Consumer

Highlights Monetary Policy: The Fed will deliver two rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet. The market is only priced for 36 bps of rate hikes this year. Maintain below-benchmark duration. Economy: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. Inflation: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome. Financial Conditions: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Feature The market-implied probability of a June rate hike jumped sharply during the past two weeks (Chart 1), and stood at 81% as of last Friday's close. In all likelihood the fourth rate hike of the cycle, and the third in the past six months, will occur at the next FOMC meeting on June 14. In our view, the Fed will deliver two 25 basis point rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet (see Box). With the market only priced for 36 bps of rate hikes during that timeframe, we continue to advocate a below-benchmark duration stance. Chart 1Still On For June Still On For June Still On For June The minutes from the May FOMC meeting, released last week, suggest that most Fed policymakers still maintain a forecast for two more hikes this year. The minutes also provide some useful insight about how FOMC participants think about the economy and what developments could cause their forecasts to change. This week we take a look at what the Fed believes, and consider whether those beliefs are well founded. Box Balance Sheet Strategy Revealed We wrote about the potential impact of the Fed’s balance sheet policy in last week’s report (please see U.S. Bond Strategy Weekly Report, “Two Challenges For U.S. Policymakers”, dated May 23, 2017, available at usbs.bcaresearch.com), but provide a brief update this week because of new information gained from the May FOMC minutes. Previously, it was unknown whether the Fed would cease the reinvestment of its securities holdings all at once, or whether it would “taper” the reinvestment by gradually increasing the amount of securities it allowed to run off. We now know that “nearly all policymakers expressed a favorable view” of a tapering strategy where the Fed will set a series of gradually increasing caps on the total amount of securities it allows to run off its balance sheet. The plan calls for the caps to be raised every three months, according to a schedule that will be set in advance. The only reason for this plan to not function smoothly would be if market participants start to view the reinvestment caps as an additional policy tool that the Fed will vary according to economic conditions. This would risk taking the focus off the fed funds rate as the main policy tool, and would make it difficult for the market to interpret the overall stance of monetary policy. The minutes show that the Fed plans to avoid this messy outcome by setting a fixed schedule for changing the reinvestment caps. If the market believes that the Fed will stick to this schedule, then the plan should work fine. The May minutes also showed that “nearly all policymakers” thought that it would be appropriate to begin the reinvestment process this year, as long as economic conditions do not deteriorate. While we still lack some important details, such as the Fed’s target for the ultimate level of reserves in the banking system, we now think it is very likely that these details will emerge at either the June or September FOMC meeting and that balance sheet run off will begin following either the September or December meeting. What The Fed Believes: Weak Q1 Growth Is Transitory Although the incoming data showed that aggregate spending in the first quarter had been weaker than participants had expected, they viewed the slowing as likely to be transitory.1 Even after last week's slight upward revision, at 1.2%, first quarter GDP growth came in well below its post-crisis average (Chart 2). However, a quick look at the major components of GDP reveals that the weakness was concentrated in consumer spending and the change in private inventories (Chart 2, bottom two panels). Growth contributions from residential and non-residential investment were actually considerably above their post-crisis averages, and the contributions from net exports and government spending were in-line with theirs (Chart 3). Chart 2The Consumer Was A Drag In Q1 The Consumer Was A Drag In Q1 The Consumer Was A Drag In Q1 Chart 3Investment Is A Bright Spot Investment Is A Bright Spot Investment Is A Bright Spot We know from history that large changes in inventories tend to mean-revert fairly quickly. In fact, we can model the inventory component of GDP growth based on the lagged change in inventories and the Backlog of Orders component of the ISM Manufacturing survey (Chart 4). Both of these factors suggest that inventories will bounce back strongly next quarter. In fact, the ISM survey shows the largest backlog of manufacturing orders since 2014. Likewise, weakness in consumer spending is unlikely to persist. The fundamental drivers of consumer spending all continue to paint a positive picture (Chart 5). Chart 4Big Backlog Of Orders Big Backlog Of Orders Big Backlog Of Orders Chart 5Consumer Spending Drivers: Part I Consumer Spending Drivers: Part I Consumer Spending Drivers: Part I Consumer confidence has hardly given back any of its post-election gains (Chart 5, panel 1). Personal income growth is already on the upswing, and income expectations point to further acceleration (Chart 5, panel 2). Employment is still growing at a reasonably robust pace, and the mild slowdown since early 2015 has been offset by stronger wage growth (Chart 5, bottom panel). Longer-run drivers of consumer spending are also solid. Households continue to accumulate wealth, and household leverage has returned to late 1990s levels. In other words, household balance sheets are the healthiest they have been since prior to the housing bubble (Chart 6). More broadly, indicators of overall GDP growth are also pointing toward an acceleration (Chart 7). The ISM Non-Manufacturing index increased to 57.5 in April from 55.2 in March, and the BCA Beige Book Monitor - an indicator based on the occurrence of certain keywords in the Fed's Beige Book2 - has gone vertical. It would be unusual for GDP growth to diverge from these two indicators for a prolonged period of time. Chart 6Consumer Spending Drivers: Part II Consumer Spending Drivers: Part II Consumer Spending Drivers: Part II Chart 7Overall Growth Indicators Overall Growth Indicators Overall Growth Indicators Bottom Line: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. The Fed is probably correct that weak Q1 growth will prove transitory. Recent Weak Inflation Readings Are Also Transitory Overall, most participants viewed the recent softer inflation data as primarily reflecting transitory factors, but a few expressed concern that progress toward the Committee's objective may have slowed.3 We dealt with the inflation outlook in last week's report,4 through the lens of our Phillips Curve inflation model. To recap, using our model we found it very difficult to craft a realistic set of economic assumptions that resulted in year-over-year core PCE inflation below 1.88% by the end of the year. In our base case economic scenario the model projects that core inflation will reach 2.11%. Because our model is based on one that Janet Yellen referred to in a 2015 speech,5 we assumed that the Fed would reach a similar conclusion with regards to the inflation outlook. Although it must be said that the May FOMC meeting occurred prior to the disappointing April CPI release, it is notable that the minutes from the May meeting say that only "one member view[ed] further progress of inflation toward the 2 percent objective as necessary before taking another step to remove policy accommodation." In other words, almost all Fed members are content to rely on Phillips Curve style inflation models, which suggest that inflation will rise in the near future, and are putting less weight on the current low level of actual inflation. Of course, that dynamic could change relatively quickly. Chart 8 shows the track record of our Phillips Curve model, and we can see that it is not unusual for large residuals - on the order of 0.5% - to persist for significant periods of time. This means that even if all of our forecasts of the independent variables in the model turn out to be correct, there is still a chance that actual inflation will not keep pace with the model. In light of current circumstances, one period in particular stands out. The period from late-1993 to mid-1994, denoted by the shaded region in Chart 8. Chart 8The Fed Still Believes In The Phillips Curve The Fed Still Believes In The Phillips Curve The Fed Still Believes In The Phillips Curve In that episode the fair value from our model suggested that inflation should trend higher. Instead, inflation fell quite sharply. Eventually the model's fair value also moved lower, driven by a declining contribution from the model's lagged inflation term,6 and also by falling inflation expectations. In our view, this latter point is particularly important. In 1993-94, the failure of inflation to keep pace with Phillips Curve forecasts eventually caused market participants to lose faith and revise their inflation expectations lower. In a worst case scenario, a large decline in inflation expectations can feed on itself, leading to a deflationary spiral from which the Fed would have difficulty escaping. Chart 9Inflation Expectations Are ##br##Tough To Measure Inflation Expectations Are Tough To Measure Inflation Expectations Are Tough To Measure The Fed is very worried about falling (or more specifically "un-anchored") inflation expectations. In her aforementioned 2015 speech,7 Chair Yellen cautioned that temporary fluctuations in import prices or resource utilization could lead to permanent changes in inflation if they also caused inflation expectations to shift. Also, the longer the Fed misses its inflation target, the more likely it is that inflation expectations will become un-tethered. This is a very real risk. For now, the FOMC continues to view inflation expectations as well anchored, although the May minutes showed that "some participants" expressed concern that "the public's longer-term inflation expectations may have fallen somewhat." One problem is that there is no perfect way to measure inflation expectations (Chart 9). Market-based measures of inflation compensation are well below levels that have been consistent with the Fed's 2% inflation target in the past (Chart 9, panel 1), but these measures are volatile and are often driven by market-specific factors unrelated to inflation expectations. Meantime, the inflation expectations of professional forecasters have been quite stable (Chart 9, panel 2), while the message from consumer inflation expectations is mixed (Chart 9, bottom panel). The University of Michigan consumer survey shows inflation expectations near an all-time low, but the New York Fed's survey shows them in an uptrend. In any event, the strong correlation between consumer inflation expectations and gasoline prices makes them questionable at best. Bottom Line: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome and that the Fed is still on track for two more rate hikes this year. Financial Conditions Are Crucial [Some participants] noted variously that the decline in longer-term interest rates and the modest depreciation of the dollar over the intermeeting period would provide some stimulus to aggregate demand, that the Committee's recent policy actions had not resulted in a tightening of financial conditions, or that some of the decline in longer-term yields reflected investors' perceptions of diminished odds of significant fiscal stimulus and an increase in some geopolitical and foreign political risks.8 The above passage shows that the Fed believes that financial conditions lead growth, a result we have also shown in prior reports (Chart 10).9 In this context, the Fed would expect financial conditions to tighten as it lifts rates, eventually causing economic growth to moderate. If financial conditions fail to tighten it would suggest that monetary policy needs to become more restrictive, and vice-versa. Financial conditions tightened dramatically following the December 2015 rate hike (Chart 11) and the ensuing growth slowdown caused the Fed to postpone the next rate hike for 12 months. Then, financial conditions were relatively unchanged following the December 2016 rate hike, and this allowed the Fed to deliver another hike in March. The large easing in financial conditions since the March hike is telling the Fed that it needs to step up its pace. Chart 10The Fed Believes That Financial Conditions Lead Growth The Fed Believes That Financial Conditions Lead Growth The Fed Believes That Financial Conditions Lead Growth Chart 11A Big Easing Since March A Big Easing Since March A Big Easing Since March Ultimately, the Fed still needs inflation to increase. This means that it does not want financial conditions to tighten too much, and would likely prefer to keep the Chicago Fed's Adjusted Financial Conditions index below the zero line (Chart 11, top panel). A negative reading from the adjusted index signals that financial conditions are easy relative to the strength of the economy. That is, they should be sufficiently accommodative to allow the economic recovery to continue and cause inflation to rise. At the same time, levels that are deep in accommodative territory signal that the Fed can move more rapidly. Bottom Line: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 2 For further details on the BCA Beige Book Monitor please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 4 Please see U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 23, 2017, available at usbs.bcaresearch.com 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 One of the independent variables in our model is a 12-month lag of the year-over-year change in core PCE inflation. The lagged inflation variable pressures the model's fair value toward the level of actual inflation. If no other variables change, then over time the lagged inflation variable will ensure that the model fair value converges toward actual inflation. 7 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 8 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 9 Please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Politics will inject further volatility into risk assets, but stocks will outperform bonds and cash on a 6-12 month horizon. The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. The combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. Feature The Economy Matters More Than Politics The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. When the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s, the equity markets performed well. In the early 70s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 1). Today, the backdrop for the economy and earnings - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, two more Fed rate hikes and higher Treasury bond yields. Trump's political woes may slow, but not completely halt the GOP's legislative agenda1. Support for Trump among his GOP base remains high at 85%, making impeachment a long shot until after the November 2018 mid-term elections (Chart 2). If the Democrats take the House, they are likely to impeach Trump in 2019. For the Trump and the Republicans in Congress, this means the impetus is even greater to make progress now on tax cuts, tax reform and infrastructure. However, the embattled White House will slow the process as the president's staff often acts as a coordinator among the various factions in Congress. With Trump's team preoccupied with political woes, they will not be effective in this role. Chart 1Economy Will Trump Politics ##br## For Financial Markets Economy Will Trump Politics For Financial Markets Economy Will Trump Politics For Financial Markets Chart 2GOP Base Not Yet Willing To ##br## Impeach Trump The Economy Trumps Politics The Economy Trumps Politics The Fed will look through the politics and focus on the health of the economy and will continue to raise rates gradually this year, with the next hike coming in June. Financial conditions have eased since the Fed's 25 basis point rate hike in December, and that alone should be enough to keep the Fed on track to tighten next month. As we have noted in recent reports, even without fiscal stimulus, the U.S. economy will still grow near its long-term potential, tighten the labor market and push up wages and inflation. The Fed has been reticent to include any impact from fiscal stimulus into their policy deliberations thus far. The minutes of the March FOMC meeting noted that "members continued to judge that there was significant uncertainty about the effects of possible changes in fiscal and other government policies". Bottom Line: The lack of progress on legislation may result in a pullback in U.S. equity prices, but absent a material weakening of the U.S. economy or profit picture, the pullback will not turn into a bear market. Checking In On The Consumer The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This backdrop will allow the Fed to pursue two rate hikes this year. The weakness in several indicators has worried some investors that the economy may be on the verge of a slowdown or even a collapse. However, a firming economy should sustain corporate earnings growth and, ultimately, higher stock prices. Consumer spending's share of GDP is 68% and increasing (Chart 3). GDP growth excluding consumer spending is more volatile than overall GDP growth. The household sector has contributed 75% to growth since the end of the recession, which is the best performance of any sector. The key drivers of spending point to further gains in the sector, and the imbalances that were present ahead of prior downturns are not evident today. Chart 3Household Share Of GDP Is At An All Time High And Rising Household Share Of GDP Is At An All Time High And Rising Household Share Of GDP Is At An All Time High And Rising Chart 4Consumer Spending Remains In An Uptrend Consumer Spending Remains In An Uptrend Consumer Spending Remains In An Uptrend Household spending growth has softened but remains in an uptrend. Broad measures of consumer spending tend to peak two to four years prior to the start of a recession. The lead time is even longer in a long-cycle expansion.2 Investors should not dismiss the weakness altogether, but position portfolios for the late-cycle environment. Personal consumption expenditure growth peaked at 4% year-over-year in Q1 2015. Auto sales, a timelier measure of spending although not as comprehensive, peaked in December 2016 (Chart 4). Applying the 2 to 4 year lead time noted above - and making the assumption that spending has indeed peaked - this points to a recession commencing in the middle of 2019 at the earliest. Household net worth is at an all-time high, and the overall wealth effect on consumer spending has been positive for some time. Our forecast for financial markets and the housing market, though modest, imply that the positive wealth effect will continue. Debt-financed spending remains a viable option for consumers, which was not the case in late 2007 before the onset of the recession. Banks have not changed their lending standards for most consumer loans and demand for these loans will stay solid despite the Fed rate increases that we expect. The Bank Credit Analyst's March 2017 report showed that even a 100-basis point rate rise from the current levels would not lift the interest payments to burdensome levels by historical standards. Incomes will continue to climb and importantly, consumer income expectations have also hit new highs. With the economy at the Fed's assessment of full employment, wage growth is accelerating, albeit more modestly than in previous recoveries. Our recent report3 found that wages tend to rise about two years after the output gap has formed a bottom. A narrowing output gap leads to a tighter labor market and higher incomes. As measured by the quit rate, job security is at a fresh cycle high (not shown). Many consumer indicators are in better shape today than they were in 2007 or at similar points in the other long cycles4 (Charts 5 and 6). We define the long cycle economic expansions as those lasting 8-10 years. The two expansions that meet the definition are 1981-1990 and 1992-2001.5 Consumer spending is running in line with incomes, unlike in the mid-2000s. Chart 5Key Consumer Metrics ##br## Remain Favorable Key Consumer Metrics Remain Favorable Key Consumer Metrics Remain Favorable Chart 6There Is Still Plenty Of Support ##br## For Solid Consumer Spending There Is Still Plenty Of Support For Solid Consumer Spending There Is Still Plenty Of Support For Solid Consumer Spending Mortgage equity withdrawal, a crucial source of debt-fueled consumer spending prior to 2007, has been non-existent in this cycle. Spending on essentials are close to all-time lows. In 2007 they were at record highs and had moved up dramatically in the prior half-decade amid escalating debt levels, rising energy prices and consumer interest rates. We are concerned by the historically high percentage of household incomes (17%) dedicated to medical care. An aging population, ever rising healthcare costs and uncertainty surrounding the future of Obamacare may drive medical spending even higher. Household debt levels as a percentage of disposable income peaked in 2008 at over 120%, but are back under 100%, i.e. at the level that existed prior to the 2007-2009 recession. The level of household debt compares favorably to similar points in the long cycles of the 1980s and 1990s. Financial obligations are at multi-decade lows (Chart 6, bottom panel). Bottom Line: The fundamentals supporting consumer spending remain solid. A healthy consumer means the economy can meet the Fed's modest GDP forecast for 2017, keeping the central bank on track to tighten twice more in 2017. This outlook supports our view for stocks over bonds in the next 6-12 months. The Fed's Balance Sheet: It's Diet Time Chart 7Fed Set To Begin Tapering In Early 2018 Fed Set To Begin Tapering In Early 2018 Fed Set To Begin Tapering In Early 2018 The minutes from the March FOMC meeting indicated that a change in the Fed's reinvestment policy will likely be appropriate "later this year". The minutes suggested that the FOMC is split on whether to simply terminate all reinvestment for both Treasurys and MBS, or to "taper" reinvestment over time. Our base case is that the Fed will follow up a June rate hike with another one in September, at which point policymakers will provide some details on their plans for balance sheet runoff to begin in January of 2018. Investors are rightly concerned about the potential impact of the runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" (i.e. that QE implied that short-rates will be held at a low level for a very long time). Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables, including inflation expectations, demographics, growth, current accounts and budget balances. The model also includes the stock of assets held by the Fed as a share of GDP. If the Fed were to begin running off its holdings of both Treasurys and MBS at the beginning of 2018 by terminating all reinvestment, then the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a fall of roughly 10 percentage points of GDP (Chart 7). Given the IMF interest rate model's coefficient of -0.9, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. However, it is more complicated than that. The impact on yields is likely to be tempered by three factors: The Fed may opt to avoid going "cold turkey" on reinvestment, choosing instead to scale back gradually. Fed President William Dudley recently commented that the Fed wants balance sheet reduction to "run in the background", such that it is not a major event for markets. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. The implication is that the balance sheet may never fully revert to historic norms relative to GDP. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions get too tight, too quickly (i.e. the term premium would rise, but would be partly offset by a lower expected path for the fed funds rate). Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).6 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than is currently discounted in the market. We could also see some upward pressure on global term premia when the ECB announces the next tapering of its QE purchase program, possibly this autumn. However, it will be years before the ECB will be in a position to reduce the size of its balance sheet. As for the Bank of Japan, we doubt that the central bank will ever shed its JGB holdings. What about the shape of the Treasury curve? Our fixed-income strategists believe that the shape of the curve will be determined by the normal cyclical dynamics we have seen in the past. We are still in a window in which the Treasury curve will steepen as yields rise. A little later in the Fed cycle, the curve will bear-flatten as the long-end begins to rise at a slower pace than the front end. We do not see balance sheet adjustment as changing these dynamics much. Similarly, with respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. While spreads have already widened a bit, in our view they still do not adequately compensate for the additional MBS supply that will hit the market when the Fed takes a step back. Historically, there is a reasonably tight correlation between MBS spreads and the spread between mortgage rates and Treasury yields (Chart 8). Thus, it is reasonable to expect mortgage rates to rise by more than Treasury yields. Chart 8MBS Spreads Set To Widen As Fed Tapers MBS Spreads Set To Widen As Fed Tapers MBS Spreads Set To Widen As Fed Tapers While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten for a long time, outside of removing negative short rates and tapering QE purchases a bit further in 2018. Meanwhile, we think the Fed will tighten by more than is currently discounted. Admittedly, the economic data have disappointed so far in 2017 and CPI inflation has softened which, at the margin, would cause some FOMC members to back away from rate hikes. Nonetheless, policymakers are focused more on the labor market than GDP to gauge the health of the expansion and the amount of economic slack. Despite the dismal Q1 GDP figures, following unimpressive growth in 2016, the unemployment rate has already fallen below what the FOMC expected the rate will be at the end of this year! A tightening labor market means that the economy is still growing above a trend pace. Unless there is a clear deceleration in wage growth as measured by the ECI or the Productivity and Cost report, the FOMC will likely hike rates by more than the 38 basis points currently discounted over the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 See Geopolitical Strategy Report, "Break Glass In Case Of Impeachment," May 17, 2017. Available at gps.bcaresearch.com 2 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 3 See U.S. Investment Strategy Weekly Report, "Still Awaiting the Next Pullback", May 15, 2017. Available at usis.bcaresearch.com 4 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 5 We did not include the 1960s in this analysis because the Fed waited too long to tighten and allowed inflation to get out of hand. 6 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017.

Highlights Fed: The Fed is likely to lift rates in June, which could roil markets if economic data do not improve between now and then. Municipal Bonds: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Economy & Inflation: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Feature How stubborn are Fed policymakers? This is an important question for markets at the moment. The Fed has clearly articulated that its base case economic outlook will result in two more rate hikes before the end of 2017, and even traditionally dovish Chicago Fed President Charles Evans said he "could be fine with two more rate hikes this year."1 Meanwhile, broad indexes of financial conditions suggest that markets can absorb another rate increase (Chart 1). Everything appears to be set up for the FOMC to lift rates by another 25 basis points when it meets next month, and this remains our expectation. The only problem is that the flow of economic data has turned decisively negative (Chart 2). Most recently, core CPI disappointed expectations by increasing only 0.1% in April, causing the year-over-year growth rate to fall to 1.9%. It was only three months ago that core CPI was growing 2.3% year-over-year. True to form, President Evans also noted last week that "downside risks [to inflation] still predominate". Chart 1Green Light From Financial Conditions Green Light From Financial Conditions Green Light From Financial Conditions Chart 2Red Light From Data Surprises Red Light From Data Surprises Red Light From Data Surprises The risk from a market point of view is that the Fed holds true to its promise and lifts rates in June, despite the fact that recent data have disappointed and inflation remains well below target. In that scenario, it is possible that markets come to the conclusion that the Fed is running an overly tight policy, resulting in a bear-flattening of the yield curve and a near-term sell-off in spread product. Chart 3Stay Positioned For Higher Yields Stay Positioned For Higher Yields Stay Positioned For Higher Yields As we have highlighted numerous times in the context of our Fed Policy Loop,2 with inflation below target, the Fed will be quick to adopt a more dovish stance when faced with a sharp tightening of financial conditions. This will put a floor under risk assets. Further, as was discussed in last week's report,3 negative data surprises are not likely to persist for much longer. But until that turnaround occurs, there is a heightened risk of a near-term widening in credit spreads if the Fed sticks to its guns. Ultimately, the Fed will continue to support credit spreads, and we remain overweight spread product on a 6-12 month investment horizon. Our 6-12 month outlook for Treasury yields is also unchanged, even though recent yield movements reflect the "hawkish Fed" scenario described above. The nominal 10-year yield has risen in recent weeks, driven entirely by real yields that have moved higher alongside increasingly hawkish rate hike expectations (Chart 3). The compensation for inflation protection has actually declined, in reaction to disappointing inflation data and perceptions of a more hawkish Fed. Even in the event that financial conditions tighten and the Fed is forced to adopt a more dovish policy stance, we would expect the decline in real yields to be offset by an increase in the cost of inflation compensation, which still has considerable upside (see section titled "The Consumer Is Strong, But Where's The Inflation?" below). We therefore continue to recommend a below-benchmark duration stance. Finally, futures market positioning is now solidly net long, suggesting that yields are biased higher during the next three months (Chart 3, bottom panel). Bottom Line: Risk assets could sell off in the near-term if economic data do not turn around and the Fed proceeds with a June hike. However, Fed policy will ultimately encourage tighter credit spreads and a higher cost of inflation compensation on a 6-12 month horizon. Remain at below-benchmark duration and overweight spread product. Municipal Bonds: Not Just About Taxes The uncertain outlook for fiscal policy is the immediate concern in municipal bond markets. While we expect some sort of tax bill will make its way through Congress before the end of the year, as of now, we don't have much clarity on what that bill will include. Lower corporate and individual tax rates seem likely, and the administration has also expressed a desire to curb deductions. Unfortunately, for now that's about all we can say for certain. Lower tax rates would be negative from the perspective of municipal bond investors, but fewer deductions would increase demand for munis, assuming the municipal bond tax exemption is not scrapped altogether. We haven't even mentioned the potential replacement of Obamacare and a possible federal infrastructure bill! For now, the muni market seems content to shrug off this uncertainty. Muni / Treasury (M/T) yield ratios are approaching their post-crisis lows across the entire curve (Chart 4), though longer maturity yield ratios remain elevated compared to pre-crisis levels (Chart 5). We recently recommended that investors favor long over short maturities on the Aaa muni curve.4 Chart 4Yield Ratios At Post-Crisis Lows Yield Ratios At Post-Crisis Lows Yield Ratios At Post-Crisis Lows Chart 5More Value In Long Maturities More Value In Long Maturities More Value In Long Maturities As for tax reform, although nothing is known for certain, we do expect that the administration's desire for increased infrastructure investment will keep the muni tax exemption in place. We also anticipate lower corporate and individual tax rates. How much of an impact will lower tax rates have on M/T yield ratios? Even that is hard to pin down, although we note that historically there has only been a loose relationship between yield ratios and the top marginal income tax rate (Chart 6). Chart 6The Municipal Treasury Yield Ratio & Tax Rates The Municipal Treasury Yield Ratio & Tax Rates The Municipal Treasury Yield Ratio & Tax Rates Further, elevated yield ratios since the financial crisis are much more driven by concerns about credit quality than changes in tax policy. With the potential for municipal bankruptcy more present than ever in investors' minds, as long as the muni tax exemption is not repealed, we think that trends in state & local government balance sheet health will continue to drive yield ratios. On that latter point, there is growing reason for optimism. Revenue Growth Ready To Rebound Periods of rising state & local government net savings have historically coincided with tightening M/T yield ratios, and vice-versa. Net savings increases when revenue growth exceeds expenditure growth. However, expenditure growth has been outpacing revenue growth since early 2015 and net savings have declined as a result (Chart 7). Unsurprisingly, state & local governments have reduced their pace of hiring in an effort to protect budgets (Chart 7, panel 3). Ratings downgrades have also spiked, but the message from our Municipal Health Monitor is that they will soon subside (Chart 7, bottom panel).5 We concur, and in fact believe that state & local government revenue growth has reached an inflection point and is poised to head higher. Breaking out the different sources of state & local government revenue we see that the recent deceleration has been concentrated in income tax and sales tax revenues (Chart 8). Property tax growth has been steady, if unspectacular. Transfers from the federal government have also decelerated since early 2015, but have been flat recently. Transfer revenue is at risk of falling if the federal government is able to pass a healthcare bill that includes the block-granting of Medicaid payments. But there is still a long road ahead before any proposed healthcare bill becomes law, and a lot can change in the interim. Chart 7A Setback In State & Local Savings A Setback In State & Local Savings A Setback In State & Local Savings Chart 8State & Local Revenue By Source State & Local Revenue By Source State & Local Revenue By Source What seems clear at the moment is that personal income growth is heading higher and consumer spending is firm (please see the following section of this report, titled "The Consumer Is Strong, But Where's The Inflation?", for a discussion of the outlook for income and consumer spending growth). Both suggest that income and sales tax revenue growth have bottomed for the time being. Chart 9State & Local Revenue By State State & Local Revenue By State State & Local Revenue By State Using data from the Rockefeller Institute, we can also examine state & local government revenue by state. Then, if we split out the nine states that are most heavily dependent on the energy and mining sectors,6 we observe that commodity-dependent states have dragged overall state & local government revenue growth lower since commodity prices collapsed in mid-2014 (Chart 9). Further, we see that revenue growth in commodity-dependent states is heavily influenced by nonresidential investment in the energy and mining sectors (Chart 9, bottom panel). Now that commodity prices have recovered from the 2014 bust and energy sector investment is coming back on line, we would expect state & local revenue growth to follow with a lag. Investment Implications Although we expect state & local government revenue growth to accelerate from here, yield ratios already reflect quite a lot of good news. Also, heightened policy uncertainty means there is an increased risk that yield ratios will widen sharply in the coming months. For now, we recommend only a neutral allocation to Municipal bonds within U.S. fixed income portfolios. However, an interesting opportunity could lie in focusing municipal bond exposure on those aforementioned commodity-dependent states, where revenues are likely to grow more quickly as energy capex rebounds, and whose bonds might still trade at a discount because of lower current revenues. Looking at Charts 10 & 11, we notice that the General Obligation (GO) bonds of energy-dependent Texas offer a yield advantage of 15 bps versus the overall Aaa muni curve at the 10-year maturity point. This is close to the same yield advantage offered by Massachusetts GO bonds, even though Massachusetts is rated Aa1 and Texas carries a Aaa rating. Other Aaa-rated states (Virginia, Georgia, Maryland, North Carolina, South Carolina and Tennessee) trade at much lower yields. Not only that, but Texas has also seen the strongest population growth during the past 12 months of all the states in our sample (Chart 11), and employment growth in Texas should continue to rebound alongside rising oil prices (Chart 12). Our Commodity & Energy Strategy service maintains a $60/bbl year-end oil price target.7 Chart 10Grab The Premium In Texas GOs Part I Will The Fed Stick To Its Guns? Will The Fed Stick To Its Guns? Chart 11Grab The Premium In Texas GOs Part II Will The Fed Stick To Its Guns? Will The Fed Stick To Its Guns? Chart 12Texas Bouncing Back Texas Bouncing Back Texas Bouncing Back Bottom Line: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Commodity-dependent states should benefit disproportionately. Texas GOs in particular look attractive on a risk/reward basis. The Consumer Is Strong, But Where's The Inflation? Consumer Spending Chart 13Consumer Spending Looks Solid Consumer Spending Looks Solid Consumer Spending Looks Solid The post-election surge in consumer confidence does not look as though it's about to reverse. At least not according to the University of Michigan Consumer Sentiment Survey, which was released last week. The expectations component of that survey, which closely tracks real consumer spending (Chart 13), rose from 87 in April to 88.1 in May, suggesting that weak first quarter consumer spending will prove to be nothing more than a blip. We like to think about consumer spending as a combination of income growth and the savings rate. On income growth, survey measures are also pointing to an imminent acceleration (Chart 13, panel 2). Meanwhile, the savings rate will likely remain elevated compared to pre-crisis levels, but is unlikely to move meaningfully higher from here. In our February 21 report,8 we noted that while tightening bank lending standards correlated with a higher savings rate prior to the financial crisis, that relationship has since completely broken down (Chart 13, panel 3). Since the housing bust, the supply of credit is no longer the chief constraint on consumer borrowing. Households are now much more concerned with maintaining the health of their own balance sheets. For this reason, we do not view the recent tightening of consumer lending standards as a meaningful impediment to consumer spending. Similarly, we do not think the recent decline in demand for consumer credit (according to the Fed's Senior Loan Officer Survey) will soon translate into much weaker consumer spending. In prior cycles, we see that loan demand tended to fall several years prior to the next recession, while the savings rate did not spike until the recession actually hit (Chart 13, bottom panel). Inflation & TIPS As was mentioned above, the Consumer Price Index for April was also released last week. Not only was the core CPI print disappointing, but the decline was broad based across the four major components of core CPI: shelter, core goods, core services excluding shelter, and medical care (Chart 14). The tick lower in shelter inflation is not surprising, and in fact should continue now that rental vacancies have put in a bottom. We would also expect core goods inflation to stay low, given that the U.S. dollar remains in a bull market. More worrisome is the large drop in core services inflation excluding shelter (Chart 14, panel 3). This component of core inflation correlates most closely with wage growth, and we would expect this component to drive core inflation higher as the labor market tightens and wage growth accelerates. It is worth noting that while wage growth has also weakened during the past few months, leading wage growth indicators are still trending up (Chart 15). Pipeline measures of inflationary pressures, such as the core Producer Price Index and the Supplier Deliveries and Prices Paid components of the ISM Manufacturing index, are the other bright spots in the inflation outlook (Chart 16). While the 10-year TIPS breakeven rate has fallen all the way to 1.85% from its post-election high of 2.08%, these pipeline measures suggest the decline will prove fleeting. Chart 14Core CPI By Major Component Core CPI By Major Component Core CPI By Major Component Chart 15Wage Growth Will Recover Wage Growth Will Recover Wage Growth Will Recover Chart 16Pipeline Measures Still Positive Pipeline Measures Still Positive Pipeline Measures Still Positive We continue to expect that the 10-year TIPS breakeven inflation rate will reach 2.4% to 2.5% by the time that core PCE inflation returns to the Fed's 2% target, sometime near the end of this year. Bottom Line: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-05-12/evans-says-risks-to-fed-inflation-outlook-still-on-the-downside 2 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "Past Peak Pessimism", dated May 9, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 5 For further details on our Municipal Health Monitor, please see: U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 6 These states are: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, West Virginia and Wyoming. 7 Please see Commodity & Energy Strategy Weekly Report, "Oil: Be Long, Or Be Wrong", dated May 11, 2017, available at ces.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Any advance in Treasury yields should be gradual and more reflective of an improving global economy than it would be restrictive for equities. Book profits in homebuilders and downgrade to neutral. Rising lumber prices will do more harm than good. In contrast, home improvement retailers are in a sweet spot. We reiterate our high-conviction overweight stance. Recent Changes S&P Homebuilding - Downgrade to neutral. Table 1 Awaiting A Catalyst Awaiting A Catalyst Feature Equities marked time at the top end of their range last week. A catalyst may be required to sustain a breakout to new highs, as robust corporate profitability and forward guidance, coupled with tame monetary conditions, are battling against a spate of economic disappointments and soft commodity prices. Financial conditions remain sufficiently easy that economic growth should rebound in the back half of the year. The Fed is in no hurry to aggressively tighten monetary policy, owing to the lack of a serious inflation threat. If hard data begin to firm, then investors will gain confidence in the durability of the profit recovery, powering a further share price advance. While there may be some concern that stronger growth will simply embolden the Fed and push up Treasury yields, we doubt that the latter will become a roadblock just yet. Last week we highlighted that it typically takes a rise to at least one standard deviation above the mean in BCA's Treasury Bond Valuation Indicator to warn that the economy and stocks are at risk of a major downturn. That level would equate to 3.3% on the 10-year Treasury yield (Chart 1). Such large moves in Treasury yields do occur occasionally, (Nov/2010-Feb 2011, summer of 2013 and winter of 2016) and have sometimes preceded/caused economic slowdowns and/or financial accidents. The speed of the adjustment clearly plays a role, as short-term spikes are much harder to digest than gradual yield advances. Nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (second panel, Chart 2). Chart 1Yields Have Room To Rise##br## Before Becoming Restrictive Yields Have Room To Rise Before Becoming Restrictive Yields Have Room To Rise Before Becoming Restrictive Chart 2Sales Will Support##br## The Overshoot Sales Will Support The Overshoot Sales Will Support The Overshoot In other words, any advance in yields should be gradual and more reflective of a better global economy than restrictive, especially given the ongoing gentle softening in the U.S. dollar. The upshot is that the string of economic disappointments should begin to fade. In recent research, we have stressed the importance of a meaningful revival in corporate sector revenue growth in order to sustain sky-high valuations (top panel, Chart 2). Encouragingly, inflation expectations are recovering globally. A whiff of inflation is a positive omen for top line growth prospects. Inflation and economic growth expectations have firmed around the world. Chart 2 shows that euro area sales per share are on track to exit deflation after a multiyear slump, based on the message from the bond market. The same is true for emerging markets. If companies outside the U.S. finally enjoy renewed top-line growth, that would bode well for a continued recovery in U.S. business sales, especially if the U.S. dollar weakens. Chart 3 shows that both EM currencies and regional confidence surveys are heralding ongoing gains in U.S. profits sourced from overseas. Nevertheless, it is critical to keep the backdrop in a longer-term context. BCA's Equity Speculation Index (ESI) signals that the advance is at a very high risk stage (Chart 4). The ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds. But, investors should maintain some non-cyclical exposure even if the market continues its advance in the short run. Chart 3Foreign-Sourced Profit Support Foreign-Sourced Profit Support Foreign-Sourced Profit Support Chart 4The Rally Is Very High Risk The Rally Is Very High Risk The Rally Is Very High Risk This week we are updating our overall view of the consumer discretionary sector and tweaking our housing-related equity positioning. Consumer Discretionary: On The Way To All-Time Highs Consumer discretionary stocks have been portfolio stalwarts in 2017 (outside of autos and select media), advancing by over 10% and besting the S&P 500 by about 400bps. The heavyweight media sub-group (ex-cable and satellite) has come under scrutiny recently, as fears that ad spending will endure a deep slump have resurfaced. However, most of our indicators suggest that ad spending, at least outside of autos, will not suffer a major downturn, given our upbeat outlook for consumption and profits. Cord-cutting is not a new phenomenon, and is already reflected in very washed out profit expectations, both on a cyclical and structural horizon (we will be covering media in more detail in an upcoming Report). Consequently, there are good odds that this impressive consumer discretionary showing will remain intact especially as last Friday's payrolls bounced smartly. Two key drivers have added fuel to this fiery performance: border adjustment tax fears have subsided and soft economic data have given the Fed enough breathing room to continue erring on the dovish side. Importantly, leading indicators of discretionary spending are heralding a solid recovery in consumer outlays. Interest rates remain near generationally low levels and oil price inflation has peaked. The economy is near full employment, signaling that wage inflation will quicken. According to BCA's Income Indicator1, consumer income growth is expected to reaccelerate imminently (bottom panel, Chart 5). While consumers have demonstrated a preference for saving vs. spending, several factors suggest that purse strings should soon loosen. Consumer confidence has soared, buoyed by income gains (third panel, Chart 5). Moreover, new highs in household net worth as a percent of disposable income signal that the upward pressure on the personal savings rate should diminish (second panel, Chart 5). The implication is that recent disappointing consumer spending data should prove transitory. While these factors could ultimately put upward pressure on interest rates, there may be a window where limited inflation pressures and weak credit growth permit only a gradual upshift in the Treasury curve. Regardless, there are other indicators pointing to additional outperformance. For instance, there is still a wide gap between forward earnings breadth and washed-out technical conditions. Roughly 75% of consumer discretionary sub-groups have rising 12-month forward profit estimates. This is sustainable as long as consumers have an incentive to spend. In contrast, the proportion of consumer discretionary sub-indexes with a positive 52-week rate of change and/or are trading above their 40-week moving average remains well below 50%. This divergence between fundamentals and technicals is an exploitable gap, which should narrow via a sustained rise in relative share prices (Chart 6). Chart 5Upbeat Consumption Outlook Upbeat Consumption Outlook Upbeat Consumption Outlook Chart 6Exploitable Gap Exploitable Gap Exploitable Gap Finally, consumer discretionary stocks are no longer expensive. On a relative forward P/E basis they trade below the historical mean and at a discount to the S&P 500. Consumer discretionary EV/EBITDA is also trailing the broad market, as well as its long-term average. If a recovery in consumer outlays pans out in the back half of the year, as we expect, then a re-rating phase is likely. However, not all sub-groups are created equal. This week we are tweaking our housing-related consumer discretionary exposure. Homebuilders' Pain... Homebuilding stocks have been moving sideways for the better part of the past four years in a narrow trading range. They are currently sitting near the top of this range. Is it time to book profits? The short answer is yes. The recent confirmation of U.S. tariffs on Canadian lumber imports represents a source of cost inflation that may embed a risk premium in share prices until a new trade deal can be worked out. Lumber prices have nearly doubled during the past sixteen months and remain the best performing commodity in 2017 (bottom panel, Chart 7). Lumber comprises anywhere between 10%-20% of the cost of a new home, underscoring that a 20% lumber tariff will add to the cost of building a new home, squeezing margins unless homebuilders can pass this cost on via increased house prices. However, we are skeptical that there is a lot of room for new house price increases given that it would make it more difficult to compete with existing house sales. While new homes have taken market share from existing homes since the residential housing market trough earlier in the decade (Chart 8), market share gains have come at the expense of profit margins. Homebuilders have been aggressively discounting properties in order to lure new buyers. Given the buildup in new home inventories, further market share gains are at risk, unless additional selling price concessions materialize. Chart 7Elevated Lumber Prices... Elevated Lumber Prices... Elevated Lumber Prices... Chart 8...Spell Trouble For Homebuilding Margins ...Spell Trouble For Homebuilding Margins ...Spell Trouble For Homebuilding Margins The implication is that builders would likely have to absorb any input cost inflation, to the detriment of margins. Indeed, homebuilder sales are already decelerating as a consequence of pricing pressure (second panel, Chart 7). A simple homebuilder profit margin proxy (comprising new house price inflation minus the residential construction wage bill) warns that operating margins will compress, irrespective of the path of lumber prices (bottom panel, Chart 8). Nevertheless, there are some positive offsets that prevent us from turning outright bearish on the niche S&P homebuilding index. These counterbalances are related to the stage of the housing recovery. Homebuilders' sales expectations have surged, nearing the previous cycle's peak, according to the NAHB survey (Chart 9). Similarly, overall housing market conditions are probing multi-year highs and buyer traffic has vaulted to the highest level since mid-2005. Homebuilders remain optimistic about new housing demand. Household formation is still running higher than housing starts, representing a bullish backdrop for future new home construction. Rising incomes and a firming job market also bode well for the prospects of residential real estate. In aggregate, house prices are still expanding according to the Case-Shiller indexes and there are pockets of frothiness in select markets. The thirty year fixed mortgage rate recently broke back below 4% (Chart 10) and banks are willing extenders of mortgage credit, allaying fears that the price of credit will undermine housing affordability. According to our updated estimates (not shown), even if mortgage rates spiked 200bps from current levels, neither affordability nor mortgage payments as a percent of median incomes would return to their respective long-term average. Chart 9Housing Market Remains Firm... Housing Market Remains Firm... Housing Market Remains Firm... Chart 10...Warranting A Neutral Stance ...Warranting A Neutral Stance ...Warranting A Neutral Stance Still, these positives are already reflected in expectations, as the sell side has aggressively upgraded homebuilding profit estimates. The net earnings revisions ratio has catapulted to a 12-year high (Chart 10). Given our more balanced outlook for homebuilding earnings, we are leaning against this exuberance. Bottom Line: Book profits of 3.4% in the S&P homebuilding index and downgrade to neutral. The ticker symbols for the stocks in this index are: DHI, LEN, PHM. ...Is Home Improvement Retailers' Gain While our confidence in further homebuilding outperformance has ebbed, the opposite is true for the S&P home improvement retail (HIR) index. We put the S&P HIR index on our high-conviction overweight list at the beginning of the year, and so far, so good. HIR stocks have outperformed the broad market and the S&P consumer discretionary sector year-to-date. There are good odds that more gains lie ahead. Industry retail sales are running at a mid-single digit rate, surpassing lackluster overall retail sales (second panel, Chart 11). Importantly, household appliance and furniture selling prices have surged, reinforcing that demand is robust and signaling that HIR same-store sales growth will likely accelerate in the busy spring selling season, and beyond (middle panel, Chart 11). Unlike homebuilders, home improvement retailers benefit from rising lumber prices. HIR companies typically earn a set margin on lumber-related sales. Thus, any absolute increase in lumber prices boosts top line growth, and profit margins (bottom panel, Chart 11). The industry's disciplined approach to store additions in the aftermath of the GFC has set the stage for ongoing selling price gains. Chart 12 shows that while house prices have overtaken the 2006 highs, increasing the incentive for homeowners to remodel and invest in this key asset, building and supply store construction activity has remained depressed. Easier mortgage lending standards should ensure that total home sales activity remains elevated, to the benefit of home prices, and provide the necessary financing needed for large projects (Chart 12). Tight labor markets, rising wages and surging consumer confidence are signaling that consumers have an appetite to re-lever and space to take on more debt (Chart 12). With store capex budgets under tight control, same-store sales and cash flow growth are bound to sustain their solid advance as renovation activity accelerates. All of this is best encapsulated by our HIR model. The model has recently soared, driven by the drop in fixed mortgage rates and surge in lumber prices, signaling that the path of least resistance is higher for relative share prices (top panel, Chart 11). Indeed, relative profits have already soared to fresh highs, also signaling the same for relative share prices (top panel, Chart 13). Oddly, analysts are overly pessimistic about the industry's sales and earnings growth prospects. In fact, top line growth estimates are trailing those of the broad market, and the 12-month forward relative profit growth hurdle is set very low at 2% (middle panel, Chart 13). Chart 11All Signals Flashing Green All Signals Flashing Green All Signals Flashing Green Chart 12Capacity Restraint Is Paying Dividends Capacity Restraint Is Paying Dividends Capacity Restraint Is Paying Dividends Chart 13Earnings Led Advance Earnings Led Advance Earnings Led Advance Given the positive message from leading indicators of remodeling activity we are far more optimistic, and expect both relative top and bottom line growth numbers to overwhelm. Bottom Line: The re-rating phase in the S&P home improvement retail index has room to run. We reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: HD, LOW. 1 Please see Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

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 The Zenith Is Passing The 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... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos 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 Bright U.S. Household Income Prospects Bright U.S. Household Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up As Households Get Formed, 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... Business Confidence Points To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving ...Especially As A Key Profit Driver Is Improving ...Especially As A Key Profit 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 Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity A 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 Deteriorating Growth Outlook Deteriorating Growth Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening Chinese Monetary Conditions Are Tightening Chinese Monetary Conditions 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 China Industrial Growth Worry China Industrial Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Slowing Chinese Credit Impulse 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 Two Worrisome Breakdowns On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Platinum's Dark Omen For EM Platinum's Dark Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally The Falling Participation In The EM Rally The Falling Participation 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 Little Cushion In EM Assets Little Cushion In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well Commodity Currency Options 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 Platinum Raises Concerns For Commodity Currencies As Well Platinum Raises Concerns 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 EUR/USD: Good News In The Price EUR/USD: Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient European Core CPI Rebound Should Prove Transient European Core CPI Rebound 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 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD 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 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR 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 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY 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 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP 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 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD 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 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD 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 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD 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 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales 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 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK 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 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK 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

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 Global Asset Prices: From Gloom To Glee Global 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 C&I Loans Will Pick Up C&I Loans Will Pick Up Chart I-3However, Household Credit ##br##Dynamics Are A Worry However, Household Credit Dynamics Are A Worry However, Household Credit Dynamics Are A Worry Chart I-4Securitization Unlikely ##br##To Be The Culprit Securitization Unlikely To Be The Culprit Securitization Unlikely 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 Job Growth Will Rebound Job Growth Will Rebound Chart I-6Household Income: Highway Star Household Income: Highway Star Household 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 Happy Shiny People Happy Shiny People Chart I-8Capex Will Rebound Capex Will Rebound Capex 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 Problems For Iron Ore Problems For Iron Ore Chart I-10Two Clouds For Global Growth Two Clouds For Global Growth Two 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? Are We Out Of The Woods Yet? Are We Out Of The Woods Yet? Chart I-12A Gauge And A Play A Gauge And A Play A 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 AUD Prices In Chinese Optimism AUD Prices In Chinese Optimism Chart I-14AUD/NZD Is Expensive AUD/NZD Is Expensive AUD/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 Domestic Conditions Favor Higher NZ Rates Vs. Australia Domestic Conditions Favor Higher NZ Rates Vs. Australia Chart I-16Speculators ##br##Are Bullish Speculators Are Bullish Speculators 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 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD 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 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR 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 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY 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 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP 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 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD 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 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD 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 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD 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 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF 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 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK 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 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK 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

Highlights A gradual rise in interest rates will not be problematic for the housing market. Throughout the cycle, it has been potential homebuyers' lack of savings, and tougher lending standards, that has held back the housing expansion. A steady improvement in household balance sheets is now allowing more households to qualify for loans. We assign low odds that housing policy reform will have a direct impact on the market over the next year; macroeconomic forces will be the primary driver for residential real estate activity and prices. Feature Since 2013, the U.S. housing market has enjoyed a relative period of calm after the bubble (2004-2007), bust (2008-2011) and prolonged clean-up period (2011-2014). Indeed, since 2013, the residential real estate market has made steady gains both in terms of construction and price returns. Rock-bottom interest rates, an improving labor market, and tight supply have provided good conditions for the housing market to expand. But these conditions are changing. Both residential investment and home prices are procyclical and highly sensitive to interest rates. With the Fed now beginning to deliberate its fourth rate hike of the cycle, investors should wonder whether this poses a risk to housing. Meanwhile, there is much talk about tax reform from Washington. This Special Report focuses on the top questions relating to the U.S. housing market. Question #1: Won't rising mortgage rates kill the nascent recovery in mortgage activity? Throughout this expansion, the level of interest rates has not been the major hurdle to the housing recovery; it was a lack of savings and tighter credit conditions that kept potential homebuyers out of the market. Table 1 is a breakdown of the National Association of Realtors' Affordability of First-time Homebuyers. The median price of a starter home is currently $199,800 and the qualifying income on such a home (assuming 10% down payment) is $42,000. Since the median family income is currently $46,040, this implies that at today's interest rates, potential first-time homebuyers do have the required income to enter the housing market. Earlier in the recovery, the problem had been the 10% down payment. According to the Federal Reserve's triennial survey of Consumer finances in 2014, median net worth for non-homeowners (i.e. renters) was $5,400, i.e. far short of the down payment required. A meaningful rise in the homeownership rate was always going to be difficult to pull off until consumers built sufficient savings for a down payment and/or mortgage lending standards loosened significantly. Table 1Potential Homebuyers: Savings A Bigger Hurdle Than Rates U.S. Housing: What Comes Next? U.S. Housing: What Comes Next? We do not have up-to-date median renter savings data (the next Federal Reserve survey of consumer finances will only be published in September), but the savings rate has risen over the past several years. It is likely that an improvement in renter finances is alleviating the major hurdle that exists for potential home buyers. Outside of the down payment issue, housing affordability is very good even under an aggressive interest rate scenario. In Chart 1, we stress-test housing affordability under different rate scenarios. Even if mortgage rates rise by 200bps, mortgage payments relative to income will remain well below their long-term average. The bottom line is that we do not see a rise in interest rates as overly problematic for the housing market. Throughout the cycle, it has been potential homebuyers' lack of savings, and tougher lending standards that have held back the expansion. A steady improvement in household balance sheets is now allowing more households to qualify for loans. Question #2: And how are lending standards today? Historically, lending standards always swung between very tight at the beginning of an economic cycle and very loose at the height of the expansion. This time, it appears that banks have kept a more cautious attitude toward consumers relative to past cycles (Chart 2). This shouldn't be a surprise, given that this was the area of greatest excesses during the past business cycle. Chart 1Higher Rates Won't Kill ##br##The Housing Recovery Higher Rates Won’t Kill The Housing Recovery Higher Rates Won’t Kill The Housing Recovery Chart 2Improved Household Balance Sheets Mean ##br##More Qualifying Borrowers Improved Household Balance Sheets Mean More Qualifying Borrowers Improved Household Balance Sheets Mean More Qualifying Borrowers As mentioned above, consumers' balance sheets have largely been mended over the course of this cycle. In fact, the average U.S. FICO score is now at an all-time high. This is great news, although still perhaps not great enough for banks. According to Deutsche Bank, the average credit score required is 750, and this number has not changed much since 2007. The average FICO score for the total U.S. population is still considerably below this. However, as scores improve, over time more and more people are qualifying. Overall, while it appears that banks have not drastically changed lending standards, more prospective buyers are meeting the criteria. Question #3: Is there still a supply glut? No- as Chart 3 shows, on a national basis, traditional measures of housing inventory for sale are near-record lows. Of course, geography is very important for real estate and some markets are tighter than others, but aggregate data does not show any meaningful imbalances. If anything, a catch-up building phase may be required in some areas. Question #4: How will Trump affect the housing market? We do not anticipate that any direct policy measures will impact the housing market in 2017. If interest rates rise over the next year because the Fed believes that monetary policy needs to tighten in the face of expansive fiscal policy, then this will surely provide a mild brake on lending activity. We address the impact of higher rates in Question #1. As for direct policy measures, perhaps the most impactful one would be a change to the mortgage interest deduction. Recall that U.S. taxpayers currently can deduct the interest expense on their mortgage to reduce their taxable income. Trump had previously floated the idea to adjust the cap on the amount of eligible debt (currently at $1 million for married couple jointly filing taxes). But earlier this month, Treasury Secretary Mnuchin dismissed this idea. Tax cuts or broader tax reform are unlikely to pass until the second half of the year at earliest. Until the legislation is written it is impossible to know what aspects of the Trump or House GOP proposals will be included. Similarly, Mnuchin has voiced that he is keen to privatize the GSEs. But that is unlikely to occur this year and the implications of such a development are unclear. The bottom line is that we assign low odds that housing policy reform will have a direct impact on the market over the next year; macroeconomic forces will be the primary driver for residential real estate activity and prices. Question #5: How much will residential real estate contribute to GDP? Residential investment currently stands at 4% of GDP (Chart 4). This is way above the low reached in 2009, but is still short of the pre-recession high of 6% of GDP and is still significantly shy of the thirty year average of 5%. Based on the still low level of inventories, and the potential for household formation to rise, a reasonable expectation is that construction climbs back to 5% of GDP over the next several years. If that occurs, then the contribution to GDP growth from construction should rise toward 0.8% this year and stay at a high level. Chart 3Inventory Is Tight Inventory Is Tight Inventory Is Tight Chart 4Construction Will Be A More Significant GDP Contributor Construction Will Be A More Significant GDP Contributor Construction Will Be A More Significant GDP Contributor Question #6: 4% of GDP is pretty small. How else does the housing market contribute to growth? The housing market affects the economy through multiple channels; even a casual observer of the 2008/09 meltdown can attest to that! Besides the banking system, it is especially homeownership that affects consumer spending patterns. First, the overall wealth effect - the change in spending that accompanies a change in perceived wealth - is driven primarily by the change in the value of housing assets, rather than financial assets (Chart 5). On average, a one-dollar decline in housing wealth tends to reduce consumption by 12 cents. This is two-to-four times as large as the impact on consumption from a one-dollar increase in housing wealth, and much larger than the impact from a one-dollar decline in stock market wealth.1 Second, homeownership impacts spending decisions through the collateral effect. Real consumption and real debt growth have been strongly correlated since 1960. As the top panel of Chart 5 shows, greater credit availability for households has been associated with lower saving rates -and thus higher consumption (this process went into reverse during the GFC).2 Since homeownership is the most significant means for households in the U.S. to access credit (over 80% of household debt is held as mortgage debt), it is really the trend in homeownership and its accompanying mortgage debt that drives the changes in household debt positions, and therefore their ability to boost spending above incomes. Now that there are reasons for the homeownership rate to rise, this wealth effect could play a larger role than during the past few years. Question #7: And how much will prices rise? The U.S. housing recovery has closely followed the classic cycle - our stylized roadmap based on the experience of countries that previously recovered from a housing/financial crisis (Chart 6). If the path of home prices continues to follow this roadmap, then real home price appreciation will be around 4% in 2017 (6% in nominal terms). Chart 5Homeownership = Leverage Homeownership = Leverage Homeownership = Leverage Chart 6More Price Gains Ahead More Price Gains Ahead More Price Gains Ahead Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Case, Quigley and Shiller. "Wealth Effects Revisited". February, 2011. 2 The Fed has done extensive work on this topic. A comprehensive background piece is available here: http://www.kansascityfed.org/publicat/sympos/2007/PDF/Muellbauer_0415.pdf

Highlights Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction A Hawkish Market Reaction A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Inflation Still Too Low Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential & Non-Residential Investment Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Wages Can Drive Income Growth Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Lending Standards Less Of A Risk Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment The U.S. Dwindling Manufacturing Employment The U.S. Dwindling Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses ...And Households Support Domestic Businesses ...And Households Support Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades