recommend an above benchmark allocation in global equity portfolios. Economic surprises in Sweden continue to outnumber the G10, heralding additional momentum gains in relative share prices (bottom panel). The elimination of NIRP would also benefit the banking sector. NIRP serves as a noose around banks' necks, as bankers cannot pass on NIRP to retail depositors weighing on NIMs. Chart 21 in the Appendix shows that Swedish financials comprise over 30% of the overall Swedish market and drive overall market performance. Thus, we are comfortable with an overweight stance in financials in Swedish only equity portfolios given the prospects of tighter monetary policy in the coming quarters. Canadian Equities Chart 14Canada The Loonie and relative equity performance also move in tandem (Chart 14). At the current juncture the bear market in oil prices has dampened both the currency and equities, as Canada is an excellent proxy for commodity prices in general and oil prices in particular. The BoC is the third most likely CB to raise interest rates in the coming months according to our analysis, raising the odds of a reversal of fortunes for Canadian equities. The relative economic surprise index is surging, opening a wide gap with relative share price momentum. If our thesis proves accurate and the BoC pulls the trigger soon, then Canadian equities will gain some traction. Under such a backdrop we recommend an overweight stance in global equity portfolios. In terms of financials, Canadian financials' market capitalization weight is the second largest in the G10, exerting significant influence in overall equity direction. If the commodity complex is healthy enough for the BoC to tighten monetary policy, then banks will outperform on the back of firming loan growth and receding commodity related NPLs. Nevertheless, the housing market poses a clear risk. Were a housing crisis to grip the Canadian economy, bank earnings and thus performance would suffer a sizable blow. Our sense is that such an outcome is highly unlikely in the next year, making us comfortable recommending overweight financials exposure in Canadian only equity portfolios. Australian Equities Chart 15Australia The positive correlation between FX rates and relative equity performance is prevalent in Australia (Chart 15). Currently, the Aussie has stayed resilient, but equities have given way suffering alongside commodities in general and iron ore prices in particular. The RBA sits in the middle of the pack in terms of hiking interest rates next according to our thesis, but still remains the fourth most likely CB in the G10 to pull the trigger ahead of the BoE and the ECB. As such, we recommend a neutral weight in global equity portfolios. While the relative economic surprise index has vaulted higher, the positive correlation with relative share price momentum seems to have broken down in recent years. Similar to Canada, Australian financials comprise a large chunk of the broad equity market (see Chart 21 in the Appendix on page 24), setting the tone for overall equity returns. If Canada's housing market is frothy, then Australia is a definite bubble and poses a significant risk to the banking sector. The APRA is breathing down banks' necks and that is reflected in recent bank underperformance. As we mentioned earlier, we doubt the Australian housing market blows up in the next 6-12 months as the RBA will be in the early innings of a tightening cycle. As a result, only a benchmark allocation is warranted in Australian banks in Australian only portfolios. U.K. Equities Chart 16U.K. Cable and relative U.K. equity performance also follow our currency/FX positive correlation playbook (Chart 16). Relative share prices have ticked up recently taking cue from the rebound in sterling. British economic surprises have been outnumbering the G10 post Brexit, and sport a positive correlation with relative share price momentum. Our U.K. macroeconomic analysis highlights that the BoE stands right in the middle of the CB pack. Importantly, the BoE is our "surprise risk" of staying easy for longer than the economic variables would suggest as the dust clears from the Brexit aftermath. Under such a backdrop we recommend a modest underweight in U.K. equities in global equity portfolios. Similarly, U.K. banks also warrant a slight underweight stance in U.K. only equity portfolios. Eurozone Equities Chart 17Euro Area Euro area stocks and the euro have been positively correlated especially since 2003. Year-to-date EUR/USD is up roughly 10% and Eurozone equities have been stellar outperformers. The catalyst for the euro's sizable gains has been the market's realization that the ECB passed its maximum easing in Q1/2017. Receding geopolitical uncertainty has also played a key role. In addition, the economy has responded well both to the extraordinarily easy monetary policy measures and move away from austerity. The bottom panel of the Chart 17 shows that relative economic surprises are probing 5-year highs pulling relative equity momentum higher. While our macro analysis suggests that the ECB stays pat for a while longer, our "surprise risk" is that the ECB moves earlier than we expect and removes some of the extreme monetary accommodation. As a result we continue to recommend above benchmark exposure both in Eurozone equities and banks/financials. Importantly, not only will euro area banks benefit from the eventual ECB's removal of NIRP and the related boost to NIMs, but also NPLs have peaked and will continue to drift lower along with the unemployment rate. More recently, the speedy and contained resolution of two Italian bank failures along with the absorption of two Spanish banks by Santander and Bankia are a giant step in the right direction. These moves also suggest that there is political will to overcome the banking issues in the euro area. Additional bank cleanup is likely and this is a welcome development in the Eurozone that should entice healthier banks to extend credit to the economy. Norwegian Equities Chart 18Norway Over the past two decades, the Norwegian krone and relative equity performance have moved in lockstep (Chart 18). Year-to-date, relative Norwegian equities have fallen to fresh cycle lows. Similar to Canada, the country's substantial oil dependency has weighed on relative share prices and also knocked down the krone. Our macro analysis concluded that the Norges Bank will be late in lifting interest rate and sits at the bottom of the G10 CBs. As a result, we recommend underweight exposure in Norwegian stocks in global equity portfolios. Financials in Norway comprise one fifth of the stock market's capitalization (Chart 21 in the Appendix on page 24) and have been on a nearly uninterrupted run since the end of the GFC and catapulted to multi-decade highs. Given our thesis of the Norges Bank staying late in raising rates we recommend lightening up on financials equities in Norwegian only equity portfolios. Swiss Equities Chart 19Switzerland Since the late 1990s relative Swiss share prices and the CHF have been enjoying an almost perfect positive correlation (Chart 19). At the current juncture Swiss stocks have been propelling higher versus the MSCI ACWI as the franc has been appreciating. There are extremely low odds that the SNB would move the needle in terms of normalizing interest rates any time soon, according to our analysis. Keep in mind that the SNB is conducting the ultimate QE experiment by purchasing U.S. stocks, underscoring that there are a lot of layers/levers of momentary policy easing that it will have to eventually to unwind. The implication is that we would lean against recent strength in the Swiss equity market and recommend a below benchmark allocation. Switzerland financials have the third lowest market cap weight in the G10 as UBS and CS are still licking their wounds from the aftermath of the GFC. Relative financials performance has been soft and taken a turn for the worse recently in marked contrast with global financials exuberance since Brexit. Our macro analysis suggests that a below benchmark allocation is warranted in financials in Swiss only portfolios. Japanese Equities Chart 20Japan The Japanese yen and relative equity performance were joined at the hip from the mid-1990s until 2009. From the end of the GFC until 2015 this correlation broke down as Japan has been in-and-out of recession. Since then however, there is tentative evidence that Japanese equities and the yen have resumed moving in tandem (Chart 20). Our macroeconomic analysis suggests that Japan will be the last G10 CB to lift interest rates. While our study would signal that investors should avoid Japanese equities, we do not have high confidence in that view. The break and resumption in the equity/currency correlation is worrisome and suggests that other more important factors are in play dictating relative share price performance. As a result, we would modestly overweight Japanese equities in global equity portfolios in line with BCA’s Global Investment Strategy service view.4 On the financials front, relative performance in Japan has fallen into oblivion. NIRP is anchoring NIMs. But, an extremely low unemployment rate suggests that NPLs will continue to probe multi decade lows and provide an offset to bank EPS. Thus, we would stick with a neutral weighting in Japanese financials.5 Appendix Chart 21G10 Financial Market Cap Weights 1 For a more detailed discussion on the correlation between equity prices and the currency market, please see Global Alpha Sector Strategy Special Report titled, "Can The S&P 500 Rise Alongside The U.S. Dollar?", dated October 7, 206, available at gss.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 16, 017, available at fes.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report titled, "Girding For A Breakout?", dated May 1, 2017, available at uses.bcaresearch.com 4 Please see Global Investment Strategy - Strategy Outlook "Third Quarter 2017: Aging Bull", June 30, 2017, available at gis.bcaresearch.com 5 Please see Global Alpha Sector Strategy Weekly Report titled "The Year Of The Letter "R"", January 13, 2017, available at gss.bcaresearch.com

Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest Chart 5No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by the global risk appetite, as approximated by corporate spreads, and commodity prices. Based on our timing model­s, the countertrend correction in the dollar is toward its tailend. Any additional weakness should be used to buy the greenback. The euro is now expensive based on our timing model. However, it could become slightly more expensive as markets continue to price in the euro area-friendly outcome of the first round of the French election. Feature In July 2016, in a Special Report titled "In Search Of A Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline, a sanity check if you will, to our regular analysis. In this report, we review the logic underpinning these intermediate-term models and provide a commentary on their most recent readings for the G10 currencies vis-à-vis the USD. UIP, Revisited The uncovered interest rate parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is the one that will make an investor indifferent between holding the bonds of country A or country B. This means that as interest rates rise in country A relative to country B, the currency of country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of country B (Chart 1). Chart 1Interest Rate Differentials Remain Useful ##br##Gauges For XR Determination There has long been a debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. Research by the Fed and the IMF suggest that incorporating longer-term rates to UIP models increases their accuracy.2 This informational advantage works whether policy rates are or aren't close to their lower bound.3 Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements do not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of investor indifference between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.4 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from each other. It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan comes to the front of the mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 2Over The Long Run, Real Rate ##br##Differentials Work Best Chart 3Real And Nominal Rates ##br##Can Be Different Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real, not nominal long-term rate differentials. Global Risk Aversion And Commodity Prices Chart 4The Dollar Benefits From Global Woes Global risk appetite is also a key factor to consider when trying to model exchange rates. Risk aversion shocks tend to lead to an appreciation in the dollar, which benefits from its status as the global reserve currency.5 Much literature has often focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power for the option-adjusted spreads on junk bonds (Chart 4). Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.6 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resource prices constitute a terms-of-trade-shock for them. However, this relationship holds up for the euro as well, something already documented by the ECB.7 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe: Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite: Proxied by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. Real rates differentials, junk spreads, and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a 3-9 month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). The U.S. Dollar Chart 5Dollar Fundamentals Strengthening... Chart 6...But Timing Could Be Better To Buy DXY To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss, and Swedish real rates weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. The FITM for the DXY has stabilized and is now slowly moving upward (Chart 5). The ITTM itself is even pointing upward, arguing that the dollar is at a neutral level and that its previous overshoot has now been corrected. However, historically, the DXY rarely stabilizes at its fair value, overshooting the mark instead. Based on historical behavior, the DXY is likely to undershoot its ITTM by another two percent or so before an ideal entry point to buy the USD emerges (Chart 6). Longer term, we continue to expect the dollar to stay on an upward trend. The U.S. neutral rate remains above that of Europe and Japan. Moreover, U.S. economic slack is dissipating much faster than in Europe, and the U.S. may already be in the process of hitting its own capacity constraints. This suggests that the Fed has much greater scope to normalize policy than the ECB. With the OIS curve pricing in a 25 basis point hike in the U.S. over the next 12 months, this will support the USD versus the euro. Japan, too, exhibits increasing signs of limited slack in its economy. However, with the BoJ committed to an inflation overshoot in order to upwardly shock moribund Japanese inflation expectations, we think that Japanese real rates will lag U.S. ones, putting significant upside on USD/JPY. The Euro Chart 7Euro Fundamentals Are Deteriorating Chart 8The Euro Is No Longer Cheap The FITM for EUR/USD has rolled over and is now pointing south, suggesting that fundamentals are moving against the euro (Chart 7). This reflects large rate differentials between the U.S. and the euro area, but also, the recent softness in some corners of the commodity complex. Last spring, the FITM did a good job forecasting the rebound in the euro, and the fact that it is flagging impeding euro weakness deserves to be highlighted. In terms of entering a short EUR/USD tactical bet, at the current juncture, the ITTM suggests an entry point is soon to emerge (Chart 8). Now that the dueling pair of the second round of the French election has been determined - Macron vs Le Pen - the euro was able to price out nightmare scenarios involving two Eurosceptic candidates. In fact, with the realization that Macron holds a 20% lead over Le Pen in second round polling, the market has begun to completely price out any euro-endangering outcome for the French election. This means that the euro is likely to move toward its historical premium to the ITTM before reverting toward its cyclical downtrend. Practically, this means that EUR/USD could run toward 1.11-1.12 before rolling over, something that may happen by May 8th. On a 12- to 18-months basis, we are comfortable with the current message from the FITM. The European economy may be growing above trend, but there remains enough slack in Europe that wage and core inflation dynamics are still very muted. This contrasts with the U.S. economy, where most indicators we track argue that wages and core inflation should gain some upward momentum this year. This means that rate differentials between the euro area and the U.S. are likely to underperform even what is priced into the relative interest rate curves. This should weigh on EUR/USD as the euro is not cheap enough to compensate for these economic dynamics. The Yen Chart 9A Dovish BoJ Will Weigh ##br##On Yen Fundamentals Chart 10The Yen Is No Longer ##br##Tactically Cheap The FITM model shows that the post-election rally in USD/JPY was overdone as the yen's fundamentals have stopped deteriorating after October 2016 (Chart 9). As we see the growing likelihood of a decreasing deflationary impulse in Japan, the strong dovish commitment of the Bank of Japan should pull Japanese real rates lower vis-à-vis their U.S. counterparts. This underpins why we remain cyclical bears on the yen. Tactically, based on the ITTM, it will soon be time to close our short USD/JPY trade. While the yen had massively undershot any rational anchor in the wake of the Trump electoral victory, this undervaluation appears to have vanished after the yen's sharp rebound (Chart 10). A small overshoot in the yen is likely, but unless one is already short USD/JPY, this move should not be chased. In fact, USD/JPY below 108 should be used as an opportunity to reverse yen longs and play what may prove to be a powerful USD/JPY rally. The British Pound Chart 11GBP: A Long-Term Bargain... Chart 12...But Upside Against USD Is Limited According to the FITM, the pound's fair value has been stable post-Brexit, but it is now beginning to point lower. However, despite this turn of events, GBP/USD is currently trading at such an exceptional discount to the FITM - courtesy of a heightened geopolitical risk premium - that this deterioration in fair value is unlikely to matter much (Chart 11). Nonetheless, the fact that fundamentals have a negative directional bias for cable is prompting us to express our tempered optimism toward the pound by shorting EUR/GBP instead of buying GBP/USD. At a tactical level, the ITTM suggests that GBP/USD could have a bit more upside. GBP/USD is at equilibrium based on our timing model, but undershoots tend to be compensated by subsequent overshoots (Chart 12). That being said, with the ITTM still pointing south - in line with the FITM - any further rebound in GBP/USD is likely to prove to be limited. GBP/USD beyond 1.33 should be used as an opportunity to sell cable. On a multi-year basis, GBP is quite cheap, not only on a PPP basis, but also when incorporating relative productivity dynamics. This means that while we have a positive dollar-bias over the next 12-18 months, our favorite non-USD currency is currently the GBP. The June 8th general election is likely to give Theresa May the parliamentary majority she needs to have a more comfortable negotiating position with the EU, helping her obtain more advantageous terms for the U.K., re-enforcing our positive long-term bias on the GBP. The Canadian Dollar Chart 13Oil And Spreads Are Working##br##Against The Loonie... Chart 14...And So Is##br## Wilbur Ross According to the FITM, the aggregate fundamentals have rolled over and are beginning to point directionally south for the loonie: Oil has lost momentum, and rate differentials are not particularly flattering for the CAD (Chart 13). That being said, the CAD has greatly lagged these same fundamentals, probably as investors have been pondering the potential negative implications for NAFTA and Canada of the Trump administration. Our ITTM suggests that with this handicap taken into account, the CAD may not be a short after all (Chart 14). However, because the CAD is more sensitive to the trend in the broad U.S. dollar and general commodity prices than anything else, we prefer to express a positive bias on the loonie by buying it against the AUD, a commodity currency that does not trade at the same discount to its ITTM. The Swiss Franc Chart 15Inflationary Dynamics Should##br## Continue To Weigh On The Franc Chart 16No Clear Timing##br## Signals Yet Even if flat for the past year or so, the directional fundamentals on the Swiss franc vis-à-vis the USD still seems to be in a long-term bear market (Chart 15). This simply highlights the fact that with the U.S. economy able to generate some inflationary dynamics while Switzerland continues to suffer from pronounced deflationary anchors, U.S. real rates have more room to move upward than Swiss ones. In terms of timing, the ITTM is in the neutral zone, suggesting that there is no particularly compelling reason to buy or short USD/CHF at the current juncture (Chart 16). The SNB is unofficially targeting a floor under EUR/CHF around 1.06 to tame the deflationary impulse in Switzerland. While the Swiss economy is improving, it is not yet strong enough to handle a removal of this policy. In all likelihood, this means that for the rest of 2017, USD/CHF will remain a near-perfect mirror image of EUR/USD. The Australian Dollar Chart 17Iron Ore Prices: From Friend To Foe Chart 18No Valuation Cushion For AUD AUD/USD has not been able to break above 0.77, and the reason simply is that the forces embedded in the FITM have sharply rolled over (Chart 17). Not only have commodity prices stopped appreciating - with iron prices, the most crucial determinant of Australia's terms of trade down 21% - but U.S. short rates and long rates have been going up relative to Australia. Most disturbing for Australia, unlike the CAD it does not possess any cushion when analyzed through the prism of our ITTM (Chart 18). This suggests that the deteriorating Australian fundamentals are likely to be directly translated into a lower AUD/USD. Moreover, historically, previous undershoots in the AUD were followed by an overshoot. We do not think this time is any different; but the dovish slant of the RBA and the drubbing received by iron ore prices suggest that if the AUD overshoots, it will be because it may not fall as fast as its fundamentals at first. If that is the case, we do expect a catch-up later this year. As previously mentioned, the relative dynamics between the Canadian and Australian ITTM suggest that investors in commodity currencies should short AUD/CAD. Moreover, on a longer-term basis, we also favor oil producers over metal ones. The supply dynamics in the oil market are much more favorable than for metals. Not only have many global oil producers cut down their output, our sister publication Commodity And Energy strategy expects the OPEC + Russia agreement to be extended for the rest of 2017.8 Meanwhile, metal production cutbacks have been much more timid. The New Zealand Dollar Chart 19NZD Suffers From ##br##Similar Ills As AUD... Chart 20...However Inflationary Backdrop##br## Is More Favorable The fundamentals for the New Zealand dollar have also rolled over after having pointed to a strong Kiwi since February 2016 (Chart 19). Interestingly, the rollover in the NZD FITM has not been as sharp as the rollover in the Australian Dollar's FITM. The ITTM does argue that as with the CAD, the NZD does have a healthy margin of maneuver before the deteriorating fundamentals become a bidding constraint (Chart 20). In fact, the recent NZD weakness may have exaggerated the underlying deterioration in NZ data. The recent stronger-than-expected inflation data may prompt investors to reconsider their very dovish take on the RBNZ. Our preferred fashion to take advantage of the NZD's discount to its ITTM is also against the AUD. Both currencies are very exposed to EM and China shocks, and both currencies display a similar beta to the USD. As such, it is very rare for the NZD to trade at a discount to the ITTM while the AUD is at equilibrium. With the New Zealand domestic economy in better shape than that of Australia, our bet is that both currencies will have to converge, which should weigh on AUD/NZD. The Norwegian Krone Chart 21NOK Fundamentals Have Worsened ##br##Even With Firm Oil Prices Chart 22Not A Good Time To##br## Buy The Krone Yet Like other currencies, the fundamentals for the Norwegian krone have begun to roll over. The sharpness of that turnaround is particularly striking when one considers that oil prices have remained resilient, despite their recent weakness (Chart 21). NOK has taken the cue from the FITM and has weakened in line with fundamentals. Is it time to lean against this weakness and buy the NOK now? We doubt it. The NOK may benefit against the USD if the euro overshoots in the wake of the French election. However, the NOK has yet to correct previous overshoots, and the fact that it currently trades in line with the ITTM suggests that it provides very little insulation against any further deterioration in its own fundamentals (Chart 22). In the longer term, we are more positive on the NOK. It is cheap based on long-term models that take into account Norway's stunning net international position of 203% of GDP. Moreover, the high inflation registered between 2015 and 2016 is now over as the pass-through from the weak trade-weighted krone between 2014 and 2015 is gone. This means that the PPP fair value of the NOK has stopped deteriorating. The Swedish Krona Chart 23Dollar Strength Has Dislodged ##br##The SEK From Fundamentals Chart 24Taking Momentum Into Account##br## The SEK Is Not Cheap The SEK continues to display one of the highest beta to the USD of all the G10 currencies. As a result, when the USD is strong, even if fundamentals do not warrant it, the SEK is especially weak. The rally in the USD in the second half of 2016 took an especially brutal toll on the krona, which has dissociated itself from its pure fundamentals. If the dollar follows the recent improvement in its own FITM, then SEK too will weaken despite its apparent undershoot (Chart 23). Now, however, the SEK's weakness will follow the deterioration in directional fundamentals. The timing model corroborates this picture. The ITTM takes into account the trend of USD/SEK, and when this is done, the undervaluation of the SEK disappears (Chart 24). Over the next three to nine months, we expect U.S. rates to have more upside relative to European ones than is currently priced in by markets. Therefore, we anticipate the USD to strengthen further, and as a corollary, the SEK will suffer especially strongly under these circumstances. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report, "Assessing Fair Value In FX Markets," dated February 26, 206, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 3 Michael T. Kiley (January 2013). 4 Please see Yin-Wong Cheung, and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 5 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016). 7 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 8 Please see Commodity And Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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Highlights Dusting Off The BCA Bond Model: As central bankers moving away from the hyper-easy monetary policies of the post-crisis era, reverting back to more traditional bond investing tools, like our BCA Bond Model - which focuses on cyclical economic pressures, valuation and momentum - can be useful. GFIS Composite Bond Indicators: After adding a new element to our classic Bond Model, carry, we come up with a new measure to assess government bond markets - the GFIS Composite Bond Indicators. Current Signals: Our new indicators point to Australia, Canada and the U.K. as looking more attractive on a relative basis than Germany or France. Feature For global fixed income investors, four key questions matter most in selecting which government bond markets to prioritize at the country level: Where each country stands in its economic cycle? Which bonds offer the best value? Which bonds exhibit the strongest price momentum? Which bonds benefit from the best carry? To answer those questions, BCA has built specific macro indicators over the years. The ones related to the cycle, value and momentum form the building blocks of the BCA Bond Model. We have not spent as much time discussing these indicators in recent years. This is because the performance of bond markets has been dominated by extraordinarily easy monetary policies (quantitative easing, negative interest rates) in the major economies since the Great Recession. As more central banks start to question the need for maintaining those crisis-era policy settings, however, the utility of referring back to our classic bond indicators is growing. In this Special Report, we re-examine our bond indicators, explain briefly how they were built, evaluate quantitatively if they still provide a consistent signal and elaborate on the best way to utilize them. To enhance the existing model, we add a "carry" component to it, which is a vital part of bond investing. Since the cyclical, value, momentum and carry indicators often give different asset allocation signals at any given point in time, we propose a way to aggregate the information into one single indicator for each country, i.e. the BCA Global Fixed Income Strategy (GFIS) Bond Composite Indicators. We then test these indicators to see if they help bond portfolio managers outperform. The report concludes by comparing the latest message from the GFIS Bond Composite Indicators versus our current recommended portfolio positioning. Specifically, we explain why we are choosing to deviate from our indicators and assess how we could shift our tilts in the future. Evaluating The BCA Cyclical Bond Indicators The most important aspect of bond investing is to understand where each country stands in its current economic cycle. As a way to quickly assess this, we developed our Cyclical Bond Indicators many years ago. Tailored for each country, the Indicators are composed of economic data such as: the unemployment rate private sector credit growth the slope of the government bond yield curve commodity prices denominated in local currency terms realized inflation rates Since economies do not always exhibit the same sensitivity to common macro drivers, we created country-specific Cyclical Bond Indicators that each use a different set of variables. After transforming the data, using de-trending and standardizing techniques, the variables are aggregated to form a single indicator for each country.1 Although Developed Market (DM) countries typically appear to be in the same phase of their economic cycle simultaneously, there are always some slight differences between them. These are crucial to identify and can make a huge difference in the government bond asset allocation process. First and foremost, knowing where a country is in its business cycle should impact expected returns on fixed income. Theoretically, bonds should underperform as the economic cycle becomes more advanced and outperform as the economic cycle deteriorates. Statistical Observations To verify that last statement, we separated the cycle for each country in our DM bond universe into seven distinct phases for the economic cycle: Euphoria End of upturn Upturn Downturn End of downturn Crisis Mega Crisis The phases of the cycle are defined by how much the Cyclical Bond Indicator diverges from its mean, which is always zero since the Indicators are standardized (i.e. removing the mean and dividing by the standard deviation). Chart 1 illustrates how our four core countries (U.S., Germany, Japan, U.K.) have gone through those cycles since 1967. At the positive end of the spectrum, the Euphoria state represents instances where economic variables have been especially upbeat (i.e. the Cyclical Bond Indicator is more than two standard deviations above the mean). At the negative end, the Crisis and Mega Crisis periods are when the Cyclical Bond Indicator is more than two and three standard deviations below the mean, respectively. Chart 1The BCA Cyclical Bond Indicators For The 'Core Four' Markets To evaluate the usefulness of the Cyclical Bond Indicator as an investment tool, we have calculated the average monthly return during each phase of the cycle for the major DM countries with a one-month lag (i.e. the March 2017 returns are based on the signals given by the February 2017 readings of the Indicators - this is done throughout the rest of this report when testing other bond indicators). The results are shown in Table 1. Table 1Bond Market Performance, Seen Through Our Cyclical Bond Indicator As expected, the average monthly performance tends to increase as an economy enters a downturn. Conversely, as an economic upturn gathers momentum, the performance of the bond market tends to decline.2 In Table 1, we highlighted the current phase for each country. Australia and U.K. are the only countries in Downturn territory right now; compared to their peers, those two countries would have the largest expected return3 of this group. On the other hand, the U.S. economy might be at the End of Upturn phase, when Treasuries should be expected to post the worst return, if history is any guide. In Table 2, we broke out the monthly results into 10-year periods to test the consistency of the indicator performance over time. Unsurprisingly, the End of Upturn phase has been quite detrimental for the DM bond markets during all eras, while the End of Downturn episodes have been good for bond investors in every decade. Table 2Bond Market Returns During ##br##The Various Stages Of Our Cyclical Bond Indicator Are Consistent Across Time Chart 2The Gains From Bond Investing##br## According To The Economic Cycle Finally, we looked into the usefulness of the Cyclical Bond Indicators in helping construct simple bond portfolios by using them as a ranking tool using the steps described in Box 1. The big picture takeaway is this: the countries with the three highest ranking Cyclical Bond Indicators (i.e. those with the slowest economic growth) outperform by roughly +6 basis points (bps) per month, on average. Similarly, the countries with the lowest-ranked cyclical indicators would underperform by -6bps, on average (Chart 2). Box 1 Ranking Bond Returns Using The BCA Cyclical Bond Indicators We calculated the average monthly excess return by buckets using the following steps: We ranked the ten countries in our bond universe by the level of their Cyclical Bond Indicators, from lowest (ranked #1) to highest (ranked #10). We then calculated the monthly currency-hedged excess return of each country versus the average of all the countries in our DM bond universe We then aggregated all the monthly results to have an average excess return for all ten of our ranking buckets We then separated them further into three buckets (the top three, middle four and bottom three ranks) and averaged the monthly excess returns for those groupings. Comments There is nothing particularly out of the ordinary with those findings - the countries with the weakest economies have the best performing government bond markets. However, the results of these statistical exercises confirm that the BCA Cyclical Bond Indicators are reliable and can confidently be used to support our qualitative analysis for each country. Importantly, following those indicators brings a dose of discipline to our bond allocation framework. For example, if our initial qualitative macro analysis diverges markedly from what the Cyclical Bond Indicator is telling us, this would represent a red flag that prompts us to question our initial conclusions. We will highlight situations like this later in this report. Evaluating The BCA Bond Value Indicators To assess the richness or cheapness of DM government bonds, BCA developed a Bond Value Indicator for each country. It is composed of several measures that have a fundamental macroeconomic relationship to bond yields, such as: Central bank policy rate expectations Trend inflation The deviation of the exchange rate from Purchasing Power Parity (PPP) The 10-year U.S. Treasury yield (as a proxy for the global bond yield) The variables are transformed using regressions, then combined to form a single measure of how far bond yields are from a theoretical fair value. Similar to other components of the BCA Bond Model, the power of these country indicators arises when comparing them amongst each other. Bond markets with yields below fair value should outperform those with yields above fair value. Just like all other asset classes, valuation is a poor tactical timing tool for fixed income. Our Bond Value Indicator is more useful in the long term; value can remain cheap/expensive for an extended period of time. For example, Germany has been the most, or second-most, expensive bond market in our bond universe since June 2013. Due to this shortcoming, the Bond Value Indicator will be given a smaller weighting in our composite indicator laid out later in this report. Statistical Observations To test this indicator, we looked at the hedged excess monthly returns generated using the same ranking procedure laid out in Box 1. The results show that investors can expect to earn about +12bps per month in excess hedged return from countries with the three cheapest valuations according to the Bond Value Indicators, and can expect to lose -6bps/month in countries that are ranked most expensive (Chart 3). Moreover, betting on countries with the cheapest ranked valuations skews favorably the odds of outperforming, from about 46% to 53% (Chart 4). Chart 3The Gains From Bond Investing ##br##According To Value Chart 4Favor The Cheaper Bond Markets Comments Currently, the U.S. bond market offers the best value (Chart 5). This contrasts unfavorably with our recommended underweight exposure to U.S. Treasuries. Nonetheless, we remain comfortable with this exposure since the U.S. economy is currently in the strongest economic cycle, and its bond market is technically less oversold than its peers (see the next section). Chart 5Bunds Look Rich, Treasuries Look A Bit Cheap Also, note that German and Japanese yields look quite expensive, although this is no surprise given the extremely easy monetary policy settings (negative rates, central bank asset purchases) in place from the European Central Bank (ECB) and Bank of Japan (BoJ). As we have discussed in recent Weekly Reports, we see far greater risks for the ECB moving to a less accommodative monetary bias in the months ahead than the BoJ, and we shifted our country allocations to reflect that view (moving to overweight Japan and cutting Germany to neutral).4 In other words, Japanese bonds will likely stay expensive for longer, unlike German debt. As we mentioned earlier, the value component warrants lesser importance in our tactical and strategic bond allocation framework since it is more long term in nature. In a nutshell, value is something good to have on your side when the macro backdrop shifts, but is not absolutely crucial to generate returns on a month-to-month basis. Evaluating The BCA Bond Momentum Indicator So far, the BCA Bond Cyclical Indicator informed us where the macroeconomic forces were the strongest and the BCA Bond Value Indicator helped us find bargains. This is all great, but bond investors could still underperform if their timing is off. The BCA Bond Momentum Indicator helps in finding the appropriate short-term timing. It has been built simply by looking at how far bond yields are relative to their primary medium-term trend. In theory, bond markets where yields are too stretched to the upside (oversold) should outperform versus countries where yields are too stretched to the downside (overbought). Statistical Observations Using the same ranking methodology explained in Box 1, investors can expect to earn roughly +11bps/month in excess return versus DM peers where conditions are the most oversold and should expect to lose -6bps/month from bond markets with the most overbought conditions (Chart 6). Comments While we do consider technical analysis as part of the tactical component in our bond allocation framework, we put less emphasis on it relative to other more fundamental factors that sustainably drive bond returns over time. Nonetheless, our ranked findings show that choosing markets based on price/yield momentum does generate fairly reliable outperformance. What About Carry? As seen so far, our traditional bond indicators encompass typical variables that would be expected to influence bond returns. Our framework would be incomplete, however, without incorporating the notion of "carry" - the investment return generated by the interest income on bonds. Having instruments that earn too little carry can be very harmful to the returns of a bond portfolio over prolonged periods. A simple observation of the long-term performance of higher-yielding credit markets (i.e. corporate debt or Emerging Market sovereigns) proves that point (Chart 7), especially in the current era where investors continue to stretch for yield given puny risk-free interest rates in so many countries. Chart 6The Gains From Bond Investing ##br##According To Momentum Chart 7Carry Plays A Huge Role ##br##For Long-Run Bond Returns Of course, most of the major carry gaps between DM sovereign bond yields disappear after currency hedging. However, even on a hedged basis, the carry differentials remain important. Currently, Italian debt carries the highest hedged yield in our DM bond universe, at 3.95%, versus 1.54% for Japan. The 241bp differential between the two is significant, especially in the current global low yield environment. However, some of that additional yield is compensation for the greater riskiness of Italian debt, given the many structural problems in that country (high debt levels, low productivity, political instability, fragile banks). In other words, a better way to evaluate carry is on a risk-adjusted basis. In Chart 8, we show the hedged 10-year government bond yields of the ten DM countries shown throughout this report, both in absolute terms (top panel) and adjusted for volatility (bottom panel). Note that Italy's ranking moves down two notches after accounting for the greater return volatility of Italian debt, while Spain offers the most attractive yield on a risk-adjusted basis. At the other end of the spectrum, Australia and Canada have less attractive yields relative to their volatilities than Japan - home of the 0% bond yield. Of course, as the old investment saying goes, "you can't eat risk-adjusted returns." As a general rule, bond markets with higher yields should be expected to outperform markets with lower yields over time. Statistical Observations An historical analysis of our DM universe using the methodology laid out in Box 1 confirms that observation. The bond markets with better ranked carry have a tendency to generate positive excess returns (on a currency-hedged basis) and, on average, produce more winning months than losing ones (Chart 9). This is true even though the higher-yielding markets are often those with higher inflation, or greater government debt levels, or more active central banks that create interest rate volatility. Chart 8Peripheral European Carry##br## Is Still The Most Attractive Chart 9The Gains From Bond Investing##br## According To Carry Comments Currently, the carry factor would favor overweighting Italy, Spain and France, while underweighting Japan, Australia and the U.K. Those relative rankings still generally hold up even after adjusting for volatility. Pulling It All Together: Introducing The GFIS Bond Composite Indicators Now that we have outlined the four elements of our proposed composite bond indicator, the question becomes: how do we aggregate those pieces? The components of our original BCA Bond Model rarely give the same message simultaneously, even after adding a new factor (carry) to the mix. Moreover, as discussed above, some elements (Cyclical and Carry) are more important than others (Value and Momentum) in delivering consistent outperformance of bond returns. Hence, to build a new composite indicator, we need to make a judgment call as to which component should be given more weight. Cyclical (50%). Here at BCA, we spend a fair amount of time trying to deeply understand economic cycles, which are a major driver of financial markets. Bonds are no exception, with changes in growth and inflation expectations forming the fundamental building blocks of yields. As such, we allocate a substantial 50% weight to the cyclical component of our GFIS Bond Composite Indicators. Value (15%). Value moves much more slowly than the other indicators and yields often diverge from fair value for long periods of time. As such, we are giving a smaller weighting of 15% to the value piece of the GFIS Bond Composite Indicators that we are designing to provide a timely signal for country allocation. Momentum (15%). Although technical analysis should be a meaningful part of any investment process, markets can often trend for extended periods before any consolidation, or even reversal, takes place. To reflect that, our momentum indicator will also carry only a 15% weighting in our composite indicator, the same as the weight given to value. Carry (20%). Carry should play an important part in a bond allocation framework. To use a sporting analogy - favoring higher-yielding bonds means starting the game with the score already in your favor. For that reason, we will give carry a 20% weight in our overall bond indicators. After combining our individual bond indicator rankings (from 1 to 10) using the weightings described above, we come up with an overall score for each country which becomes the GFIS Composite Bond Indicator (Table 3). Ranking the countries according to their respective scores gives a new indication as to which bond markets we might want to overweight or underweight. Table 3Combining The BCA Bond Indicators Statistical Observations Chart 10Our Composite Bond Indicator ##br##Adds Value At The Extremes To test the investment performance of our new GFIS Composite Bond Indicators, we created an equally-weighted index using the monthly hedged returns of the ten countries in our DM bond universe. We then created two portfolios: One composed of the countries with the three best composite scores; The other composed of the countries with the three worst composite scores. In both cases, those sample portfolios out-/under-performed the equally-weighted index as expected, proving that value can be extracted by following the recommendations of the GFIS Composite Indicators (Chart 10). Comments This automatic/quantitative ranking of the countries is designed as a guideline only. The goal here is to quickly find what could be the most appealing bond markets on a relative basis. Judgment on whether to apply the findings should and will always take precedence when we make our investment recommendations. Also note, in attributing weightings across the components, we have not used any optimization techniques to find the perfect balance. We simply relied on our judgment for a simple reason: optimization gives the best fit according to a set of historical market volatilities and correlations. During periods when volatilities change, or correlations become less stable, the historically-optimal weightings may produce sub-optimal investment results. We prefer to use a constant set of weights across our individual indicators, derived from our own investment intuition and preferences. What Could Be Our Next Portfolio Tweaks? We compare the latest rankings from our GFIS Composite Bond Indicators to our current fixed income country allocations in Table 4. Deviations between the two can provide some ideas for possible changes to our recommendations. Table 4The GFIS Composite Bond Indicator##br## Vs. Our Current Recommendations From this table, two observations arise: The three countries that rank the highest, Australia, Canada and U.K. are at neutral in our recommended portfolio (Chart 11). Should we move them to overweight? Among the three countries that rank the worst, we are still only at neutral Germany and France (Chart 12). Should we move to an underweight stance given the signal from our new Composite Bond Indicator? On the first point, we have turned decidedly less negative on Australia and U.K. bonds of late.5 In the next few months, if more signs of cyclical deterioration emerge, we will be tempted to align ourselves with our composite indicators and overweight those markets. Although as we discussed in a recent Special Report, another set of our in-house indicators, the Central Bank Monitors, are pointing to pressures to tighten monetary policy in Australia, Canada and the U.K., perhaps providing some justification for only being neutral on those markets.6 On the second point, we recently downgraded core Europe to neutral from overweight, given our growing concern that the ECB will be forced to announce a tapering of its asset purchases, likely starting in early 2018.7 We anticipate that our next move will be to a full-blown underweight position on both Germany and France, although we prefer to wait until after the upcoming French elections before making that shift. Given our view that the populist Marine Le Pen will not win the presidency, we expect to be cutting Germany before France, as there is still a wide political uncertainty premium built into French-German bond spreads.8 Chart 11Bond Upgrade Candidates Chart 12Bond Downgrade Candidates Going forward, we will continue to monitor our GFIS's Composite Bond Indicators to supplement/confirm our macro analyses and to discover some potential portfolio moves/trades. Additionally, we will look to further test and refine the Composite Bond Indicators by looking at different weighting schemes among the component indicators, how the correlations between the components shift over time (and if there is any information from those changes), and other considerations. Now that we've "dusted off" our classic bond indicators, there is plenty of additional research that can be done to build on the initial results shown in this report. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We have built the Cyclical Bond Indicators using data going back to 1967 for most DM countries, allowing for a robust historical analysis across the different bond markets. 2 Since global bonds have experienced a powerful secular bull market over the past 35 years, the majority of monthly returns in the history of the Cyclical Bond Indicator have been positive. As such, shorting bonds in absolute terms has seldom proved to be a value-added proposition. The only exceptions are when the macro landscape has entered the Euphoria state, which has been quite rare. 3 In local currency terms 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 5 Please see BCA Global Fixed Income Strategy Weekly Reports, "Will The Hawks Walk The Talk?", dated March 7, 2017 (on the U.K.), and "It's Real Growth, Not Fake News", dated February 21, 2017 (on Australia), both available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28, 2017, available at gfis.bcaresearch.com 7 Please see BCA Global Fixed Income Strategy Weekly Report, "March Madness", dated March 14, 2017, available at gfis.bcaresearch.com 8 Please see BCA Global Fixed Income Strategy Special Report "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com

Highlights The locomotive of the U.S. economy, the consumer, remains supported by powerful tailwinds. The Fed will be able to tighten monetary policy relative to other central banks by a higher degree than the market appreciates. The dollar will rise further. Use this dip to buy more dollars. Being tactically long the yen is a hedge against growth disappointments. Set a stop-sell for AUD/NZD. Feature In June of last year, we wrote a piece titled "What Could Go Right?" arguing key changes in the global economy may have justified a more pro-risk stance for investors.1 The core of the argument was that markets were pricing in a lot of negatives, as the annual return of the global stock-to-bond ratio was deeply negative and could only fall further if a recession were to emerge. Moreover, as commodity prices were improving, we foresaw a waning of deflationary forces that had engulfed the world. This easing deflation would cause real rates to fall and economic activity in EM to rebound. Chart I-1Global Asset Prices: From Gloom To Glee Over the subsequent nine months, this scenario moved from the world of theories to being the reality for the global economy. Today, the annual return of the global stock-to-bond ratio is now the mirror image of last June (Chart I-1). Thus, for the stock-to-bond ratio to move higher, we need to explore where growth may come from. Moreover, we need to consider whether this growth is likely to help the dollar or help other currencies. The U.S. Is In Charge The U.S. economy continues to show the most promise. It is true that some signs do point to a weak Q1. Much noise has been made about the decline in commercial and industrial loans. We are more sanguine. To begin with, the Conference Board includes C&I loans in its list of lagging indicators, not leading ones. Additionally, C&I loans lag banks' lending standards, and, in fact, the weakness in this subsection of credit aggregates is the natural consequence of the 2015-2016 tightening in lending standards. Their recent easing points toward a rebound in C&I loans, as do core durable goods new orders (Chart I-2). What is more concerning is the slowdown in credit to households (Chart I-3). The U.S. economy is driven by household dynamics and the Conference Board does include consumer credit in its list of leading indicators. Moreover, the amount of MBS and ABS on primary dealers' balance sheets remains in a downtrend. This is worrisome because it suggests that the slowing accumulation of consumer debt on banks' balance sheet is genuine, and not a reflection of securitization (Chart I-4). Chart I-2C&I Loans##br## Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit However, there are causes to minimize these concerns. Mainly, the drivers of household income and spending are still healthy. First, U.S. financial conditions remain easy, a phenomenon that tends to boost GDP growth in the following quarters, suggesting that national income will remain strong. Second, the outlook for employment in the U.S. remains robust. As Chart I-5 illustrates, the employment components of the ISM and the Philly Fed surveys both point to a pick-up in job creation. This further supports the notion that nominal household income will strengthen Third, our real disposable income indicator, based on various components of the NFIB survey, is showing that households should enjoy strong income growth in the coming months (Chart I-6). Moreover, despite the failure of the AHCA, Marko Papic, the head of BCA's Geopolitical Strategy service argues that it will be much easier for the GOP to implement tax cuts, especially geared toward the middle class, than it was to repudiate the much-maligned Obamacare.2 This could further help household disposable income. Chart I-5Job Growth Will Rebound Chart I-6Household Income: Highway Star Fourth, household liquid assets represent 270% of disposable income, the highest level in decades. Moreover, household debt-servicing costs are still near multi-generational lows, suggesting that households are in the best financial shape they have been in decades. And fifth, household confidence has surged to its highest levels since 2000, reflecting both the large increase in net worth created by surging asset values as well as the very low level of unemployment in the U.S. (Chart I-7). Thus, the decline in the savings rate from 6.2% in 2015 to 5.5% at present could deepen further, adding more impetus to transform income gains into consumption gains. At the worst, this development suggests that the household savings rate will not rise much. These factors all imply that household consumption will remain robust and may in fact accelerate in the coming quarters. Consequently, that capex too has upside. We have highlighted how capex intentions have risen substantially, and this has historically been a powerful leading indicator of capex itself.3 However, the financial press is replete with commentators reminding us that the positive global economic surprises have mostly been a reflection of "soft data" and that "hard data" has not followed through. Not only do we philosophically disagree with this statement - historically soft data does indeed lead hard data - but as Chart I-8 illustrates, core capital goods orders have risen quite sharply, mimicking the developments in retail sales. A combination of strong retail sales and strong orders tend to portend to a rise in capex. Chart I-7Happy Shiny People Chart I-8Capex Will Rebound These developments raise the likelihood that U.S. growth will power the global economy and that the Fed will be in a good position to make good on its intent to increase interest rates two more times this year. In fact, there is even a growing probability that the Fed will add another tool to its tightening arsenal: letting MBS run off, resulting in a contraction of its balance sheet. The combined tightening of two more hikes and a shrinking balance sheet will be much greater than any tightening emanating from an ECB taper. As we argued last week: Europe's inflation and wage backdrop remains icy cold, limiting how far the ECB can tighten monetary policy.4 While an environment of globally rising rates is normally negative for the yen, with the BoJ displaying and even easier bias than in the past, any increase in rates in the U.S. is likely to supercharge weaknesses in the yen, as the BoJ will put a lead on JGB yields and force them to remain subdued.5 As a result of these views, we remain very committed dollar bulls on a 12-18 months basis and recommend using the current dip in the dollar as a buying opportunity, especially on a trade-weighted basis. Bottom Line: While consumer loan growth has slowed - which could result in a poor Q1 U.S. growth number - the outlook for U.S. household income and consumption remains promising. This will also feed through to higher investment growth, clearing the Fed's path toward higher rates. This dip in the dollar should be used as an occasion to buy the greenback. But Why Still Long The Yen Tactically? This position has two purposes. First, we have been worried about dynamics in China that could cause a correction in EM markets.6 More recently, the decline in Chinese house-price appreciation has deepened, representing an ominous sign for the iron ore market (Chart I-9). Poor metal prices tend to represent a negative terms of trade shock and therefore an economic handicap for many large EM nations. Moreover, back in June, the improvement in Taiwanese IP was one of the factors that prompted us to highlight a potential improvement in the global economy. So was the uptrend in our boom/bust indicator. Today, not only is the boom/bust indicator losing steam, but Taiwanese IP has sharply rolled over (Chart I-10). While this is not a reason to worry about our bullish view on the U.S. economy, this could suggest that the global manufacturing upswing has seen its heyday, a development that is likely to weigh more heavily on EM economies than on the U.S. Any EM stress is likely to boost the yen's appeal, temporarily countering the BoJ's aggressive stance. Chart I-9Problems For Iron Ore Chart I-10Two Clouds For Global Growth Second, we do not want to be dogmatic on our U.S. growth view. As the top panel of Chart I-11 illustrates, increases in 2-year Treasury yields have tended to lead to decreases in U.S. inflation expectations. While we would argue that the U.S. economy is on a stronger footing to withstand higher rates than at any point since 2010, a policy mistake is not out of the scope of probabilities. If rising rates is indeed a policy mistake, a large risk-off event would be a very likely outcome, one that boosts the yen. Finally, as the middle and bottom panels of Chart I-11 shows, a fall in U.S. inflation expectations would also extract its toll on EM and cyclical plays, further reinforcing any disappointment out of China, and further adding shine to the yen. Our original target on USD/JPY was 110, we are moving it to 108. At this point, we will become sellers of the yen, unless we see signs that the global economy is entering a more dangerous path than originally anticipated. Additionally, investors looking to express a bearish view on EM may want to go short MXN/JPY (Chart I-12). The peso has massively rallied and is now at a crucial technical spot against the JPY. Moreover, while being short USD/JPY may be a dangerous move - after all, we are playing what amounts in our view to a countertrend bounce in the yen - if EM are at risk, these risks could be exacerbated by the tightening in financial conditions created by a higher dollar. Mexico, with its high external debt, representing nearly 70% of GDP, is particularly exposed to this problem. Also, MXN, with its high liquidity for an EM currency, is often a vehicle for investors to play EM weaknesses. Thus, shorting MXN/JPY could be a great hedge for investors with long EM exposures. Chart I-11Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play Bottom Line: Being tactically long the yen in a portfolio offers two advantages. First, it is a direct play on any disappointment of investors in the EM space, and, second, it is also a hedge against the risks to our strong U.S. growth view. AUD/NZD: Not A Bargain It is often argued that AUD/NZD is a bargain as it trade 6% below its purchasing power parity rate. This may be a valid reason to buy this cross, but only for investors with extremely long investment horizons, as PPP deviations can take seven years to correct. In fact, following the recent rebound in AUD/NZD, we would be inclined to short this pair once again. On the international front, AUD/USD seems to be driven by the dynamic in Chinese nominal GDP growth. We doubt Chinese nominal GDP growth will accelerate much beyond Q1. As Chart I-13 illustrates, AUD/USD seems to have moved ahead of Chinese GDP, putting this currency at risk. We also can also interpret AUD/NZD as a vehicle to play the growth rebalancing in China. The AUD (iron ore, other metals, and coal) is a bet on industrial and investment growth while the NZD (dairy, meat, and wool) is a wager on the Chinese households. As China moves away from an investment-led growth model toward a more consumption-led growth model, AUD/NZD should underperform. A simple fair value model for this cross designed to capture these dynamics as well as the USD dynamics indicates that AUD/NZD is 8% overvalued (Chart I-14). Chart I-13AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive Moreover, still with an eye firmly planted on China, AUD/NZD has tended to perform poorly when Chinese monetary conditions tighten. The recent upward move in the Chinese 7-day repo rate could be a harbinger of bad things to come for this cross. Relative domestic factors also temper any bullishness on AUD/NZD. Kiwi house prices are outperforming Aussie prices and New Zealand inflation is catching up to that of Australia's. Moreover, the RBA has been paying more attention to the poor state of the Australian labor market, while that of New Zealand remains very strong. These dynamics suggest that kiwi rates could rise relative to that of Australia (Chart I-15). More technically, investors are massively long the AUD relative to the NZD (Chart I-16). This usually is a good signal to bet against this pair. Chart I-15Domestic Conditions Favor##br## Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Bottom Line: Shorting AUD/NZD at current levels makes sense. Not only is it a way to take advantage of the desire by Chinese authorities to rebalance growth away from the Chinese industrial sector, the Kiwi economy is outperforming that of Australia, and too much negativity has been priced in for the RBNZ relative to the RBA. Finally investors are overly long the AUD relative to the NZD. Set up a stop-sell of AUD/NZD at 1.1100, with a target of 1.000 and a stop at 1.1330. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "What Could Go Right?", dated June 24, 2016 available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe", dated March 22, 2017 available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016 available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "JPY: Climbing To The Springboard Before The Dive", dated February 24, 2017 available at fes.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, "Healthcare Or Not, Risks Remain", dated March 24, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The DXY displayed resilience this week: the third estimate for U.S. GDP in 2016Q4 outperformed expectations at 2.1%, after being revised up from 1.9%; consumer confidence increased to 125.6, the highest level since 2000; yet Initial jobless claims ticked in at 258,000, underperforming expectations of 248,000 but beating previous figures of 261,000. Another factor lifting the dollar were recent comments by Secretary of Transportation, Elaine Chao, who stated that Trump's $1 trillion infrastructure plan will be unveiled later this year. This could be considerably positive for U.S. economic growth as it will cover a large part of the economy: "transportation infrastructure, energy, water and potentially broadband and veterans hospitals as well." Although specifics were not disclosed, such stimulus in the face of tightening labor market could fan inflation. Under the assumption of a proactive Fed, this could translate into a strong dollar. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Last week's hawkish comments by ECB board member Ewald Nowotny drove the euro higher, while recent comments by Peter Praet confirmed that "a very substantial degree of monetary accommodation is still needed", which pushed the euro down. Promoting the euro's downside were Italian industrial sales and orders, which contracted at a monthly pace of 3.5% and 2.9% respectively, although annual rates remain positive. Article 50's invocation was another factor which contributed to volatility. How Brexit negotiations evolve will dictate movements in EUR/GBP for the foreseeable future. President Tusk's demeanor was also quite negative in his speech, focusing on minimizing "the costs for EU citizens, businesses and Member States". In other news, Portugal's Finance Minister Mario Centeno hinted at a possible upgrade to the growth forecast to around 2% from 1.5% as exports grew by 19% in January. As exports continue to be a key driver of growth for this country, this suggests a weaker euro is still needed to support growth in the periphery. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been mixed for Japan: Corporate services prices rose by 0.8% year-over-year, outperforming expectations. However, retail trade yearly growth deteriorated to 0.1% from 1% the previous month, underperforming expectations. Furthermore, manufacturing PMI fell to 52.6 from 53.3 the previous month. We are changing our tactical target for USD/JPY from 110 to 108. The decline in Chinese property prices as well as slowing inflation expectations in the U.S. might create a risk off environment that will affect carry currencies and will benefit the safe havens like the yen. On a cyclical basis, we remain yen bears, as recent sluggishness will only embolden BoJ policy makers to maintain their radical monetary stance. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 It's official: Theresa May has triggered Article 50. The pound reacted relatively positive to the event as both parties in the negotiations chose to start with the carrot rather than the stick: In her letter to the EU Theresa May stated that she hoped to enjoy a "deep and special" relationship with the European Union once Brexit is finalized. On the other side of the channel, Donald Tusk also pledged to work "closely" with their counterparts in London, and that he hoped that the U.K. will stay a close partner after Brexit. These developments are encouraging, as it shows that cooler heads might prevail at the end of the day. This rosier outlook in an environment where expectations for the Britain are still too pessimistic makes the pound a very attractive buy, particularly against the euro, despite the potential for short-term volatility as the stick will ineluctably come out. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 In an attempt to curb housing market euphoria, all four major banks - ANZ, CBA, NAB and Westpac - increased lending rates on investor and interest-only mortgages this month. Fitch Ratings reports that the tightening was done "ahead of probable regulatory tightening", as hinted frequently by the RBA. Rising wholesale funding costs due to tighter U.S. policy is also a motivating factor behind this. For the time being, the housing market risk will continue to be restricted through macroprudential policies rather than actual tightening by the central bank. Eventually risks related to record-high household debt will limit the capacity of the RBA to increase rates. On the brighter side, banks are well positioned with strong capital buffers and pre-impairment to profitability, with Fitch rating them 'Stable'. This means that risks may not lie with the banking sector, but that the consumer sector will be the key drag on growth. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In the current environment, although we like to continue to be short the NZD against the yen, we are also shorting AUD/NZD once again. Beyond its uncorrelated nature, there are many reasons why this is an attractive cross to short: AUD/NZD tends to perform poorly when Chinese monetary conditions tighten. Therefore, the spike in Chinese repo rates could weigh on this cross. Furthermore, investors are very long the AUD relative to the NZD. This gives us confidence that this cross might be in overbought territory and that the 5.5% rally in AUD/NZD over the last 2 months may be exhausting itself. Finally, as we have mentioned before, domestic factors still favor the NZD, as kiwi house prices are rising at a faster pace than Aussie ones, which should put pressure on rate differentials. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD is displaying some strength on the back of stronger oil prices, outweighing the pressure from a stronger USD. As mentioned last week, the trend for USD/CAD is still negative in the short term, as corroborated by a negative MACD trend. The greenback's seasonal behavior is also generally negative in April, which could buoy the CAD in the next month. Nevertheless, at the Bank of Canada's meeting in two weeks, Poloz is likely to continue displaying a dovish rhetoric, limiting the CAD's resilience. Similar to Australia, risks lie with the consumer sector, which is burdened by a huge debt load. This gives another reason for Poloz to stay off hikes for the time being and concentrate instead on promoting the implementation of macroprudential policies to regulate lending standards and mitigate housing market risks. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF now hovers around 1.07, clearing the implied floor by the Swiss National Bank. Recent data have been positive: The Zew survey for economic expectations reached 29.6, up from 19.4 in February. It is now at the highest level in 3 years. The KOF leading indicator came at 107.6, above expectations. Although it does seem that the Swiss economy is still improving, the SNB will stay resolute in its intervention for the time being. Indeed, this was the message of SNB Governing Board Member Andrea Maechler, who asserted that there was no limit on their expansion of FX reserves, and that the Swiss franc was "strongly overvalued". We will continue to observe how the Swiss economy develops. However, for the time being the SNB is likely to keep its floor in place. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week, even in the face of a rally in oil prices. This has been in part due to a phenomenon that should continue in the next months: an appreciation of the U.S. dollar against EM and commodity currencies. Furthermore, domestic factors should continue to weigh on the krone, as employment continues to contract and inflation is receding due to the stabilization of the krone. Indeed, Governor Olsen signaled that the Norges bank will likely leave rates unchanged for "a good while" due to these developments. Furthermore, oil could be at risk as well, as the market is starting to doubt the Russian commitment to its deal with OPEC. This, coupled with a slowdown in EM, could prompt a down leg in oil, hurting the NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data came out strong: Retail sales annual growth remains unchanged at 2.7%; The producer price index grew at 7.5%; Consumer confidence for March was at 102.6, down from the previous 104.3. Interesting technical developments for the krona are pointing to further weakness. USD/SEK has rebounded from oversold levels and the MACD line is beginning to overtake the signal line. More importantly, the Coppock curve is rebounding, signifying a bullish trend. EUR/SEK is showing similar signs with the MACD pointing up and the Coppock curve rebounding. Interestingly, Swedish inflation expectations have substantially decreased this week which might give the Riksbank cover to remain dovish. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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Highlights The years since the 2008 Global Financial Crisis have been dominated by the major central banks emptying their toolkits to fight off deflationary pressures and sustain even modest nominal growth rates. Extraordinary policy measues like quantitative easing, negative interest rates and "forward guidance" were all intended to be signals to expect nothing but stimulative monetary policy, even if there were brief pickups in growth or realized inflation rates. This helped suppress both bond yields and volatility, forcing investors to take on more risk to generate acceptable returns in fixed income markets. Now, however, there are signs that the world economy may finally be becoming a bit more "normal" after the years of malaise. While growth can hardly be described as booming, there are a growing number of countries that appear to have passed the worst phase of the excess capacity/deflation pressures that dominated the post-crisis era. This is creating more two-way risk with regards to central bank decisions than we have seen for some time. In this Special Report, we update one of our favorite tools to assess the potential for monetary policy changes, the BCA Central Bank Monitors. We present them in a chartbook format with a focus on the relationship to government bond yields. Feature An Overview Of The BCA Central Bank Monitors The BCA Central Bank Monitors are composite indicators that are designed to measure the cyclical growth and inflation pressures that can influence future central bank policy decisions. We created Monitors for the major developed economies: the U.S., Euro Area, Japan, the U.K., Australia, Canada and New Zealand. The list of data series used to construct the Monitors is not the same for each country, but the components generally measure the same things (i.e. manufacturing cycles, domestic demand pressures, commodity prices, labor market conditions, exchange rates, etc) Right now, the Monitors are rising in a coordinated fashion for the first time since 2011 (Chart 1 on Page 1). What is different in 2017 is that there is much less spare capacity in the developed economies than there was six years ago. For central bankers who still adhere to the Phillips curve tradeoff of unemployment versus inflation, tight labor markets alongside highly accommodative policy settings pose a problem. In the rest of this report, we show the individual Central Bank Monitors, along with measures of spare capacity and inflation for each country. We also show the correlations between the Monitors and changes in government bond yields, both before and after the 2008 Crisis. Correlations have shifted in the post-crisis era, but there are still some reliable relationships that can provide signals for bond investors. The broad conclusions: Japanese Government Bonds (JGBs) are the ideal country overweight in a world where all other developed economy central banks are witnessing rising cyclical pressures, while bonds in the U.K., Australia and New Zealand are likely to struggle as central banks in those regions become increasingly hawkish (Chart 2). Chart 1More Central Banks Are Under Pressure To Tighten Chart 2Tightening Pressures (Ex-Japan) ##br##Can Push Bond Yields Higher The Fed Monitor Is Pointing To Additional U.S. Rate Hikes Our Fed Monitor has just recently pushed above the zero line, indicating the need for the Fed to tighten policy (Chart 3A). The Fed already began raising the funds rate back in late 2015, but this was the beginning of normalizing the crisis-era policy settings rather than a move to offset improving U.S. cyclical conditions. The latter is now indeed happening, and it is perhaps no surprise that the Fed has just delivered 50bps of rate hikes in a span of three months. Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. Chart 3CThe Fed Monitor Is Most Correlated To ##br##Shorter Maturity U.S. Treasuries We still see the Fed pursuing a relatively gradual process of raising rates further in 2017, but in line with the current FOMC projections of another 50bps of tightening before year-end. Measures like the output gap and the unemployment gap (unemployment relative to the level consistent with stable inflation) show no spare capacity in the U.S. economy (Chart 3B). At the same time, core inflation continues to only grind higher and inflation expectations are also drifting up towards the Fed's 2% target. This can hardly be qualified as an "overheating" economy that needs a sharp tightening of monetary conditions, particularly with the still-expensive U.S. dollar not providing any stimulus. The correlations between our Fed Monitor and the year-over-year changes in U.S. Treasury yields (Chart 3C) have been extremely low since the 2008 Crisis - unsurprising with the Fed keeping the funds rate near zero for most of that period while also buying large amounts of Treasuries. While the correlations appear to be shifting on the margin, we still see the Treasury curve steepening first (via rising inflation expectations), then flattening later (through tighter monetary conditions). BoE Monitor Calling For Tighter U.K. Policy Our Bank of England (BoE) Monitor is at very elevated levels (Chart 4A), driven by a combination of improving production data and high inflation. There is much more bubbling beneath the surface, however. The more domestically-focused components of the Monitor are losing some upward momentum, while the inflation elements are also starting to top out as the big post-Brexit depreciation of the Pound is losing momentum. Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Chart 4CGilts Are At Risk From A More Hawkish Turn From The BoE This is creating a dilemma for the BoE - respond to high U.K. inflation with tighter monetary policy, or focus on the slowdown in domestic demand and do nothing? The BoE signaled in February that the biggest concern for policy was a slump in consumer spending led by lower real income growth on the back of rising inflation. Yet at the March policy meeting, one BoE member even voted to raise rates and others raised concerns about the elevated level of U.K inflation. With even policymakers unsure about their next move, the marginal swings in U.K. growth should have an even greater impact on Gilt yields. The U.K. economy is running around full capacity and both headline and core inflation are rising (Chart 4B). Somewhat surprisingly, the correlations between changes in Gilt yields and our BoE Monitor have actually increased since the 2008 Crisis (Chart 4C). This raises a potential risk for the Gilt market if the BoE decides that the U.K. economy is not slowing as much as it is expecting. For now, we continue to recommend a neutral stance on Gilts until there is greater clarity on the state of the economy. ECB Monitor Reflects A Less Deflationary Backdrop In Europe Our European Central Bank (ECB) Monitor has recently crept above the zero line for the first time in three years (Chart 5A). This is driven mostly by the current uptrend in headline inflation in the Euro Area, but also by the steady improvement in economic growth. Chart 5AEuro Area: ECB Monitor Chart 5BExcess Capacity in Europe Dwindling Fast Chart 5CStable Correlations Between The ECB Monitor & The Front End Of The Yield Curve The Euro Area is the one economy presented in this report where no indicator (either the output gap or unemployment gap) is pointing to a lack of spare capacity (Chart 5B). All of the rise in headline Euro Area inflation can be attributable to base effects related to last year's rise in oil prices and decline in the euro. The latest ECB projections call for core inflation to return to just under 2% in 2019, suggesting that there is no hurry to begin tightening monetary policy. Yet the ECB remains in an asset purchase program which is set to expire at the end of this year, so a policy decision must be made in the next 3-6 months. We expect the ECB to begin tapering its bond buying in the first quarter of 2018, with interest rate hikes to follow after the tapering has been completed. The ECB could raise rates before tapering to try and minimize the impact on Peripheral sovereign and corporate bond yields (it is buying both), although that would likely create a greater degree of tightening than the ECB would like before full employment is reached. Given the strong correlations between our ECB Monitor and much of the Euro Area yield curve (Chart 5C), however, we anticipate moving soon to an underweight stance on Euro Area bonds after our recent downgrade to neutral. BoJ Monitor: Nothing To See Here Our BoJ Monitor has been in the "easier policy required" zone for most of the past 25 years, barring a brief blip above the zero line that heralded the rate hikes in 2006/07 (Chart 6A). Inadequate growth and excess capacity remain the biggest problem with Japan's economy, preventing any meaningful upturn in inflation beyond that caused by higher commodity prices or a weaker yen. Chart 6AJapan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation Chart 6CLonger-Maturity JGB Yields Have No Correlation To The BoJ Monitor Even with Japan operating at full employment, with an unemployment rate at 3%, there has barely been any acceleration in wages or core inflation (Chart 6B). The only way out of this for Japan is to keep monetary policy settings as easy as possible to ensure that there is enough growth to eat away at the remaining spare capacity in the Japanese economy. That means keeping both policy rates and the yen as low as possible, and hoping that this will cause enough of a rise in inflation expectations to lower real interest rates and boost domestic demand. As an added "kicker", the BoJ is even anchoring the long end of the Japan yield curve by targeting a 0% yield level on 10-year government debt - a policy that we do not expect to change anytime soon. We see Japan as a low-beta "safe haven" government bond market in an environment where other central banks are seeing some tightening pressures and Japanese bonds have virtually no correlation to the BoJ Monitor (Chart 6C). We continue to recommend an overweight stance on Japan within an overall defensively positioned government bond portfolio with below-benchmark duration exposure. BoC Monitor: No Big Need To Tighten In Canada Our Bank of Canada (BoC) Monitor has recently moved into positive territory (Chart 7A) , primarily due to some improvement in growth and higher commodity prices. Given the close linkages between the U.S. and Canadian economies, we include some U.S. growth variables in our BoC Monitor and these are also helping boost the indicator. However, there are no signs that the Canadian economy is overheating - unless you are trying to buy a home in Toronto - with both the output gap and unemployment gap not yet in positive territory (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BStill Not Much Inflation In Canada Chart 7CThe BoC Monitor Is Highly Correlated To Shorter-Maturity Canadian Bonds The BoC is maintaining a dovish bias at the moment. Some of that has to do with the uncertainty over the U.S. economic outlook, especially with regards to the fiscal and trade policies of the Trump administration. While a boost to U.S. growth via a fiscal easing could help support Canadian exports to the U.S., any move to renegotiate trade agreements involving the two countries could end up hurting the Canadian economy. Add to that the concerns over the bubbly valuations of Canadian real estate that could be pricked by even modest rate increases, and the BoC will likely not want to contemplate any early tightening of monetary policy. The higher correlations between our BoC Monitor and the front end of the Canadian yield curve (Chart 7C) suggest that a bear flattener would be the appropriate trade if and when the BoC does contemplate a rate hike. For now, however, we see that as a low-probability event and we are maintaining a neutral stance on Canadian bonds until there is greater clarity on U.S. growth and Trump's policy agenda. RBA Monitor: Higher Because Of Growth, Not Inflation Our Reserve Bank of Australia (RBA) Monitor has surged into the "tighter policy required" territory in recent months (Chart 8A), driven by higher commodity prices and stronger Asian export demand. Survey-based measures of inflation expectations are also part of the Monitor, and those have also been rising despite a lack of realized inflation in Australia (Chart 8B). The low inflation readings have been causing a bit of a problem for the RBA, given the tight labor market and that boost to Aussie demand from better Asian growth. This is especially true given the surprisingly soft readings on employment growth, consumer confidence and spending, all occurring against a persistent deceleration in core inflation. The RBA was focusing on the inflation story last year when it delivered some surprise rate cuts, and we still suspect that a lack of inflation pressure will keep the RBA on hold for at least the next few months. We are currently at a neutral stance on Australian government bonds, given these conflicting forces of better export growth but weakening domestic demand. The lack of an inflation threat could make Australia an outperformer in a world of rising bond yields. Given the surge in our RBA Monitor, however, we see some risk in looking at Aussie bonds as a potential safe haven market given upward pressures on yields in the U.S. and Europe. The correlations between Australian yields and the RBA Monitor are extremely high (Chart 8C), and have actually gone up in the post-crisis era. Chart 8AAustralia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA Chart 8CAussie Bonds Across The Curve Are Highly Correlated To The RBA Monitor RBNZ Monitor: A Strong Case For A Rate Hike Our Reserve Bank of New Zealand (RBNZ) Monitor is strongly in positive territory (Chart 9A), led by the components focused on commodity prices and global growth. However, there is a fairly solid structural case for an RBNZ rate hike, given the lack of any spare capacity in New Zealand and inflation on the rise (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ Chart 9ANZ Bonds Are Vulnerable To Current Cyclical Pressures The RBNZ has been maintaining a dovish bias of late, although it has chosen to sight more "international" risks related to geopolitics, rather than domestic economic conditions. Perhaps this is nothing more than a fear of a potential shock outcome in the upcoming French elections, although it could also be worries that tensions between the Trump White House and China (or, worse yet, North Korea) could trigger a hit to demand for New Zealand exports to Asia. In the end, we think the RBNZ will be forced to a hike off the current record low interest rates as the next policy move. While we do not include New Zealand government bonds as part of our model fixed income portfolio, we do currently have a bearish rates trade on in our list of Tactical Overlay Trades, choosing to pay 12-month NZD OIS rates. We will maintain that recommendation, but we may look to add some bearish New Zealand bond trades, as well, given the strong correlation between our RBNZ Monitor and bond yields (Chart 9C). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com

Highlights Beyond the healthcare vote and its implication for Trump's fiscal stimulus, other risks lurk in the background. Market complacency is at historical extremes but Chinese reflation is rapidly dissipating. The euro could benefit in this environment, especially as markets price in a Macron victory. Longer-term, the euro remains hampered by its two-speed recovery, which will limit the capacity of the ECB to lift rates. Stay long EUR/AUD, short USD/JPY and NZD/JPY. Feature The dollar correction continues. The recent wave of dollar weakness has been dubbed a reversal of the "Trump trade". There is some truth to this. The difficulty President Trump and House Speaker Ryan are facing to pass the American Health Care Act (their replacement for Obamacare) is raising questions about how much tax cuts and infrastructure spending Trump will actually be able to implement. Even if the House votes in favor of the new bill (which is still an unknown at the time of writing), the Senate remains a question mark. So the narrative goes, if the Trump stimulus is at risk, the economy will be weaker, the Fed will not hike interest rates as much as anticipated, and the dollar will falter. While there is validity to this thesis, we think the picture is more nuanced. The potential for less fiscal stimulus in the U.S. is a real worry, but our main concern is that the global industrial sector's growth improvement does not continue the way investors expect. In this environment, the dollar is likely to perform poorly against European currencies and the yen, but hold its own against EM and commodity currencies. We are positioned for such a development. These trends would be reminiscent of the kind of dollar dynamics that emerged in late 2015 / early 2016. Chinese Reflation Matters Too! What underpins our thesis? As our sister service, Global Alpha Sector Strategy, has highlighted in this week's report, the Yale Crash Confidence index has hit 100%, indicating that all of the respondents surveyed expect the stock market to go up in 2017. Moreover, the Minneapolis Fed's market-based implied probability of a 20% or more selloff in the S&P 500 has fallen below 10%, the lowest level since 2007.1 With this high degree of complacency, a rollover in the global economic surprise index represents a major risk for the asset most levered to the global industrial sector (Chart I-1). To us, the key behind the 2016 rebound in global industrial activity was China. While Chinese growth is not about to experience a sharp slowdown, it is unlikely to improve further. To begin with, Chinese monetary conditions are already rolling over (Chart I-2). The big improvement in this indicator in 2016 was the crucial ingredient behind the rebound in global trade, global industrial activity, and all the assets levered to these phenomena. Chart I-1Surprises Are Not ##br##Growing Anymore Chart I-2Chinese Monetary Conditions ##br##Are Tightening We are seeing tentative signs of a mini liquidity crunch emerging in the Chinese interbank system. Seven-day repo rates, a key benchmark for Chinese lending terms, have surged from 3.8% at the end of last week to 5.5% on Tuesday, before settling at 5%, the highest level in two and a half years (Chart I-3). By allowing this volatility, policymakers are most likely sending a warning shot to the Chinese real estate sector, which has been a key driver of Chinese metal demand in 2016. This sector alone accounts for 20% and 32% of global refined copper and steel consumption, respectively. Also, as we have highlighted previously, fiscal stimulus was another key factor behind the floor put under Chinese industrial production and fixed asset investment last year. However, Chinese fiscal spending peaked at a 25% yoy growth rate in November 2015 and is now near 0%. This suggests that a key source of stimulus in China has been removed. It is true that Chinese fiscal stimulus is heavily conducted through credit policy. In this context, the recent rise in Chinese borrowing rates does indicate that the Chinese authorities are not intent in jacking up growth anymore. The reduced growth target for this year is a clear re-affirmation of this change in focus. We are seeing signs that these adjustments are starting to bite. The growth rate of new capex projects started has rolled over and is now flirting with the zero line. As Chart I-4 highlights, this indicator provided a very positive signal for the AUD last year and is now forewarning potential risks. Chart I-3Is The PBoC Sending A Message##br## To The Real Estate Industry? Chart I-4Big Risk For##br## The AUD Additionally, the Canadian venture exchange, an index of high risk, small-cap Canadian equities has historically displayed a tight correlation with Chinese GDP growth (Chart I-5). This market is experiencing a negative divergence between its MACD and prices, potentially an early sign that investors are beginning to worry about China. Risk assets globally are not ready for these developments. In fact, EM spreads are hovering near cycle lows, junk spreads are extremely narrow, the VIX is also near cycle lows, and our global complacency indicator suggests that investors are not ready for negative Chinese surprises (Chart I-6). Not only would a negative surprise out of China cause a repricing of all these factors, but periods of market stress - even shallow stress - are associated with rising correlation among assets and among individual equities. The low level of correlation among S&P 500 constituents has been an important factor behind the fall in the VIX and the rise in margin debt. A rise in risk aversion could get turbo-charged by a rectification of these low correlations, prompting a temporary wave of debt liquidation (Chart I-7). Chart I-5A Key China Gauge Is Losing Momentum Chart I-6Complacency Abounds Chart I-7Correlation Risk In this environment, U.S. stocks could easily correct by 5% to 10%. EM stocks may have even more downside as they are more directly exposed to the biggest risk factor: China. From a currency market perspective, this means that defensive currencies could outperform pro-cyclical ones. This is why we remain long the USD against a basket of commodity currencies, but short against the yen - the most countercyclical currency of all. We also are long the euro against the AUD. These views make our publication more cautious about the near-term outlook than BCA's house view. Bottom Line: Risks beyond the outlook for tax cuts in the U.S. lurk in the background. The Chinese authorities have moved away from stimulating the economy, and some early cracks are showing. A collapse is not in the cards, but given the high degree of complacency present across markets, a disappointment in a supposedly perfect environment would create a headwind for EM and commodity currencies but boost the defensive EUR and JPY. Why Long EUR/AUD Tactically? While the negative view on the AUD fits cleanly in the narrative described above, our motivation to be long the euro is more multifaceted: The euro area has negative nominal interest rates and a current-account surplus of 3.3% of GDP, meaning it exhibits key characteristics of a funding currency. In a risk-off event where unforeseen FX market volatility rises, funding currencies perform well. We expect a further normalization of the French OAT / German bunds spread as we get closer to the French election. Macron is beating Le Pen by more than 20% in second-round polling (Chart I-8). This gap is five times greater than the advantage Clinton held over Trump at a similar point in the U.S. presidential campaign. As we argued in a joint Special Report co-published with our Geopolitical Strategy team seven weeks ago, this kind of advantage is highly unlikely to be overcome by May 7. Thus, the euro area break-up risk premium can narrow between now and then.2 Finally, the number of investors expecting rising short and long rates has bottomed in Europe relative to the U.S. Historically, this indicator has provided valuable lead on EUR/USD. It is currently painting a tactically bullish story for the euro (Chart I-9). Moreover, in the event of market stress, with investors pricing in two more rate hikes by year end in the U.S., but none in Europe, the scope for temporary downward revisions in the U.S. is higher than in Europe. This could put more upward pressure on this indicator and therefore, the euro. Chart I-8Macron: En Marche! Chart I-9Short-Term Euro Upside Together, these factors suggest that the euro could rebound toward 1.12 before the middle of 2017. Again, our favored currency to play this move is against the AUD. EUR/USD: Short-Term Gain But Long-Term Pain Chart I-10Monetary Policy Is The ##br##Common Shock In Europe What about the longer term dynamics for the euro? We are more skeptical of the common currency's ability to rally durably, and we are expecting the euro to fall below parity by mid-2018. Based on our months-to-hike indicator, the market expects the ECB to hike by the fall of 2018. We disagree and think the first hike could come much later. While the economic rebound in Europe is real, it seems to be very dependent on the high degree of easing that has been put in place by the ECB. As Chart I-10 illustrates, the credit impulse - a measure underpinning domestic economic activity - and the euro have moved very closely together. While we do not imply that the credit impulse's rebound has reflected the fall in the euro, their tight co-movement has been driven by a similar factor: easy money. Thus, a removal of that easy money could prompt a reversal of that domestic improvement. Even more crucially, the conditions in the periphery are what really matters to the ECB. At the beginning of the millennium, the ECB was acting as Germany's central bank, keeping rates too low for the periphery, but alleviating Germany's deflationary tendencies. Today, the ECB behaves as the periphery's central bank. Germany seems ready to handle higher interest rates, but the same is not true for most other European countries. To begin with, even within the core, wage dynamics remain tepid. French and Dutch wages continue to slow while Austrian wage growth has collapsed near 0% (Chart I-11A). If the situation is poor in most core countries, it is dismal in the periphery. Wages are still contracting in Greece and Portugal, and growing at a sub 1% pace in Spain and Italy (Chart I-11B). These differentiated wage trends reflect the fact that worker shortages in the periphery are simply inexistent, while in Germany, they are commonplace (Chart I-12). Chart I-11AOnly Germany Is Witnessing##br## Strong Wages... Chart I-11BOnly Germany Is Witnessing ##br##Strong Wages... Chart I-12...Because Germany Has The##br## Tightest Labor Market.... As a result, the dynamics in core inflation remain muted. German core inflation has been extremely stable near 1% for six years now, but is hitting record lows levels of 0.3% in France (Chart I-13A and Chart I-13B). Core inflation also remains near 0% in most peripheral nations. Chart I-13A...Explaining Europe's Bifurcated Core Inflations Chart I-13B...Explaining Europe's Bifurcated Core Inflations When the Fed first increased rates in 2015, U.S. wages were growing at 2%. This is a far cry from current levels in Europe. Moreover, the first U.S. rate hike was a mistake considering the subsequent deceleration in growth and poor performance of risk assets. Thus, the Fed experience is probably not an example for the ECB to emulate. Moreover, rising interest rates represent a risk for debt servicing ratios in many European countries, limiting the ECB's ability to hike if nominal growth does not pick up further. The Netherlands, Belgium, Portugal, and France rank amongst the countries with the highest private-sector debt servicing costs as a percent of income. Meanwhile Italy and Portugal score extremely poorly when this metric is applied to the public sector (Chart I-14). The Italian and Portuguese cases are especially worrisome as rising stress caused by rising rates will further lift government rates. An argument has also been made that for the ECB, what matters is the headline rate of inflation. We would argue that since Draghi became the leader, this inflation measure is less relevant. But nonetheless, let's temporarily entertain this premise. It has also been argued that if European and U.S. statistical agencies treated housing similarly, inflation on both sides of the Atlantic would be the same. As Chart I-15 illustrates, this is no longer true. Chart I-14Debt Service Payments Are ##br## A Problem In Europe Chart I-15European Inflation Is Lower, ##br##No Matter What This line of reasoning also forgets that since 2014, the U.S. has endured a 22% appreciation in the trade-weighted dollar, which could have already curtailed nearly 1% to U.S. GDP growth, a significant amount of monetary tightening. However, the euro has greatly depreciated over this time frame, representing a large monetary easing. Due to these highly divergent monetary backdrops, one can deduce that endogenous inflationary pressures are much greater in the U.S. than in the euro area. All these factors suggest that it will be hard for the ECB to increase rates by the end of 2018. Thus, on a cyclical basis we would fade this recent massive fall in the ECB's months-to-hike metric (Chart I-16). On the U.S. ledger, the labor market is clearly tightening and the U6 unemployment rate is now congruent with levels where wages have gained traction in previous cycles (Chart I-17). This suggests that the market is correct to expect the Fed to hike much more aggressively in the coming years. In fact, while the near future might be filled with political complexity, we continue to expect fiscal stimulus to materialize in the U.S by 2018, suggesting upside risk to the Fed's forecast. Chart I-16Too Soon! Chart I-17The U.S. Labor Market Is Tight Finally, equilibrium real rates in Europe are probably substantially lower than in the U.S. Not only have European interest rates been historically lower than in the U.S., but also, slower population growth alone would justify lower neutral rates. This highlights that the scope for the ECB to hike is limited compared to the Fed. These bifurcated monetary dynamics will continue to support the USD on a 12-18 months basis, and as a corollary, hurt the euro despite its apparent cheapness on a PPP basis. Bottom Line: The months-to-hike in the euro area has fallen to less than 20 months. While Germany could handle higher rates, poor wage and core inflation dynamics in the rest of the euro area suggest it is still much too early to increase rates. Moreover, without a more significant pick-up in growth, many European nations will face dire debt-servicing situations if the ECB hikes rates durably. Meanwhile, the U.S. is moving closer to full employment, a situation warranting higher rates. The euro could fall below parity by mid-2018. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Alpha Sector Strategy Weekly Report, "Caveat Emptor" dated March 24, 2017 available at gss.bcaresearch.com 2 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, "The French Revolution" dated February 3, 2017 available at fes.bcaresearch.com and gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 March weakness has been because of a mix of monetary and fiscal disappointments. The Fed's "unhike" initiated the downtrend as markets were surprised by the dovish tone of the Fed's communications. Now, President Trump and his team are facing difficulties passing the American Health Care Act. Markets are extrapolating this difficulty to the realm of fiscal policy in general. Nevertheless, it is unlikely for the DXY to breach the 98-99 support level this month. The stronger current account number of USD -112.4 billion was supported by high foreign income, suggesting a key warning sign for the USD cyclical bull market is not present. Stronger new home sales monthly growth of 6.1% highlights that domestic economic activity remains robust, meaning the Fed is unlikely to disappoint over the life of the business cycle. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Political risks have been exaggerated in Europe, with the Dutch and Austrian elections confirming that populist successes in Europe are overstated. As such, the French election will likely be market-bullish with a Le Pen defeat. This entails a further normalization of OAT / Bund spreads, and a short-term bullish outlook for the euro, which is likely to settle above 1.10. Corroborating this view, the MACD is currently above 0 and outpacing the signal line, a bullish development. Inflationary pressures are building up in Europe with German PPI at 3.1% annually in February. However, outside Germany, even the core, let alone the periphery, seems to be struggling, with poor wage growth. The ECB will therefore need to stay easy for longer to protect the euro area's weakest members, capping the long-term upside to rates and the euro. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has continued to rally, with USD/JPY trading below 111 over the last couple of days. We continue to be bullish on the yen on a tactical basis, as we believe that the global industrial sector will fall short of investors' expectations. This is an environment where the dollar will probably appreciate against EM currencies, but falter against the yen. On a cyclical basis we remain yen-bearish, as U.S. rates should continue to go up, while Japanese rates will continue to be anchored around 0%. The Bank of Japan will continue with this policy, as the depreciation of the yen has given a boost to exports, which are now growing at 11.3% on a yearly basis, as well as to the economy as a whole, which should yield higher inflation expectations over time. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The British pound rallied on Tuesday following the unexpected surge in headline inflation in February from 1.8% to 2.3%. This number is significant, because inflation has broken through the BoE's target. The central bank remains cautious, as the MPC pointed out that the rise in inflation is not domestic, but rather a reflection of the fall in the pound. However, we believe that internal inflationary pressures might start to emerge: the U.K. economy is doing much better than expected and the labor market is tight. Recent data highlights this, and opens the possibility that the pound could rally, particularly against the euro: Retail sales growth and retail sales ex fuel growth came in at 3.7% and 4.1% respectively, outperforming expectations. The CBI Distributive Trades Survey monthly growth also beat expectations, coming in at 9%. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As mentioned last week, the AUD's strength was a temporary feat. Before declining, the Aussie was initially lifted by high house price growth of 7.7% annually for 4Q2016, really surpassing expectations. The RBA minutes highlighted a need for the current monetary policy to remain very accommodative: labor market conditions remain mixed, household perceptions of personal finances is at average levels, wage growth remains subdued, and inflation is expected to rise only slowly. The outlook for the AUD is therefore likely to remain poor. Corroborating this view is a contracting Westpac Leading Index number of -0.1% that may be foretelling weak data. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Yesterday, the RBNZ kept its policy rate unchanged at 1.75%. Governor Graeme Wheeler once again asserted that the kiwi remains overvalued, although he welcomed the recent depreciation of the trade-weighted kiwi. More depreciation might be in the cards, particularly against the U.S. dollar and the yen. Global FX Vol stands at very low levels, thus any uptick could severely hamper the NZD, a carry currency. Furthermore, the tightening in Chinese monetary conditions will likely weigh on commodity currencies. Nonetheless, the NZD could perform well against the AUD as domestic inflationary pressures in Australia are much weaker than in New Zealand. Additionally, the tightening in Chinese monetary conditions should be more harmful for the AUD, given that iron is more sensitive to economic activity than dairy products. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has sustained the recent oil shocks well, helped by the USD's weakness. Indeed, Canadian data has generally been positive: Manufacturing shipments increased 0.6% monthly in January, much above the expected -0.4%; Wholesale sales increased 3.3% in January on a monthly basis; Monthly retail sales picked up to 2.2% and 1.7% when autos are excluded; The 2017 government budget marginally loosened fiscal policy. As the greenback is likely to display further downside, the short-term outlook for USD/CAD is negative. This is corroborated by the negatively trending MACD line. However, Governor Poloz is likely to maintain a dovish tilt relative to the Fed, signifying longer-term CAD weakness. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Following the surge in the Euro, EUR/CHF has moved back to 1.07. This has eased some pressure off the SNB, which was active in the foreign exchange market to preserve the floor in this cross. The early returns of this policy seem positive, as data is showing a gradual recovery in Switzerland: The SNB's trimmed mean core inflation measure (TM15) is now in positive territory and continues to rise. Swiss PMI has surged so far this year, and now stands at the highest level since 2011. So far these improvements are not enough to prompt a change in policy by the SNB, as inflation needs to be sustained at a higher level and corroborated by wages. Nevertheless, we will continue to monitor economic developments in Switzerland to assess whether the SNB could remove its floor under EUR/CHF. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week, as the sharp decline in oil has been offset by a downturn in the U.S. dollar. The outlook for the krone remains poor though, as the economy is weak, and inflation is falling quickly. Recent data illustrates this: After a gradual slowdown, non-financial business credit is now heading into outright contraction. Employment is contracting at a 1% rate, while wages are contracting at a 4% pace. Core inflation has plunged to 1.5% from its peak of 4% around 6 months ago. This poor economic outlook leads us to believe that the dovish bias of the Norges Bank will stay entrenched for the time being, putting downward pressure on the krone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Inflationary pressures continue to emerge in Sweden. We believe these pressures are likely to pick up further. USD/SEK has broken down below a key trend line that has underpinned its rally since May 2016, suggesting that as the euro continues to rebound, the SEK will also outperform the USD. However, it remains to be seen if the SEK can outperform the euro: while the SEK tends to be more sensitive to the dollar's weakness than the euro, the Riksbank is likely to want to make sure that the early signs of inflation in Sweden do indeed generate a durable way out of any deflationary tendencies in this economy. This means that the Swedish central bank is likely to try to weigh on any strength in the SEK, especially against the euro. However, as inflation is indeed coming back, the Riksbank will likely be forced to abandon its super-dovish stance later this year. The SEK will ultimately rally further against the euro on a 12-18 months basis. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The global economy has turned the cap and is on a sustainable uptrend. Yet, the AUD and CAD have over-discounted the improvements and are at risk of suffering a disappointment if global manufacturing activity remains firm but does not accelerate much. Moreover, the Australian and Canadian domestic economies remain too weak to justify rates moving in line with the Fed. Rate differentials will continue to weigh on both currencies. While the CAD is cheaper than the AUD and warrants an overweight position versus the Aussie, we are adding it to our short commodity currency basket trade. The ECB will not ease further, but it will not tighten this year either. Feature Since their February highs, the Australian and Canadian dollars have declined by 2.7% and 3.6% respectively. In May 2016, we wrote that commodity currencies could continue to perform well, but that ultimately, this strong performance would only prove transitory and that the AUD and the CAD would once again resume their downtrends.1 Is this recent weakness the beginning of a more pronounced selloff? We believe the answer is yes. How Great Is The Global Backdrop? Much ink has been spilled regarding the improvement in the global industrial sector. Global PMIs have perked up the world over, semi-conductor prices have been booming, metal prices have been on a tear, and Chinese excavator sales have been growing at a 150% annual rate (Chart I-1). It would seem that the world economy is out of the woods. This is true, but asset markets are not backward looking, they are forward looking. The improvement in global economic conditions that we have witnessed has driven the impressive rally in stocks, EM assets, commodity, and commodity currencies in 2016. But what matters for future asset markets' performance, and especially growth sensitive currencies like the AUD and the CAD, is future global growth. Where do we stand on that front? We do not expect an economic relapse like in 2015 and early 2016. Some key elements have changed in the global economy, suggesting it is not as hampered by deflationary forces as it once was: DM industrial capacity utilization has improved (Chart I-2). Also our U.S. composite capacity utilization indicator that incorporates both the manufacturing and service sectors has now moved into "no slack" territory. This suggests that deflationary forces that have so negatively affected the DM economy in 2015 and 2016 are becoming tamer. Chart I-1Signs Of An Economic Rebound Chart I-2Improving Global Capacity Utilization Commodity markets are much more balanced than in 2015-2016. Not only has excess capacity in the Chinese steel and coal sector been drained, but the oil market has moved from being defined by excess supply to a surplus of demand (Chart I-3). This suggests that commodities are unlikely to be the same deflationary anchors they were in the past two years. The global contraction in profits is over. Profits are a nominal concept, and in 2015 and 2016, U.S. nominal growth hovered around 2.5%, in line with the levels registered in the 1980, 1990, and 2001 recessions (Chart I-4). As a residual claim on corporate revenues, profits display elevated operating leverage. Thus, nominal GDP growth moving from 2.5% to 4% on the back of lessened deflationary forces will continue to support profits. Chart I-3Oil: From Excess Supply To Excess Demand Chart I-4Last Year Was A Nominal Recession This also means that the rise in capex intentions that began to materialize last summer is likely to genuinely support capex growth and the overall business cycle in the coming quarters, especially in the U.S. (Chart I-5). Additionally, the inventory cycle that has weighed on EM and DM economies is now over (Chart I-6). While growth is likely to be fine based on these factors, for the AUD and CAD to move higher, growth needs to accelerate further. The problem is that based on our Nowcast for global manufacturing activity, things are as good as they get now (Chart I-7). Chart I-5Improving DM ##br##Capex Outlook Chart I-6Inventories: From ##br##Drag To Boost Chart I-7If Global Industrial Activity Doesn't ##br##Improve, CAD and AUD Are Toast In China, which stands at the crux of the global manufacturing cycle, we see the following factors hampering further improvements: The Chinese fiscal impulse has rolled over. Fiscal stimulus does impact the economy with some lags. The peak in the Chinese boost was reached in November 2015, with government expenditures growing at a 24% annual rate, but today, they are growing at a 4% rate. The deleterious effect on growth of this tightening may soon be felt. Chinese liquidity conditions have deteriorated. Interbank borrowing rates are already rising (Chart I-8), and the PBoC has drained an additional RMB 90 billion out of the banking system this week alone. These dynamics could be aimed at cooling down the real estate bubble in the country. Falling activity in that sector would represent a significant drag on the industrial and commodity sectors globally. Chart I-8Tightening Chinese Liquidity Conditions Chart I-9The NZD Weakness Should Be A Bad Omen The fall in Chinese real rates may have reached its paroxysm in February. Commodity price inflation may have hit its peak last month, suggesting the same for Chinese producer prices. A slowing PPI inflation will raise real borrowing costs in that economy and further tighten monetary conditions. Corroborating these risks, Kiwi equities, a traditional bellwether of global growth continue to buckle down. In fact, the New Zealand dollar is offering the same insight. Being the G10 currency most sensitive to the combined effect of wider EM borrowing spreads and commodity prices, its recent fall may presage some problems in these spaces (Chart I-9). To be clear, we are not expecting a wholesale collapse in growth. Far from it, but an absence of acceleration or a mild deceleration, could have troubling effects on commodities. The case of oil this week is very telling. Inventories have been going up, but the frailty of the oil market was mostly a reflection of the extraordinary bullish positioning of investors (Chart I-10, left panel). The same is true for copper, investors are very long and thus, vulnerable to mild growth disappointments (Chart I-10, right panel). Chart I-10AInvestors Are Bullish Industrial Commodities Chart I-10BInvestors Are Bullish Industrial Commodities Oil is not the only commodity experiencing a large accumulation in inventories. China, the key consumer of metals, is now overloaded with large inventories of both iron ore and copper (Chart I-11). This combination of high bullishness and rising inventories represents a risk for metals, especially if the positive growth impulse in China slows somewhat from here. Chart I-11China Has ##br##Hoarded Metals Chart I-12Can Growth And Reflation Surprises Increase##br## As Policy Becomes Less Easy? Adding to these risks is the Fed. The Fed is on the path to increase rates a bit more aggressively than was recently anticipated by markets. U.S. real rates are responding in kind, and key gauges like junk bonds, gold, or silver are also highlighting that global liquidity conditions may begin to deteriorate at the margin. While this tightening is not a catastrophe, it is still happening in an environment of elevated global leverage and potentially decelerating growth. This is not the death knell for risk assets, but it does represent a risk for the asset classes that are not pricing in any potential rollover in the elevated level of global surprises and reflation (Chart I-12). Commodity currencies are not ready for this reality. To begin with, positioning on the key commodity currencies has rebounded substantially, and risk reversals on these currencies as well as EM currencies are at levels indicative of maximum bullishness amongst investors. Also, the Australian dollar is expensive relative to its fundamentals, including the terms of trade. This makes the Aussie very vulnerable to small shocks to metal or coal prices (Chart 13, left panel). The CAD is not as pricey as the AUD, but nonetheless, it has lost its previous valuation cushion (Chart I-13, right panel). It also faces its own set of risks. Chart I-13ANo Valuation Cushion In CAD And AUD Chart I-13BNo Valuation Cushion In CAD And AUD This set of circumstance highlights that the room for disappointment in these currencies is now large. Bottom Line: While 2016 was a dream come true for investors in commodity currencies, 2017 may prove to be a tougher environment. Global growth is not about to plunge, but for commodity currencies to rally more, global manufacturing activity needs to accelerate further. Here the hurdle is harder to beat. Not only is the Chinese reflationary impulse slowing exactly as the global manufacturing sector hits exceptional levels of strength, but the Fed is also marginally tightening its stance. This means that expensive currencies like the BRL and AUD, as well as the cheaper but still vulnerable CAD could suffer some downside if industrial growth temporarily flattens, an event we judge more likely than not. Domestic Considerations Chart I-14We Build Houses In Canada When it comes to the AUD and the CAD, global risk is skewed to the downside, but what about domestic considerations? Here again, signs are not as great as one might hope. When it comes to Canada, the capacity to withstand higher rates is limited. The elephant in the room is the risk posed by the U.S. border adjustment tax. BCA thinks that this tax could be implemented in a diluted form, one were apparels, food, energy, etc. are exempt from the deal. However, the industries representing the American "rust-belt" are likely to be fully covered. This means that machinery and cars in particular could be the key targets of the BAT. This is a huge problem for Canada. Take the car industry as an example. Canada exports C$80 billion in vehicles and parts to the U.S., or 15% of its merchandise exports, nearly 4% of GDP. The potential hit from this tax on the country could be large. Also, the Canadian economy is even more levered to house prices that the Australian one. As Chart I-14 illustrates, the share of residential investment in Canada is much higher than in Australia, despite the slower growth of the population in Canada than in the Australia. Additionally, Canadian consumption is much more geared to housing than in Australia. Canadian households are experiencing slower nominal and real wage gains than their Australian counterparts. Yet their consumption per head growth is similar to that of Australia, and their confidence is substantially higher, reflecting a stronger wealth effect in Canada than in Australia (Chart I-15). Furthermore, despite the rebound in commodity prices and profits in 2016, Canadian and Australian credit growth have been slowing sharply (Chart 16, top two panels); however, Canada suffers from a higher level of debt service payment than Australia, despite the fact that the Canadian household debt to disposable income is 170% versus 185% in Australia (Chart I-16, bottom panel). These factors amplify the negative potential of higher interest rates in Canada relative to Australia. But Australia also suffers from its own ills. Total hours worked continue to deteriorate in that country and job growth is even more heavily geared to the part-time sector than in Canada. Additionally, while Canada will benefit from a small amount of fiscal expansion in the coming years, Australia is tabled to experience a large degree of fiscal austerity (Chart I-17). In this context, it will be difficult for the Australian labor market to outperform that of Canada. Chart I-15Canadian Households Are ##br##More Levered To Housing Chart I-16Slowing Credit Growth In ##br##Canada And Australia Finally, while the Canadian core CPI is elevated at 2.1%, this largely reflects pass-through from the previous collapse in the CAD, and this is expected to dissipate as wage growth remains tepid at 1.2%. But the Australian situation is even more troubling. Australia has been incapable of generating much inflation, and the fall in hours worked suggests that the labor market may be easing, not tightening. With the 10% increase in the AUD from its trough in 2016, inflation is unlikely to rise enough to prompt the RBA to become much more hawkish in the coming months. Thus, we think that both Canadian and Australian rates will continue to lag U.S. ones, putting more downward pressures on the CAD and the AUD versus the USD, despite the recent improvement in trade balances in both nations. (Chart I-18). Moreover, even if the decline in Australian interest rate differentials relative to the U.S. were to be less pronounced than in Canada, the AUD is much more misaligned with differentials than the CAD, adding to the Aussie's vulnerability. Chart I-17Fiscal Policy: Canada Eases, ##br##Australia Tightens Chart I-18Rate Differentials Will Continue##br## To Help The USD Bottom Line: Domestic conditions remains challenging for Australia and Canada. In both nations, debt service payments are already elevated, suggesting it will be hard for the central bank to increase rates without prompting accidents. While Australia seems less geared to the housing sector than Canada, its labor market dynamics are poorer, it faces a more austere fiscal policy, and it has trouble generating any inflation. We expect rate differentials to continue to move against both the CAD and the AUD versus the USD. Investment Conclusions At this point, the CAD and AUD are essentially entering an ugly contest. For both of these currencies, the global backdrop could prove to be more difficult in 2017 than in 2016. Moreover, both these currencies are handicapped by fundamental domestic issues that will further prevent rates to rise vis-à-vis the U.S. As such, we are now adding the CAD to our short commodity currency basket trade against the USD. AUD/USD may move toward 0.65-0.60 and USD/CAD may rally toward 1.40-1.45. Comparatively, both the AUD and CAD suffer from different but equally important handicaps. The only thing that would put the CAD at the nicer end of the ugly contest are its valuations. Our PPP model augmented for productivity differentials continues to show that the CAD is cheap against the AUD, corroborating the message of our long-term fair value models (Chart I-19). Also, as we highlighted above, CAD is more in line with its IRP-implied fair value than the AUD. We therefore recommend investors overweight the CAD vis-à-vis the AUD. A Few Words On The ECB Yesterday, Draghi struck a cautious tone in Frankfurt. While he acknowledged that deflationary risks in the euro area have decreased relative to where they stood last year, the governing council still thinks downside risks, even if of a foreign origin, slightly overshadow upside risks to its forecast. While the ECB feels that there is less of a need to implement additional support to the economy in the future, it judges the current accommodative setting to still be warranted. We agree. It is true that headline inflation in Europe has moved to 2%, but core inflation, which strips the very important base effect in energy prices that has lifted HICP, remains flat at low levels. Moreover, wage growth in the euro area remains tepid, confirming the lack of persistent domestic inflationary pressures in Europe (Chart I-20). Thus, the ECB elected to maintain asset purchases to the end of December at EUR60 billion per months. Rates are also unlikely to rise until after the end of the purchase program. In this environment, while the trade-weighted euro may move higher, the cyclical outlook continue to be negative for EUR/USD as monetary policy divergences between the U.S. and Europe will grow as time passes. On a 3-month basis, if we are correct that global growth may not accelerate further, the potential for a correction in EM and commodity plays could provide a temporary fillip to the euro. As markets currently priced in less rate hikes from the ECB than the Fed, the scope for pricing out the anticipated rate hikes is lower in Europe than in the U.S. if risk assets experience a correction within a bull market. This means that DXY may weaken or stay flat even if the trade-weighted dollar rises during that time frame. Chart I-19AUD / CAD Is Expensive Chart I-20The ECB's Dilemma Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Pyrrhic Victories" dated April 29, 2016 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to show resilience with the ADP employment change crushing expectations by 108,000. Although the USD did not react proportionately to this specific news, this is only a firmer signal of the confirmation for a rate hike next week. With the market pricing in almost a 100% probability of a hike, the Fed is unlikely to disappoint. What matters now is the messaging around the hike. In this regard, Trump's aggressive fiscal stance and the economy's consistent resilience is making a good case for the Fed to remain supportive of its forecasts. On a technical basis, the MACD line for the DXY is above the signal line, while also being in positive territory. Momentum is therefore pointing to a strong upward trend for the dollar in the short term. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB left its policy rates and asset purchase program unchanged. Although President Draghi acknowledged the euro area's resilience as risks have become "less pronounced", he also noted that risks still "remain tilted to the downside". In the press release, the Governing Council continued to highlight that they continue to expect "the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases". The message is therefore mixed. Growth is expected to remain resilient in the euro area, but significant domestic slack and global factors have forced the ECB to remain cautious. Cyclical risks to the euro are more to the downside than to the upside in the current environment. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Machine tool orders yearly growth came in at 9.1%, the highest level since the third quarter of 2015. Labor cash earnings yearly growth came above expectations at 0.5%. However GDP growth was disappointing, coming in at 1.2% against expectations of 1.6%. We continue to be bearish on the yen on a cyclical basis. Although there has been some improvement, economic data has still been too tepid for the Bank of Japan to even consider rolling back some of its most radical policies. After all, the BoJ has established that they now have a price level target instead of an inflation target, which means that inflation would have to overshoot 2% for a significant period of time in order to switch from their easing bias. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 After the vote in the House of Lords, Theresa May has been dealt yet another blow to her Brexit hopes as the upper house of the U.K. voted for giving parliament veto power over the final exit deal of Britain from the European Union. This news have been positive for the pound at the margin, as the perception of softer Brexit increases. The prime minister will now appeal this decision to the House of Commons. If she is defeated here, the pound could rally significantly. On the economic side, recent data has been disappointing: Market Services PMI not only went down from the previous month but also underperformed expectations, coming in at 53.3. Halifax house prices yearly growth came in at 5.1%, underperforming expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As expected, the RBA left its cash rate unchanged at 1.5%. The currency was little changed from this announcement. However, following last week's depreciation, the AUD followed through with further depreciation on Wednesday due to a strengthening greenback. This affected the AUD twofold: the appreciating dollar added pressure on the AUD, and on commodity prices which further exacerbated the AUD's decline - copper prices are down more than 4% and iron ore futures are down almost 3%. Risks are to the downside for the AUD: declining copper and iron ore prices foretell that the AUD's decline may continue; China's regulation on coal imports and energy production will further damage Australia's export market. On a shorter-term basis, the MACD line is below the signal line and indicates negative momentum. Additionally, the MACD line has breached negative territory, adding further downward momentum. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi continues to fall, and has now lost all of the gains from earlier this year. The outlook for the NZD against other commodity currencies is puzzling: on the one hand the NZD is very sensitive to emerging market spreads, which means that it would be the primary victim of the dollar bull market, as a rising dollar drains liquidity from EM and hurts fixed income instruments in these countries. On the other hand, domestic factors provide a tailwind for the NZD as strong inflationary pressures are emerging in the kiwi economy and New Zealand continues to be the star performer amongst its commodity peers. Overall, we are inclined to be tactically more bullish on the NZD against the AUD, as the NZD/USD has reached oversold levels, while AUD/USD has been firmer amidst the rally in the U.S. dollar. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following up from last week's depreciation is an even weaker CAD this week. USD/CAD appreciated greatly amidst a large decline in oil prices after crude oil stocks increased by around 7 mn bbl more than the previous change and the consensus amount. This trend is likely to continue as rig counts continue to increase. A rising USD is likely to exacerbate the decline in the CAD as it will continue to weigh on oil prices. We have previously noted that the CAD will stay very affected by U.S. trade relations and rate differentials. This trend is likely to continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been encouraging: Unemployment continues to be very low at 3.3%. Headline inflation came in at 0.5%. At this level inflation now stands at its highest since 2011. Although these developments are positive, the SNB will continue to aggressively intervene in the currency and prevent further appreciation. The SNB has been keen on keeping their unofficial floor of 1.065 in EUR/CHF, even on the face of risk-off flows coming into Switzerland due to the European election cycle. In fact, the SNB reserves surged at the highest pace since December 2014, which indicates that the central bank has been having its hands full. For now the SNB will continue with this policy, however, we will continue to monitor Swiss data to assess whether a change in policy by the SNB is possible. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied sharply following the 5% plunge in oil prices, as the rise in inventories came at almost 7 million barrels above expectations. The risk profile for the NOK is the opposite of the NZD. External factors should help the Norwegian economy vis-à-vis other commodity currencies, as oil should outperform industrial metals given that it has a lower beta to China and Emerging markets. On the other hand, the domestic situation has deteriorated. Nominal GDP is contracting, the output gap stands around -2% of potential GDP, and the credit impulse continues to be negative. Meanwhile, inflation is starting to recede, as the effect of the depreciation of the NOK on 2015 is dissipating. All of these factors should support a dovish bias from the Norges Bank, hurting the NOK going forward. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona will resume its cyclical downward trend as the USD continues to climb, being one of the currencies with the highest betas to the dollar. Our bullish case for the krona is weakened by the Riksbank's extremely cautious tone which, so to speak, stopped the krona in its tracks. EUR/SEK stopped its depreciation abruptly in the beginning of February and has since appreciated. Momentum, however, does seem to be slowing down for this cross as the Swedish economy remains inherently resilient. As a large proportion of Sweden's exports to the euro area are re-exported to EM, additional risks may emanate from China as any potential slowdown in the world's second largest economy could provide a risk to Sweden's industrial sector. This could add deflationary pressures to the economy, which can solidify the Riksbank's dovish stance even further. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com