Currencies

Highlights Venezuela's economic implosion accelerated with the oil price crash. The petrodollar collapse is suffocating consumption as well as oilfield investment, creating a "death spiral" of falling production. The military has already begun assuming more powers as Maduro becomes increasingly vulnerable, and will likely take over before long. OPEC's cuts may help Maduro delay, but not avoid, deposition. Civil unrest/revolution could cause a disruption in oil production, profoundly impacting oil markets. Feature The wheels on the bus go round and round, Round and round, Round and round ... The story of Venezuela's decline under the revolutionary socialist government of deceased dictator Hugo Chavez is well known. The country went from being one of the richest South American states to one of the poorest and from being reliant on oil exports to being entirely dependent on them (Chart 1). The straw that broke the back of Chavismo was the end of the global commodity bull market in 2014 (Chart 2). Widespread shortages of essential goods, mass protests, opposition political victories, and a slide into overt military dictatorship have ensued.1 Chart 1Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Chart 2Commodity Bull Market Ended Commodity Bull Market Ended Commodity Bull Market Ended The acute social unrest at the end of 2016 and beginning of 2017 raises the question of whether Venezuela will cause global oil-supply disruptions that boost prices this year.2 One of the reasons we have been bullish oil prices is the fact that the world has little spare production capacity (Chart 3). This means that political turmoil in Venezuela, Libya, Nigeria, or other oil-producing countries could take enough supply out of the market to accelerate the global rebalancing process and drawdown of inventories, pushing up prices. Image Image The longer oil prices stay below the budget break-even levels of the politically unstable petro-states (mostly $80/bbl and above), the more likely some of them will be to fail. Venezuela, with a break-even of $350/bbl, has long been one of our prime candidates (Chart 4).3 Venezuela is on the verge of total regime collapse and a massive oil production shutdown. This is not a low-probability outcome. However, the fact that the military is already taking control of the situation, combined with our belief that OPEC and Russia will continue cutting oil production to shore up prices, suggest that the regime may be able to limp along. Therefore a continuation of the gradual decline in oil output is more likely than a sharp cutoff this year. Investors should stay short Venezuelan 10-year sovereign bonds and be aware of the upside risks to global oil prices. A Brief History Of PDVSA State-owned oil company PDVSA is the lifeblood of Venezuela. It once was a well-run company that allowed foreign investment with a reasonable government take, but now it is shut off from direct foreign investment. In 1996-1997, prior to Chavez being elected in late 1998, Venezuela was a rampant cheater on its OPEC quota, producing 3.1-3.3 MMB/d versus a quota of ~2.4 MMB/d in 1996 and ~2.8 in 1997. The oil-price crash that started in late 1997 and bottomed in early 1999 (remember the Economist's "Drowning In Oil" cover story on March 4, 1999 predicting $5 per barrel crude prices?) was a critical event propelling the rise of Chavez (Chart 5). One of the planks in Chavez's platform was that Venezuela had to stop cheating on OPEC quotas because that strategy had helped cause the oil-price decline and subsequent economic misery. Without the oil-price crash, Chavez would not have had such strong public support in the run-up to the 1998 elections, which he won. Chavez did in fact rein in Venezuela's production to 2.8 MMB/d in 1999, which had a positive impact on oil prices and reinforced OPEC. In 2002 and 2003, there were two labor strikes at PDVSA and a two-day coup that displaced Chavez. When Chavez returned to power, he fired 18,000 experienced workers at PDVSA and replaced them with political loyalists. Since then, the total number of employees at PDVSA has swelled from about 46,000 people in 2002, when PDVSA was producing 3.2 MMB/d, to about 140,000 people today, when it is producing slightly below 2 MMB/d. Average oil revenue per employee was over $500,000/person in 2002 at $20 oil, versus about $100,000/person today at $50 oil. Suffice it to say, PDVSA is stuffed to the gills with political patronage, and a strike or a revolution inside PDVSA against President Nicolas Maduro is unlikely. However, if opposition forces manage to seize control of government, the Chavistas in control of PDVSA may attempt to shut down operations to deprive them of oil revenues and blackmail them into a better deal going forward. Chart 5Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Image Venezuela is estimated to have the world's largest proved oil reserves at about 300 billion barrels (Chart 6). In addition, there are 1.2-1.4 trillion barrels estimated to rest in heavy-oil deposits in the Orinoco Petroleum Belt (at the mouth of the Orinoco river) that is difficult to extract and has barely been touched. Chart 7Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster These reserves are somewhat similar to Canada's oil sands. It is estimated that 300-500 billion barrels are technically recoverable. In the early 2000s, there were four international consortiums involved in developing these reserves: Petrozuata (COP-50%), Cerro Negro (XOM), Sincor (TOT, STO) and Hamaca (COP-40%). However, Chavez nationalized the Orinoco projects in 2007, paying the international oil companies (IOCs) a pittance. XOM and COP contested the taking and "sued" Venezuela at the World Bank. XOM sought $14.7 billion and won an arbitrated decision for a $1.6 billion settlement in 2014. Venezuela continues to litigate the case and the amount awarded to investors has apparently been reduced by a recent ruling. Over the past decade, as Venezuelan industry declined due to dramatic anti-free market laws, including aggressive fixed exchange rates absurdly out of keeping with black market rates, the government nationalized more and more private assets in order to get the wealth they needed to maintain profligate spending policies. The underlying point of these policies is to garner support from low-income Venezuelans, the Chavista political base. In addition to the Orinoco nationalization, the government appropriated equipment and drilling rigs from several oilfield service companies that had stopped working on account of not being properly paid. In 2009, Petrosucre (a subsidiary of PDVSA) appropriated the ENSCO 69 jackup rig, although the rig was returned in 2010. In 2010, the Venezuelan government seized 11 high-quality land rigs from Helmerich & Payne, resulting in nearly $200MM of losses for the company. These rigs were "easy" for Venezuela to appropriate because they did not require much private-sector expertise to operate. As payment failures continued, relationships with the country's remaining contractors continued to be strained. In 2013, Schlumberger (SLB), the largest energy service company in the world, threatened to stop working for PDVSA due to lack of payment in hard currency. PDVSA paid them in depreciating Venezuelan bolivares, but tightened controls over conversion into U.S. dollars. Some accounts receivables were partially converted into interest-bearing government notes. Promises for payment were made and broken. SLB has taken over $600MM of write-downs for the collapse of the bolivar (Haliburton, HAL, has taken ~$150MM in losses). With accounts receivable balances now stratospherically high at approximately $1.2 billion for SLB, $636 million for HAL (plus $200 million face amount in other notes), and $225 million for Weatherford International, the service companies have already taken write-offs on what they are owed and have refused to extend Venezuela additional credit. Unlike the "dumb iron" of drilling rigs, the service companies provide highly technical proprietary goods and services, from drill bits and fluids to measuring services. The lack of these proprietary technical services diminishes PDVSA's ability to drill new wells and properly maintain its legacy production infrastructure. Venezuela's production started falling in late 2015 - well before OPEC and Russia coordinated their January 2017 production cuts (Chart 7). Drought contributed to the problem in 2016 by causing electricity shortages and forced rationing of electricity (60-70% of Venezuela's electricity generation is hydro); water levels at key dams are still very low, but the condition has eased a bit in 2017. After watching crude oil production fall from 2.4 MMB/d in 2015 to 2.05 MMB/d in 2016, OPEC gave Venezuela a production quota of 1.97 MMB/d for the first half of 2017, which is about what they were expected to be capable of producing. In essence, Venezuela was exempt from production cuts, like other compromised OPEC producers Libya, Nigeria and Iran. So far, Venezuela has produced 1.99 MMB/d in the first quarter, according to EIA. Venezuela's falling production is not cartel behavior but indicative of broader economic and political instability. Venezuela is losing control of oil output, the pillar of regime stability. Bottom Line: The double-edged sword for energy companies is that if the regime utterly fails, the country's 2MM b/d of production may be disrupted. However, if government policy shifts - whether through the political opposition finally gaining de facto power or through the military imposing reforms - Venezuela could ramp up its production, perhaps by 1MMB/d within five years, and more after that if Orinoco is developed. How Long Can Maduro Last? Chavez's model worked like that of Louis XIV, who famously said, "après nous, le déluge." Chavez benefited from high oil prices throughout his reign and died in 2013 just before the country's descent into depression began (Chart 8). He won his last election in 2012 by a margin of 10.8%, while Maduro, his hand-picked successor, won a special election only half a year later by a 1.5% margin, which was contested for all kinds of fraud (Chart 9). Chart 8A Hyperflationary Depression A Hyperflationary Depression A Hyperflationary Depression Image Thus Maduro has suffered from "inept successor" syndrome from the beginning, compounding the fears of the ruling United Socialist Party of Venezuela (PSUV) that the succession would be rocky. Maduro lacked both the political capital and the originality to launch orthodox economic reforms to address the country's mounting inflation and weak productivity, but instead doubled down on Chavez's rapid expansion of money and credit to lift domestic consumption (Chart 10).4 Chart 10Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Chart 11Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not The economic collapse was well under way even before commodities pulled the rug out from under the government.5 Remarkably, the recovery in export revenue since 2010 did not occasion a recovery in foreign exchange reserves - these two decoupled, as Venezuela chewed through its reserves to finance its growing domestic costs (Chart 11). This means Venezuela's ability to recover even in the most optimistic oil scenarios is limited. Another sign that the economic break is irreversible is the fact that, since 2013, private consumption has fallen faster than oil output - a reversal of the populist model that boosted consumption (Chart 12). Chart 12Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Chart 13Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Critically, the external environment turned against Maduro and PSUV as oil prices declined after June 2014. In November 2014 Saudi Arabia launched its market-share war against Iran and U.S. shale producers, expanding production into a looming global supply overbalance. Brent crude prices collapsed to $29/bbl by early 2016 (Chart 13). This pushed Venezuela over the brink.6 First, hyperinflation: Currency in circulation - already expanding excessively - has exploded upward since 2014. The 100 bolivar note has exploded in usage while notes of lower denominations have dropped out of usage. Total deposits in the banking system are growing at a pace of over 200%, narrow money (M1) at 140%, and consumer price index at 150% (see Chart 10 above). Real interest rates have plunged into an abyss, with devastating results for the financial system. The real effective exchange rate illustrates the annihilation of the currency's value. Monetary authorities have repeatedly devalued the official exchange rate of the bolivar against the dollar (Chart 14). However, the currency remains overvalued, which creates a huge gap between the official rate and the black market rate, which currently stands at about 5,400 bolivares to the dollar. Regime allies have access to hard USD, for which they charge high rents, and the rest suffer. Chart 14Official Forex Devaluations Official Forex Devaluations Official Forex Devaluations Chart 15Domestic Demand Collapses Domestic Demand Collapses Domestic Demand Collapses Second, the real economy has gone from depression to worse: Exports peaked in October 2008, nearly recovered in March 2012, and plummeted thereafter. Imports have fallen faster as domestic demand contracted (Chart 15). Venezuela must import almost everything and the currency collapse means staples are either unavailable or exorbitantly expensive. Venezuelan exports to China reached 20% of total exports in 2012 but have declined to about 14% (Chart 16). This means that Venezuela has lost a precious $10 billion per year. The state has also been trading oil output for loans from China, resulting in an ever higher share of shrinking oil output devoted to paying back the loans, leaving less and less exported production to bring in hard currency needed to pay for production, imports, and debt servicing. Both private and government consumption are shrinking, according to official statistics (Chart 17). Again, the consumption slump removes a key regime support. Chart 16Chinese Demand Is Limited Chinese Demand Is Limited Chinese Demand Is Limited Chart 17Public And Private Consumption Shrink Public And Private Consumption Shrink Public And Private Consumption Shrink Third, Venezuela is rapidly becoming insolvent: Venezuela's total public debt is high. It stood at 102% of GDP as of August 2014, and GDP has declined by 25%-plus since then. Total external debt, which becomes costlier to service as the currency depreciates, was about $139 billion, or 71% of GDP, in Q3 2015 (Chart 18). It has risen sharply ever since the fall in export revenues post-2011. The destruction of the currency by definition makes the foreign debt burden grow. Chart 18External Debt Soars... External Debt Soars... External Debt Soars... Chart 19...While Forex Reserves Dwindle ...While Forex Reserves Dwindle ...While Forex Reserves Dwindle The regime's hard currency reserves are rapidly drying up - they have fallen from nearly $30 billion in 2013 to just $10 billion today (Chart 19). Without hard cash, Venezuela will be unable to meet import costs and external debt payments. In Table 1, we assess the country's ability to make these payments at different oil-price and output levels. Assuming the YTD average Venezuelan crude price of $44/bbl, export revenue should hit about $32 billion this year, while imports should hover around $21 billion, leaving $11 billion for debt servicing costs of roughly $10 billion (combining the state's $8 billion with PDVSA's $2 billion). Thus if global oil prices hold up - as we think they will - the regime may be able to squeak by another year. Image In short, the regime could have about $11 billion in revenues left at the end of the year if the Venezuela oil basket hovers around $44/bbl and production remains at about 2 MMB/d. That is a "minimum cash" scenario for the regime this year, though it by no means guarantees regime survival amid the widespread economic distress of the population. Chart 20Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue If production drops to 1.25 MMb/d or lower as a result of the economic crisis - or if Venezuelan oil prices settle at $28/bbl or below - the regime will be unable to meet its import costs and debt payments. It will have to sell off more of its international assets as rapidly as it can (Chart 20), restrict imports further, and eventually default. Moreover, the calculation becomes much more negative for Venezuela if we assume, conservatively, $10 billion in capital outflows, which is far from unreasonable. Outflows could easily wipe out any small remainder of foreign reserves. So far, the government has chosen to deprive the populace of imports rather than default on external debt, wagering that the military and other state security forces can suppress domestic opposition for longer than the regime can survive under an international financial embargo. This strategy is fueling mass protests, riots, and clashes with the National Guard and Bolivarian colectivos (militias). An extension of the OPEC-Russia production cuts in late May, which we expect, will bring much-needed relief for Venezuela's budget. Thus, there is a clear path for regime survival through 2017 on a purely fiscal basis, though it is a highly precarious one - the reality is that the state is bound to default sooner or later. Moreover, the socio-political crisis has already spiraled far enough that a modest boost to oil prices this year will probably be too little, too late to save Maduro and the PSUV in its current form. As we discuss below, the question is only whether the military takes greater control to perpetuate the current regime, or the opposition is gradually allowed to take power and renovate the constitutional order. Bottom Line: Even if oil production holds up, and oil prices average above $44/bbl as we expect, the country's leaders will have to take extreme measures to avoid default. Domestic shortages and military-enforced rationing will compound. As economic contraction persists, social unrest will intensify. Will The Military Throw A Coup? Explosive popular discontent this year shows no sign of abating. It is a continuation of the mass protests and sporadic violence since the economic crisis fully erupted in 2014. However, as recession deepens - and food, fuel, and medicine shortages become even more widespread - unrest will spread to a broader geographic and demographic base. Protests since September 2016 have drawn numbers in the upper hundreds of thousands, possibly over a million on two occasions. Security forces have increasingly cracked down on civilians, raising the death toll and provoking a nasty feedback loop with protesters. Reports suggest that the poorest people - the Chavista base - are increasingly joining the protests, which is a new trend and bodes ill for the ruling party's survival. Already the public has turned against the United Socialist Party, as evinced by the December 2015 legislative election results and a range of public opinion polls, which show Maduro's support in the low-20% range. In the 2015 vote, the opposition defeated the Chavistas for the first time since 1998. The Democratic Unity Roundtable won a majority of the popular vote and a supermajority of the seats in the National Assembly. Since then, however, Maduro has used party-controlled civilian institutions like the Supreme Court and National Electoral Council - backed by the military and state security - to prevent the opposition's exercise of its newfound legislative power. Key signposts to watch will be whether Maduro is pressured into restoring the electoral calendar. The opposition has so far been denied local elections (supposedly rescheduled for later this year) and a popular referendum on recalling Maduro. So it has little reason to expect that the government will hold the October 2018 elections on time. The government is likely to keep delaying these votes because it knows it will lose them. In the meantime, the opposition has few choices other than protests and street tactics to try to pressure the government into allowing elections after all. Further, oil prices are low, so the regime is vulnerable, which means that the opposition has every incentive to step up the pressure now. If it waits, higher prices could give Maduro a new infusion of revenues and the ability to prolong his time in power. The question at this point is: will the military defect from the government? The military is the historical arbiter of power in the country. Maduro - who unlike Chavez does not hail from a military background - has only managed to make it this far by granting his top brass more power. Crucially, in July 2016, Maduro handed army chief Vladimir Padrino Lopez control over the country's critical transportation and distribution networks, including for food supplies. He has also carved out large tracts of land for a vast new mining venture, supposed to focus on gold, which the military will oversee and profit from.7 What this means is that the government and military are becoming more, not less, integrated at the moment. The army has a vested interest in the current regime. It is also internally coherent, as recent political science research shows, in the sense that the upper-most and lower-most ranks are devoted to Chavismo.8 Economic sanctions and human rights allegations from the U.S. and international community reinforce this point, making it so that officials have no future outside of the regime and therefore fight harder for the regime to survive.9 Still, there are fractures within the military that could get worse over time. Divisions within the ranks: An analysis of the Arab Spring shows that militaries that defected from the government (Egypt, Tunisia), or split up and made war on each other (Syria, Libya, Yemen), exhibited certain key divisions within their ranks.10 Looking at these variables, Venezuela's military lacks critical ethno-sectarian divisions, but does suffer from important differences between the military branches, between the army and the other state security forces, and between the ideological and socio-economic factions that are entirely devoted to Chavismo versus the rest. Thus, for example, it is possible that Bolivarian militias committing atrocities against unarmed civilians could eventually force the military to change its position to preserve its reputation.11 Popular opinion: Massive protests have approached 1 million people by some counts (of a population of 31 million) and have combined a range of elements within the society - not only young men or violent rebels/anarchists. Also, public opinion surveys suggest that supporters of Maduro have a more favorable view of the army, and opponents have a less favorable view.12 This implies that Maduro's extreme lack of popular support is a liability that will weigh on the military over time. Military funds shrinking: Because of the economic crisis, Maduro has been forced to slash military spending by a roughly estimated 56% over the past year (Chart 21). The military may eventually decide it needs to fix the economy in order to fix its budget. Image Autonomous military leader: That General Lopez has considerable autonomy is another variable that increases the risk of military defection or fracture. As the country slides out of control Lopez will likely intervene more often. He already did so recently when the Chavista-aligned Supreme Court tried to usurp the National Assembly's legislative function. The attorney general, Luisa Ortega Diaz, broke with party norms by criticizing the court's ruling. Maduro was forced to order the court to reverse it, at least nominally restoring the National Assembly's authority. Lopez supposedly had encouraged Maduro to backtrack in this way, contrary to the advice of two notable Chavistas, Diosdado Cabello and Vice President Tareck El Aissami. Ultimately, military rule for extended periods is common in Venezuelan history. Chavez always deeply integrated the party and military leadership, so the regime could persist through greater military assertion within it, or the military could take over and initiate topical political changes. Finally, if Lopez is ready to stage a coup, he may still wait for oil prices to recover. It makes more sense to let the already discredited ruling party suffer the public consequences of the recession than to seize power when the country is in shambles. Previous coup attempts have occurred not only when oil prices were bottoming but also when they bounded back after bottoming (Chart 22). It would appear that the Venezuelan military is as good at forecasting oil prices as any Wall Street analyst! For oil markets, the military's strong grip over the country suggests that even if Maduro and the PSUV collapse, the party loyalists at PDVSA may not have the option of going on strike. The military will still need the petro dollars to stay in power, and it will have the guns to insist that production keeps up, as long as economic destitution does not force operations to a halt. Bottom Line: There is a high probability that the military will expand its overt control over the country. As long as the leaders avoid fundamental economic reforms, the result of any full-out military coup against Maduro may just mean more of the same, which would be politically and economically unsustainable. Chart 22Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Chart 23Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Investment Implications Any rebound in oil prices as a result of an extension of OPEC's and Russia's production cuts at the OPEC meeting on May 25 will be "too little, too late" in terms of saving Maduro and the PSUV. They may be able to play for time, but their legitimacy has been destroyed - they will only survive as long as the military sustains them. To a great extent, the ruling party has already handed the keys over to the military, and military rule can persist for some time. Hence oil production is more likely to continue its slow decline than experience a sudden shutdown, at least this year. This is because it is likely that military control will tighten, not diminish, when Maduro falls. Incidentally, the military is also more capable than the current weak civilian government of forcing through wrenching policy adjustments that are necessary to begin the process of normalizing economic policy - such as floating the currency and cutting public spending. But any such process would bring even more economic pain and unrest in the short term, and it has not begun yet. Even if the ruling party avoids defaulting on government debts this year - which is possible given our budget calculations - it is on the path to default before long. We remain short Venezuelan 10-year sovereign bonds versus emerging market peers. This trade is down 330 basis points since initiation in June 2015, but Venezuelan bonds have rolled over and the outlook is dim (Chart 23). Within the oil markets, our base case is that global oil producers have benefitted and will benefit from the marginally higher prices derived from Venezuela's slow production deterioration. Should a more sudden and severe production collapse occur, the upward price response would be much more acute. A sustained outage of Venezuelan production would send oil prices quickly towards $80-$100/bbl as a necessary price signal to curb demand growth, creating a meaningful recessionary force around the globe. Oil producers, specifically U.S. shale producers that can react quickly to these price signals, would stand to benefit temporarily from the higher prices, but would again suffer from falling oil prices in the inevitable post-crisis denouement. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 For the military takeover, please see "Venezuelan Debt: The Rally Is Late," in BCA Emerging Markets Strategy, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com; BCA Commodity and Energy Strategy Weekly Report, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com; and Energy Sector Strategy Weekly Report, "The Other Guys In The Oil Market," dated April 5, 2017, available at nrg.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Venezuelan Chavismo: Life After Death," dated April 2, 2013, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2013," dated January 16, 2013, and Monthly Report, "The Reflation Era," dated December 10, 2014, available at gps.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available at ems.bcaresearch.com. 7 For Lopez's taking control, please see "Venezuelan Debt: The Rally Is Late" in BCA Emerging Markets Strategy Weekly Report, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. For the gold mine, please see Edgardo Lander, "The Implosion of Venezuela's Rentier State," Transnational Institute, New Politics Papers 1, September 2016, available at www.tni.org. 8 The junior officers have advanced through special military schools set up by Chavez, while the senior officials have been carefully selected over the years for their loyalty and ideological purity. Please see Brian Fonseca, John Polga-Hecimovich, and Harold A. Trinkunas, "Venezuelan Military Culture," FIU-USSOUTHCOM Military Culture Series, May 2016, available at www.johnpolga.com. 9 Please see David Smilde, "Venezuela: Options for U.S. Policy," Testimony before the United States Senate Committee on Foreign Relations, March 2, 2017, available at www.foreign.senate.gov. 10 Please see Timothy Hazen, "Defect Or Defend? Explaining Military Responses During The Arab Uprisings," doctoral dissertation, Loyola University Chicago, December 2016, available at ecommons.luc.edu. 11 Civilian deaths caused by the National Guard and Chavez's loyalist militias triggered the aborted 2002 military coup. Please see Steven Barracca, "Military coups in the post-cold war era: Pakistan, Ecuador and Venezuela," Third World Quarterly 28: 1 (2007), pp. 137-54. 12 See footnote 8 above.

Dear Client, I am on the road this week meeting clients. Instead of our regular Weekly Report, we are sending you a piece written by my colleague Brian Piccioni, head of our Technology Sector Strategy Service. In this Special Report Brian discusses how the limitations of Bitcoin and other cryptocurrencies make them extremely speculative investments. Furthermore he discusses the possibilities of blockchain technology for the financial service industry going forward. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Summary Modern cryptocurrencies (virtual currencies based on cryptographic methods) originated with the introduction of blockchain technology and the simultaneous launch of Bitcoin. As we noted in our February 9, 2016 Special Report "Bitcoin and Blockchain Technology": Bitcoin has numerous deficiencies which expose its users to fraud; Governments are concerned with use of cryptocurrencies for money laundering, tax evasion, and other criminal activities; The market for Bitcoin is unregulated, liquidity is low, and there is good reason to be suspicious of market quotes for the currency; It is unlikely any virtual currency will become a form of legal tender absent government oversight; and Any investment in Bitcoin related activities should be viewed as highly speculative. In contrast, blockchain technology associated with Bitcoin: Can be applied by the financial services industry to reduce fraud and improve transaction times; Can reduce overhead associated with maintaining a trusted intermediary; Blockchain-related technologies are open and it is hard to imagine that any derivative technology would not be. Therefore, any unusual returns associated with knowledge of the mathematics or applications of blockchain are likely to be transient in nature. The technology itself, however, may lead to significant improvements in the velocity and security of certain types of transactions. Recent Developments Japan Legalizes Cryptocurrencies While we stand by our original analysis, it appears that Japan has allowed the use of virtual currencies effective April 1, 2017, albeit with significant oversight. Requirements include minimum capital levels and annual audits for exchanges. It is unclear to us why the Japanese government saw fit to introduce these changes, and it remains to be seen whether such oversight will be effective. Introduction Of Blockchain As Service Microsoft,1 IBM,2 and Deloitte3 have introduced blockchain services which should facilitate adoption by their traditional clients. We refer readers to the footnotes to explore the quickly changing nature of these firms' offering and we expect that other firms offering software and IT consulting for large enterprise clients will likely also introduce blockchain-related products. Although purists might observe that a centralized approach to blockchain removes the benefits of a distributed leger (see below), it also allows for the correction of many of blockchain's deficiencies (namely anonymity and irreversible transactions). This would make it more applicable in a regulated environment, assuming the implementation incorporates safeguards equivalent to a distributed ledger. Bitcoin Hype Appears To Be Subsiding While Enterprise Interest Is Growing Although we still see some coverage of the day-to-day moves in Bitcoin pricing, we get the sense that hype over cryptocurrencies is subsiding. Online discussions regarding speculating in cryptocurrencies appear to be less excited and neo-Libertarians appear to have moved on. Meanwhile, it seems that financial institutions are taking blockchain technology more seriously, and a large majority of financial services firms expect to deploy blockchain-related technologies over the next few years,4, 5 though some are more cautious on timing.6 Virtual Currencies And Bitcoin According to the ECB, a virtual currency: "... is defined as a digital representation of value, not issued by a central bank, credit institution or e-money institution, which in some circumstances can be used as an alternative to money"7 The IMF has produced Figure 1 which explains the differences between virtual, digital, and cryptocurrencies. Bitcoin was described in a 2008 paper "Bitcoin: A Peer-to-Peer Electronic Cash System".8 The paper outlines a technique (see Figure 2) which does away with the need for a trusted intermediary in executing secure transactions through the use of public key encryption and timestamps. Figure 1Overview Of Virtual Currencies Blockchain And Cryptocurrencies Blockchain And Cryptocurrencies Figure 2Simplified Diagram Of Bitcoin And Blockchain Function Blockchain And Cryptocurrencies Blockchain And Cryptocurrencies Blockchain technology, on which Bitcoin relies, provides: Anonymity of source and destination (neither buyer nor seller need to know each other); Irreversibility, such that no transaction can be reversed without the consent of the parties; and Security, subject to certain limitations, through redundancy and a peer to peer network. The mathematics of blockchain technology creates a verifiable distributed ledger among many computers on a peer to peer network. Because there is no central ledger, costs with maintaining it, arbitrating disputes and compensating for fraudulent transfers are all eliminated. A distributed ledger also means an asset can exist in only one place: there is no chance of embezzlement where an asset is purportedly on one set of books while actually being somewhere else. Bitcoin and blockchain technologies are not synonymous: there are an unlimited number of virtual currencies which can be produced using blockchain-like technologies and blockchain technology can be used to in non-currency applications. Limitations Of Cryptocurrencies Cryptocurrencies present a challenge for governments as anti-money laundering regulations typically require enforcement and monitoring by trusted third parties to report suspicious transactions to authorities. A secure anonymous transaction system such as Bitcoin provides a ready workaround for money laundering and tax evasion, characteristics quickly embraced by the underworld. A complete analysis of the challenges posed by virtual currencies in general and cryptocurrencies in particular can be found in the IMF Staff Discussion Note "Virtual Currencies and Beyond: Initial Considerations".9 Where Theft Isn't Quite Illegal There are three ways to obtain Bitcoin: Exchange "real" money for Bitcoin via an online virtual currency exchange; Exchange good or services for Bitcoin; or "Mine" them using a computer to solve the cryptographic problems. Typically there are more consumers than sellers (i.e. more drug users than drug dealers), so most users convert money to and from Bitcoin via exchanges. Mining still goes on but as the cryptographic hashes become more difficult to solve, and the computing resources and electricity now needed to "mine" Bitcoin require a significant investment.10 Transaction Costs Are Not Insignificant Although blockchain removes the need for a trusted intermediary, introduction of an exchange creates an intermediary. A staggering number of Bitcoin exchanges have been "hacked", most likely by the operators themselves. Lack of regulatory oversight and the anonymous nature of the transactions, including theft, mean that such hacks are rarely solved and victims do not get their Bitcoin back even when they are. It is not clear whether theft of a virtual currency is, in fact, illegal: the question of whether theft of virtual property is theft is a subject of debate,11, 12 suggesting there is no clear answer. Even courts treat the matter differently when there is no issue of criminality besides the alleged theft.13, 14 Besides the money lost to users from fraud, high exchange rates associated with converting Bitcoin to and from "real" currency further add to costs, suggesting that for many users untraceable transactions is more important than transaction costs. Cryptocurrency Can Be Irrevocably Destroyed Or Lost One other feature of Bitcoin which presents a challenge is that it requires a private key or password to transfer it. This means that one can imagine a scenario where an embezzler steals money from a business and immediately converts it into Bitcoin. If caught the embezzler might threaten to destroy the private key, and therefore the money is lost forever. Similarly, the heirs of someone who placed his trust in Bitcoin rather than a bank may discover their inheritance is lost forever unless care was taken to ensure the private key is accessible to the estate after death.15 These issues might arise with any asset secured by a blockchain system unless there are built in safeguards against it. Illiquidity And Unregulated Markets Virtual currency markets have two important characteristics: they are extremely illiquid and unregulated making market manipulation relatively straightforward. Bitcoin, currently has a market cap of about $30B16 but has average daily volume in the range of about 3.4% of the market cap. Note that since transaction costs (though not the exchange rates) associated with Bitcoin are small and optional,17 and since the market is unregulated and anonymous, there is nothing to prevent individuals from wash trading or other forms of market manipulation.18 Chinese Yuan trading volume has rapidly increased since 2013, and up until January 2017 accounted for the overwhelming majority of Bitcoin trading (Chart 1). Although other factors may have influenced the rise in Chinese bitcoin trading, zero-fee trade structures (which lead to wash trading) contributed as well. Chinese Bitcoin trading volume collapsed in January 2017, after exchanges began charging trading fees, likely due to regulatory pressure from the government.19 This had a dramatic impact on the volume of Bitcoins traded globally (Chart 2), although the price has stayed high, indicating that marginal demand from Bitcoin bulls remains high enough to keep them in charge of this market for now. As has happened before in 2013, prices will likely drop once these bulls capitulate. Chart 1Bitcoin Trading Volume* Breakdown##br## (Top 3 Currencies) Blockchain And Cryptocurrencies Blockchain And Cryptocurrencies Chart 2Bitcoin Trading Volumes Collapsed ##br##After Chinese Exchanges Introduced Transaction Fees Bitcoin Trading Volumes Collapsed After Chinese Exchanges Introduced Transaction Fees Bitcoin Trading Volumes Collapsed After Chinese Exchanges Introduced Transaction Fees Unregulated financial systems devolve to fraud, and there is no reason to believe a market dominated by unsophisticated, anonymous, participants trading an intangible asset with uncertain liquidity where fraud or theft is not necessarily illegal is, in any way, an efficient market. Sadly, even mainstream media appear to ignore these realities when covering Bitcoin and related price moves. Distributed Legers And Their Application One of the most significant innovations associated with cryptocurrencies is the concept of a secure, distributed ledger (Figure 3, left panel) in lieu of a centralized ledger maintained by a trusted authority such as a bank or brokerage (Figure 3, right panel). Although the application of distributed ledgers has been with cryptocurrencies, there are many potential applications in traditional financial markets since assets such as stocks and bonds are held by a dealer while ownership can change frequently. Adoption of a distributed ledger system can20 and has been used to "facilitate the issuance, cataloging and recording of transfers of shares of privately-held companies on The NASDAQ Private Market". According to NASDAQ, "Blockchain technology has the potential to assist in expediting trade clearing and settlement from the current equity market standards of three days to as little as ten minutes".21 Aspects of Bitcoin which permit its criminal use are not inherent characteristics of blockchain, or distributed ledger technologies in general. The technology will almost certainly be improved in order to eliminate those problems by incorporating an audit trail (to reduce its use for tax evasion or money laundering), reversibility (to allow for the reversal of trading errors), and so on. Figure 3 Blockchain And Cryptocurrencies Blockchain And Cryptocurrencies Investment Summary And Implications For Currency Markets The long term investment impact of Bitcoin will likely be insignificant as exchanges and mining operations disappear into the dark net (i.e. the part of the Internet used by criminals). Investors should consider a position in Bitcoin, whether the currency or related services such as exchanges or mining, to be highly speculative. Blockchain Technology Is Open To Anyone The profusion of cryptocurrencies shows that blockchain technology can be adapted by anyone with the requisite understanding the mathematics involved. Time and again we find investor interest in certain emerging technologies rapidly dissipates once expertise becomes commonplace, regardless of the broader impact on society. We suspect a similar thing will happen with blockchain technology namely that it will become broadly used in a number of applications, however, besides the few companies which are acquired, few will become significant or profitable and most such acquisitions will be written down not long after they are consummated. Blockchain Technology Will Be Broadly Adopted Blockchain technology has broad implications for the financial services industry as a mechanism to reduce costs and transaction times. These are all unequivocal positives for the industry and society in general, but can be construed as deflationary and not conducive to sustainable profit gains. What Does This All Mean For Currency Investors? The progress in blockchain-related technology is a promising development for the future ease of transaction processing. However, due to the limitation embedded in Bitcoin and other cryptocurrencies, fiat currencies are not yet at risk. For the time being, BTC and co. are still very speculative and volatile instruments that do not qualify as stores of value. In fact, the concerns of global governments with the use of cryptocurrencies for illicit purposes, as well as all the security risks still associated with their ownership, continue to be handicaps. This suggests that when it comes to the need for safety, these cryptocurrencies are not yet alternatives to the dollar, Swiss franc, and government bonds issued by the German and U.S. governments. Instead, gold and precious metals should remain the vehicle of choice for investors concerned with safety and the debasing of fiat currencies that may result from the large debt loads of the advanced economies' governments. As a result, we continue to think of these crypto currencies as high beta plays on the dollar and Chinese capital flows. Since BCA's view is that the dollar bull market is about to resume in full force, this implies that investors should fade the recent BTC rally. Moreover, the capital controls put in place by the Chinese authorities are working, and China is raising the cost of transacting in BTC. With BTC now expensive, and expected returns fading, this combination is likely to prove poisonous for Bitcoin. Another big selloff is thus likely. Final Thoughts A significant barrier to entry in technology markets is Intellectual Property (IP). Blockchain is an open technology, though is likely that extensions to blockchain could be made which the inventors hope will remain proprietary. However, there are several barriers to this happening: Any blockchain system is based on mathematics, and it is not clear when mathematics can be patented22, 23 Distributed ledgers work best when there are many users; and Any blockchain system would have to be open and understood to be trusted. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Paul Kantorovich, Research Analyst paulk@bcaresearch.com 1 https://azure.microsoft.com/en-ca/solutions/blockchain/ 2 https://www.ibm.com/blockchain/ 3 http://rubixbydeloitte.com/ 4 http://www.bain.com/publications/articles/blockchain-in-financial-markets-how-to-gain-an-edge.aspx 5 https://www.ethnews.com/deutsche-bundesbank-optimistic-about-blockchain-for-financial-markets 6 https://www.fnlondon.com/articles/blockchain-for-finance-is-10-years-away-20170410 7 https://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemesen.pdf 8 https://bitcoin.org/bitcoin.pdf 9 http://www.imf.org/external/pubs/ft/sdn/2016/sdn1603.pdf 10 http://motherboard.vice.com/read/bitcoin-is-unsustainable 11 www.nzlii.org/nz/journals/CanterLawRw/2011/21.pdf 12 https://virtualcrimlaw.wordpress.com/2013/11/03/alls-fair-in-love-and-wow-virtual-theft-may-elude-real-life-prosecution/ 13 http://www.dailymail.co.uk/news/article-2328922/Teenager-dragged-court-giving-away-friends-VIRTUAL-gold-coins-online-fantasy-game.html 14 http://www.virtualpolicy.net/runescape-theft-dutch-supreme-court-decision.html 15 http://www.dailydot.com/business/what-happens-bitcoin-when-you-die/ 16 http://coinmarketcap.com/ 17 https://en.bitcoin.it/wiki/Transaction_fees 18 http://cointelegraph.com/news/115382/bitcoin-price-analysis-wash-trading-and-rising-volume 19 http://www.coindesk.com/chinas-big-three-bitcoin-exchanges-end-no-fee-policy/ 20 http://ir.nasdaq.com/releasedetail.cfm?releaseid=938667 21 http://ir.nasdaq.com/releasedetail.cfm?ReleaseID=948326 22 http://techcrunch.com/2013/03/28/judge-says-mathematical-algorithms-cant-be-patented-dismisses-uniloc-claim-against-rackspace/ 23 http://www.supremecourt.gov/opinions/13pdf/13-298_7lh8.pdf Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. unemployment rate stands 0.1 points below the FOMC's year-end projection and 0.4 points below its estimate of NAIRU. If the unemployment rate keeps falling, it will have nowhere to go but up - and the U.S. has never been able to avoid a recession whenever the unemployment rate has risen by more than one-third of a percentage point. So far the FOMC has failed in its efforts to tighten monetary policy. U.S. financial conditions have actually eased sharply since the Fed resumed hiking rates in December. The Fed will turn more hawkish over the coming months. Stay short the January 2018 fed funds futures contract and position for a stronger dollar. What happens in the euro area has become increasingly irrelevant for what happens to EUR/USD. Even if the ECB raises rates somewhat more rapidly than expected, this will be largely counterbalanced by hawkish actions by the Fed. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Feature Beware Of Full Employment Chart 1Recoveries Usually Lose Steam##br## WhenThe Unemployment Rate Falls Below NAIRU Recoveries Usually Lose Steam WhenThe Unemployment Rate Falls Below NAIRU Recoveries Usually Lose Steam WhenThe Unemployment Rate Falls Below NAIRU After eclipsing 10% in 2009, the U.S. unemployment rate fell to 4.4% in April, 0.1 points below the median end-2017 dot in the Fed's Summary of Economic Projections, and 0.4 points below the FOMC's estimate of NAIRU.1 The fact that most Americans who want to work are able to find jobs is obviously a good thing. However, today's increasingly tight labor market does have a dark side: As Chart 1 illustrates, recoveries have tended to run out of steam whenever the unemployment rate has fallen below its full employment level. Two points about the unemployment rate are worth keeping in mind: The unemployment rate has rarely been stable over time; usually, it is either rising or falling. The former tends to occur very quickly, while the latter is more drawn out. The unemployment rate displays momentum over short horizons, but is "mean-reverting" over the long haul (Chart 2).2 Since there is a limit to how low the unemployment rate can go, periods when it is below its full employment level typically do not last long. This is confirmed by Chart 3, which shows that there is a clear positive correlation between the degree of labor market slack and the onset of the next recession: High slack means that a recession is usually far away, whereas low slack means that a downturn is approaching. And it doesn't take much of an increase in the unemployment rate to sow the seeds for another recession - the U.S. has never escaped a recession in the postwar period whenever the three-month moving average of the unemployment rate has risen by a mere one-third of a percentage point (Chart 4). Chart 2The Unemployment Rate Is Mean-Reverting Over The Long Haul, But Displays Momentum In The Short Term The Fed's Dilemma The Fed's Dilemma Chart 3The Degree Of Labor Market Slack And The Onset Of The Next Recession: A Clear Positive Correlation The Fed's Dilemma The Fed's Dilemma Chart 4What Goes Down Must Come Up? What Goes Down Must Come Up? What Goes Down Must Come Up? Rising unemployment tends to generate all sorts of vicious cycles. When someone loses their job, they spend less. The resulting decline in aggregate demand forces firms to lay off workers, leading to even less spending throughout the economy. A weaker economy also makes it more difficult for borrowers to pay back loans, causing them to pare back spending. Falling asset prices only serve to exacerbate this problem. Threading The Needle Today's low unemployment rate puts the Federal Reserve in a bind. On the one hand, if the Fed raises rates too quickly, this could precipitate exactly the sort of downturn that it is trying to avoid. On the other hand, if the Fed fails to raise rates quickly enough, this could cause the economy to overheat. This, in turn, may force the Fed to raise rates aggressively - something that would destabilize both the economy and financial markets. The hope is that the Fed succeeds in threading the needle to ensure that the economy achieves a soft landing. There are some reasons to be optimistic about such an outcome, but also several reasons to be pessimistic. On the optimistic side, inflation expectations remain well anchored. This means that an overheated economy is unlikely to produce a powerful price-cost spiral such as the one that broke out in the 1970s. This limits the risk that the Fed will be forced to raise rates dramatically. The real economy is also not suffering from the sort of clear-cut imbalances that plagued the late innings of the last two business cycles - a massive capex overhang in the late 1990s, and an even larger housing overhang in the years leading up to the Global Financial Crisis. Private debt levels have also fallen as a share of GDP for most of the recovery, unlike in past cycles (Chart 5). On the pessimistic side, uncertainty about the level of the neutral rate - the interest rate consistent with full employment and stable inflation - will make it difficult for the Fed to calibrate monetary policy in a way that ensures a soft landing. It typically takes 12-to-18 months for changes in monetary conditions to fully make their way through the economy. Thus, if the Fed does end up either too far behind or too far ahead of the curve in normalizing monetary policy, it may not realize this until it's too late. Structurally slower potential GDP growth could also complicate matters. The Congressional Budget Office estimates that real potential GDP growth will average only 1.8% over the next 10 years, compared to 3.1% between 1980 and 2007 (Chart 6). Today's equity valuations are arguably pricing in faster GDP growth. Should growth settle below 2% - a rate that has often been associated with stall speed - risk assets could suffer, complicating the Fed's efforts in achieving a soft landing. Chart 5The Economy Is Not Showing ##br##Clear-Cut Signs Of Imbalances The Economy Is Not Showing Clear-Cut Signs Of Imbalances The Economy Is Not Showing Clear-Cut Signs Of Imbalances Chart 6Potential GDP Growth Is Not ##br##What It Used To Be Potential GDP Growth Is Not What It Used To Be Potential GDP Growth Is Not What It Used To Be The Fed's Choice Given the choice between erring on the side of raising rates too slowly or too quickly, the Fed has opted for the former. This is a quantitative statement, not a qualitative one. Chart 7 shows that U.S. financial conditions have eased considerably since the Fed resumed raising rates last December, thanks to a weaker dollar, tighter credit spreads, and a soaring stock market. If the whole point of hiking rates is to tighten financial conditions, then the Fed has not done enough. Worries that the headline unemployment rate may understate the true amount of labor market slack partly explain the Fed's angst in raising rates as quickly as it has in past cycles. While the headline rate has fallen back to its 2007 low, the broader U-6 unemployment rate - which incorporates people who are out of the labor market but claim to want a job, as well as those who are working part-time for economic reasons - is still 0.7 points above it. Likewise, the employment-to-population ratio for prime-age workers (ages 25-to-54) is 1.7 points below its pre-recession levels. The "quits rate" - a good measure of labor market confidence - also remains a notch below its pre-recession peak. Perhaps most glaringly, the median duration of unemployment has only fallen back to 10.2 weeks, which is still close to the high of the previous cycle (Chart 8). Chart 7Financial Conditions Have Been Easing Financial Conditions Have Been Easing Financial Conditions Have Been Easing Chart 8Headline Unemployment Rate ##br##Back To 2007 Levels, But Other ##br##Measures Still Point To Slack Headline Unemployment Rate Back To 2007 Levels, But Other Measures Still Point To Slack Headline Unemployment Rate Back To 2007 Levels, But Other Measures Still Point To Slack Each of these factoids has a counterargument: The elevated share of involuntary part-time workers may be partly due to the effects of Obamacare, which has made it burdensome for companies to add full-time workers to the payrolls;3 the low quits rate and the high median length of unemployment may reflect the aging of the population as well as lower gross job creation (Chart 9); and automation, globalization, and low-skilled immigration may have depressed real wages for less-educated workers, causing them to abandon the labor market (Chart 10). Nevertheless, with core inflation still below the Fed's 2% target, it is not hard to see why the Fed has elected to take a "go slow" approach so far. Chart 9The Labor Market Has Become Less Dynamic The Labor Market Has Become Less Dynamic The Labor Market Has Become Less Dynamic Chart 10Less-Educated Men Are Fleeing The Labor Market The Fed's Dilemma The Fed's Dilemma The Hawks Spread Their Wings That may be changing, however. The growth in nominal unit labor costs has already surpassed 2% and is close to the peaks reached in 2000 and 2007 (Chart 11). Most other measures of wage growth remain in a clear uptrend (Chart 12). If GDP growth accelerates over the remainder of the year, as we expect, the Fed will pursue a more aggressive tightening path than what the market is currently discounting. Chart 11Unit Labor Cost Inflation Close To Past Peaks Unit Labor Cost Inflation Close To Past Peaks Unit Labor Cost Inflation Close To Past Peaks Chart 12Most Measures Of Wage Growth Are In An Uptrend Most Measures Of Wage Growth Are In An Uptrend Most Measures Of Wage Growth Are In An Uptrend Recent communications from the Fed have revealed an increasingly hawkish bias. The latest Fed statement downplayed the slowdown in Q1 as "transitory." This follows Chair Yellen's comment that "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."4 Investment Conclusions Higher U.S. rate expectations should give the dollar a boost (Chart 13). We do not agree with the often-heard argument that the actions of foreign central banks will materially weaken the dollar. Consider the case of the ECB. There has been much speculation that the ECB will phase out some of its emergency measures. That may well happen, but even if it does, a full-fledged hiking cycle is nowhere on the horizon. According to a recent ECB study, the rate of labor underutilization still stands at 18% in the euro area, 3.5 points higher than in 2008 (Chart 14).5 Stripping out Germany, the rate of underutilization would be seven points higher (Chart 15). It is still too early for Mario Draghi to begin removing monetary accommodation in a concerted manner. Chart 13Higher U.S. Rate Expectations ##br##Should Give The Dollar A Boost Higher U.S. Rate Expectations Should Give The Dollar A Boost Higher U.S. Rate Expectations Should Give The Dollar A Boost Chart 14Labor Market Slack In The Euro Area Remains High... The Fed's Dilemma The Fed's Dilemma Chart 15...Especially Outside Of Germany The Fed's Dilemma The Fed's Dilemma Moreover, anything the ECB does which inadvertently leads to a stronger euro will likely be matched by offsetting hawkish actions by the Fed. Remember that the Fed needs to tighten financial conditions in order to prevent the unemployment rate from falling so much that it has nowhere to go but back up. A weaker dollar runs contrary to that strategy. The argument above can be applied more broadly. The euro rallied in the lead-up to the French election on the now-realized hope that Emmanuel Macron would prevail. Put aside the fact that Macron's platform calls for cutting the budget deficit from 3.2% of GDP this year to 1% of GDP in 2022 - something which, all things equal, would lead to less monetary tightening and a correspondingly weaker euro. Even if Macron's victory somehow did manage to allow the ECB to raise rates earlier than it would have otherwise, it is hard to believe that this would not influence the pace of Fed rate hikes. U.S. financial conditions could tighten through some combination of higher rates and/or a stronger dollar. The only way the Fed could engineer a tightening in financial conditions while the trade-weighted dollar still weakened would be to jack up interest rates by an inordinate amount. However, this outcome would require that other central banks raise rates even more. That's not going to happen. Stay short EUR/USD. We think the euro will reach parity against the dollar later this year. Where does this leave equities? So long as global growth remains solid and corporate earnings are in an uptrend, the path of least resistance for stocks is up. However, the risk is that the Fed overplays its hand and ultimately tightens monetary policy too much. This could lead to a broad-based global slowdown towards the end of 2018. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the unemployment rate consistent with stable inflation. 2 An Ordinary Least Squares (OLS) regression using monthly data between 1960 and 2017 shows that the change in the unemployment rate over the coming three months is positively associated with a change in the unemployment rate over the prior three months, and negatively associated with the level of the unemployment gap. 3 See, for example: Marcus Dillender, Carolyn Heinrich, and Susan Houseman, "Effects of the Affordable Care Act on Part-Time Employment: Early Evidence," Upjohn Institute Working Paper, 2016. 4 Janet Yellen, "Semiannual Monetary Policy Report To The Congress," February 14, 2017. 5 Please see ECB, "Focus: Assessing Labour Market Slack," Economic Bulletin Issue 3, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The risk to EM currencies is to the downside over the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. The cross-currency basis spread can be used to calculate exchange rate-hedged yield on local currency bonds for U.S. dollar and euro-based investors. On a currency-hedged basis, Korean, Russian and Mexican local bonds offer the highest yield, while Turkish, South African and Chinese fixed-income securities stand at the opposite end of the spectrum. Feature The Big Picture: A Stampede Into EM Bonds There has been a stampede into EM risk assets since early this year. Fixed-income investors' search for yield is understandable, given DM bond yields are very low. However, we believe investors are underappreciating currency and other risks embedded in EM that are likely to manifest in the next 6-12 months. In other words, the fact that DM bond yields are low in of itself does not justify chasing EM bonds and currencies. Investment in EM should primarily be based on the merits of EM fundamentals. With respect to EM local bonds, total returns for international investors are greatly influenced by exchange rate moves. Not only does currency depreciation undermine returns for foreign investors, but in many high-yielding fixed income markets, bond yields also rise when their respective country's currency depreciates, and vice versa (Chart I-1). Furthermore, Chart I-2 demonstrates that high or rising interest rates historically have not precluded bear markets in EM currencies. On the contrary, historically, it was exchange rate that determined the direction and level of local interest rates: a strong currency led to lower interest rates and a weak currency warranted rising interest rates. This was especially true with the recent darlings of investors, the Brazilian real and South African rand. Chart I-1EM Local Bond Yields And ##br##Currencies: Negative Correlation EM Local Bond Yields And Currencies: Negative Correlation EM Local Bond Yields And Currencies: Negative Correlation Chart I-2In EM, Currencies Drive ##br##Interest Rates Not Vice Versa In EM, Currencies Drive Interest Rates Not Vice Versa In EM, Currencies Drive Interest Rates Not Vice Versa In our weekly reports, we have argued at length why EM currencies are set to depreciate considerably, and we will not repeat the rationale in this report. Instead, our focus this week is on hedging mechanisms and the concept of cross-currency basis swap. Specifically, we calculate what yields would be on offer to U.S. dollar- and euro-based investors in EM local currency bonds after hedging the EM exchange rate risk. This can be done via cross-currency basis swaps. We also demonstrate the mechanism behind the hedge, and present the relative attractiveness of local yields across the EM universe after hedging. EM local currency bonds are only comparable to each other as well as to U.S. Treasurys and German bunds after hedging exchange rate risk. We conclude that Korea, Russia and Mexico local bond markets offer the highest hedged yields, while Turkey, South Africa and China provide the lowest hedged yield. Bottom Line: The risk to EM currencies is to the downside in the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. Cross-Currency Basis Swap The cross-currency basis spread is the price of a cross-currency basis swap. This spread is directly quoted in the marketplace. The swap allows two parties involved to temporarily access each other's currencies without having to take on foreign currency exposure. Chart I-3 demonstrates an equal-weighted average basis spread for nine EM currencies (Mexico, Russia, Korea, Malaysia, Turkey, South Africa, China, Hungary, Poland) and the aggregate EM exchange rate versus the greenback. Chart I-4 does the same but against the euro - i.e., EM cross-currency basis spread versus the euro, and the EM aggregate exchange rate against the euro. Chart I-3EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar Chart I-4EM Versus Euro And Cross-Currency Basis Swap With Euro EM Versus Euro And Cross-Currency Basis Swap With Euro EM Versus Euro And Cross-Currency Basis Swap With Euro A few considerations are in order: A negative basis spread means that U.S. dollar investors are paid to hedge their EM currency exposure - i.e., they can enhance their U.S. dollar yield by forgoing their EM local yield and hedging their EM exchange rate risk. The aggregate EM basis spread was very wide in 2011 before the EM bear market began. This meant that not many investors hedged their EM currency exposure before the second half of 2011. From 2011 through to mid-2016, various EM cross-currency basis spreads narrowed. The narrowing occurred at an uneven pace, at times in sync with EM rallies and at other times with EM selloffs. This suggests that fixed-income investors were periodically hedging their EM currency exposure via basis swaps until the middle of 2016. Since the middle 2016 - the point when confidence in EM fixed-income rally was cemented - the basis swap spread has widened. This entails that EM fixed-income investors have been reluctant to hedge their currency risk via basis swaps. This corroborates the lingering complacency among the investment community with respect to EM risk. Chart I-5EM Domestic Bond Yields ##br##Over U.S. Treasurys Are Low EM Domestic Bond Yields Over U.S. Treasurys Are Low EM Domestic Bond Yields Over U.S. Treasurys Are Low There is no strong and stable correlation between the EM basis swap spread and EM exchange rate moves (appreciation/depreciation). However, the persisting negative sign of the basis spread implies stronger secular demand for hedged U.S. dollar funding from EM companies and banks than demand for hedged EM currency exposure among foreign investors and companies. Remarkably, the spread of EM local bond yields over 5-year U.S. Treasurys is at the bottom of the trading range that has prevailed over the past seven years (Chart I-5). Provided that EM exchange rate risk is currently considerable, the current level of EM local yields does not warrant blind yield chasing. Hedging Mechanism While obtaining funds in the spot foreign exchange market and hedging via forwards is possible, liquidity in forwards becomes very poor beyond 12 months. Cross-currency basis swaps allow hedging up to multiple years, effectively locking in yields until the maturity of the bond. The following illustrates the transactions involved in the hedging process. A fixed-income portfolio manager (PM) starts with $1 U.S. dollar. This investor enters into a cross-currency basis swap with Counterparty A who, let's say, owns Malaysian ringgits. The PM gives $1 and receives 4.3 MYR, where 4.3 is the spot exchange rate. The PM also agrees to swap back 4.3 MYR for $1 at maturity. The PM then takes the 4.3 MYR and purchases a Malaysian 5-year local currency government bond yielding 3.7% (Chart I-6). During the lifetime of the swap, the PM receives U.S. LIBOR from Counterparty A. In return, she/he must pay Counterparty A KLIBOR (the Kuala-Lumpur interbank offered rate, presently 3.9%) plus the basis spread, which is currently -50 basis points. The PM collects 3.7% yield from the ownership of Malaysian government bonds (Chart I-7). Thus, a negative basis spread of 50 basis points implies that the PM would be paying less than KLIBOR, which is the ordinary rate for borrowing ringgits. At the maturity of the swap contract, the PM redeems the bond and pays 4.3 MYR back to Counterparty A. In exchange, Counterparty A returns $1 U.S. dollar (Chart I-8). Chart I-6Hedging Mechanism: Step 1 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields Chart I-7Hedging Mechanism: Step 2 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields Chart I-8Hedging Mechanism: Step 3 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields The transaction allowed the international fixed-income investor to gain exposure to local currency Malaysian government bonds with almost no currency risk, as the PM received all of the payments in U.S. dollars. On a net basis, the investor receives the following yield: U.S. LIBOR + local yield - (KLIBOR + BASIS), or 2.3% = 2.0% + 3.7% - (3.9%-0.5%). Importantly, this yield is in U.S. dollars, meaning the PM has secured the principal investment and the yield on it in U.S. dollars while gaining exposure to Malaysian local currency sovereign bonds. The latter entails that the portfolio will gain/lose from changes in prices of Malaysian government bonds. Besides, the investor still has some currency exposure on the quarterly flows of interest payments. However, this is miniscule in comparison to the notional. Currency-Hedged Local Bond Yields Using the method described above to calculate hedged returns for individual countries, we ranked the resulting yields for EM countries with available data. Unfortunately, some markets like Brazil do not have a cross-currency basis swap market. Chart I-9 ranks currency-hedged yield for U.S. dollar investors for investments in 5-year local currency fixed-income bonds. Chart I-9EM Local Bonds: Currency-Hedged Yields For U.S. Dollar Investors EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields We also did the same calculation for the euro using German bunds as a proxy. For pairs that do not have direct cross-currency basis swaps with the euro or U.S. dollar, we use the euro/U.S. dollar cross-currency basis to do the conversion. Chart I-10 classifies EM countries according to their hedged euro yield for euro-based international fixed-income investors. Chart I-10EM Local Bonds: Currency-Hedged Yields For Euro-Based Investors EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields For 5-year local bonds, the highest hedged yields are offered by Korea, Russia and Mexico. In contrast, the lowest hedged yields for 5-year domestic local bonds are offered by Turkey, South Africa and China. These hedged yields are calculated on our best estimate of transactions happening at the mid-point of the bid-ask spread. The EM cross-currency swap market is often illiquid. Coupled with the fact that the hedging process requires multiple transactions, the hedged return can be quite lower. To conclude, the highest-yielding local bond markets do not always offer the highest yield when taking currency hedging into account. A caveat is in order: Applying hedging via basis swaps eliminates exchange rate risk, but it does not eliminate risk from fluctuations in bond prices (capital gains/losses). Therefore, in the event that EM local bond yields rise as their currencies depreciate, hedging via basis swaps will not protect against capital losses. Therefore, basis swap hedging should be used by long-term fixed-income investors who have deployed a lot of capital in EM local bond markets and share our concerns on EM exchange rates. These investors typically have a higher tolerance for asset price swings compared with traders who have little tolerance for short-term losses. The latter should sell out of EM domestic bonds altogether. Investment Implications This exercise reinforces our existing overweights in Korean, Russian and Mexican bonds within the EM local currency bond universe. Similarly, it also corroborates our underweights in Turkish and South African domestic bond markets. Although we expect most EM currencies will depreciate versus both the U.S. dollar and the euro in the next 12 months, the Korean won (as well as other low-yielding Asian currencies such as the TWD and the SGD), the Russian ruble and the Mexican peso are less vulnerable, and will outperform other EM currencies. By contrast, the TRY and the ZAR are among the most vulnerable, even after adjusting for their high carry. A plunge in these currencies will also force their local bond yields higher. Hence, capital losses on local bonds even after hedging exchange rate risk could be substantial in these countries. Furthermore, we also continue to recommend overweight positions in local currency bonds in Poland, Hungary, India and Chile within the EM universe. Henry Wu, Research Analyst henryw@bcaresearch.com

Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist Global Recovery Will Persist Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Labor Market Still Strong Labor Market Still Strong Chart 3Look For Above 2% Growth Look For Above 2% Growth Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Surprise Indexes Will Converge Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification

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 Ongoing monetary tightening in China poses a substantial threat to EM risk assets. Yet financial markets remain highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Business conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The pillars of the EM business cycle are China, commodities, and their own domestic credit cycle, rather than the U.S. and Europe. Continue shorting/underweighting the Malaysian currency, stocks and sovereign credit. Feature Chart I-1China: Ongoing Liquidity Tightening China: Ongoing Liquidity Tightening China: Ongoing Liquidity Tightening There is one major underappreciated risk in global financial markets: China's gradual yet unrelenting monetary tightening. Though slow and measured, this policy tightening constitutes a significant risk, particularly for emerging markets. The basis is that it could trigger a disproportionally large negative effect on Chinese growth because it is taking place amid a lingering credit bubble in China.1 Mainland interbank rates and onshore corporate bond yields have risen as the People's Bank of China (PBoC) has reduced its net liquidity injections via open market operations (Chart I-1, top panel). The PBoC's monetary tightening is bound to reduce money/credit growth in China. The bottom panel of Chart I-1 demonstrates that changes in the central bank's claims on commercial banks lead by 3 months asset growth at commercial banks. Diminished liquidity injections by the PBoC will soon push commercial banks to reduce the pace of their balance sheet expansion. Asset growth/loan origination among policy banks2 has already slowed (Chart I-2). On top of this, China's regulatory tightening aimed at curbing speculative (high-risk) financial activity will also curtail commercial banks' loan origination. For example, bank regulators are forcing banks to bring off-balance-sheet assets onto their balance sheets. As a result, money/credit growth is set to decelerate meaningfully. This, in turn, will cause another slump in this credit-addicted economy. It is very probable that the mini-business cycle in China has already reached its peak - our credit and fiscal impulse heralds further drop in the manufacturing PMI (Chart I-3). Chart I-2Commercial Banks And Policy ##br##Banks' Loan Growth To Slow Further Commercial Banks And Policy Banks' Loan Growth To Slow Further Commercial Banks And Policy Banks' Loan Growth To Slow Further Chart I-3China's Growth Has Rolled Over China's Growth Has Rolled Over China's Growth Has Rolled Over While China's monetary tightening is not a direct risk to domestic demand in the U.S. or Europe, it poses an imminent risk to commodities prices and EM risk assets. Consistent with slowing Chinese manufacturing output growth, commodities prices trading in mainland China have lately tanked. Bottom Line: BCA's Emerging Markets Strategy team maintains that ongoing monetary tightening in China poses substantial risks to EM risk assets and commodities. Yet financial markets remain complacent. Perplexing Complacency It is very perplexing that EM risk assets have so far ignored the risks stemming from China's tightening and renewed relapse in commodities prices. It seems portfolio allocation into risk assets, including those in the EM universe, is pushing prices higher irrespective of a major relapse in forward-looking indicators for both China and EM growth. EM stocks, currencies and credit spreads have decoupled from a number of indicators with which they historically had a high correlation: In recent weeks, we have brought to investors' attention that an unsustainable gap has been opening between the commodities currencies index - an equal-weighted average of AUD, NZD and CAD - and both EM exchange rates and EM share prices in local currency terms (Chart I-4A & Chart I-4B). Chart I-4AHeed The Message From Commodities Currencies Heed The Message From Commodities Currencies Heed The Message From Commodities Currencies Chart I-4BHeed The Message From ##br##Commodities Currencies Heed The Message From Commodities Currencies Heed The Message From Commodities Currencies Not only have commodities currencies decisively rolled over, but also commodities prices have begun sliding. Historically, EM risk assets in general and the sovereign credit market in particular have always sold off when commodities prices have drifted lower (Chart I-5). EM equity volatility is back to its lows (Chart I-6). This corroborates reigning complacency in the marketplace. Chart I-5Commodities Prices And ##br##EM Sovereign Spreads Commodities Prices And EM Sovereign Spreads Commodities Prices And EM Sovereign Spreads Chart I-6A Sign Of Complacency A Sign Of Complacency A Sign Of Complacency EM sovereign and corporate spreads have also fallen to their narrowest levels in recent years (Chart I-7). Notably, our valuation model for EM corporate bonds - which is constructed based on our EM Corporate Financial Health Index - posits that EM corporate credit is very expensive (Chart I-8). Chart I-7EM Sovereign And Corporate Spreads EM Sovereign And Corporate Spreads EM Sovereign And Corporate Spreads Chart I-8EM Corporate Credit Is Expensive bca.ems_wr_2017_05_03_s1_c8 bca.ems_wr_2017_05_03_s1_c8 Finally, EM local currency bond yield spreads over U.S. Treasurys have also dropped a lot, signifying complacency on the part of EM investors (Chart I-9). Chart I-9EM Local Bond Yield Spreads ##br##Over U.S. Treasurys Are Low EM Local Bond Yield Spreads Over U.S. Treasurys Are Low EM Local Bond Yield Spreads Over U.S. Treasurys Are Low Bottom Line: EM financial markets are not cheap, and investors are highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Can EM Decouple From China? An oft-asked and relevant question is whether EM ex-China can decouple from China itself. Not for the time being, in our view. On the contrary, as we argued in last week's report titled Toward A Desynchronized World,3 China's slowdown will weigh on the majority of the EM investable equity, currency and credit markets. As a result, growth conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The three pillars of EM ex-China growth are commodities, China and their domestic credit cycles. The primary link is via commodities. As China's growth decelerates and its imports relapse, commodities prices will plunge (Chart I-10). Latin America, Africa, the Middle East, Russia, Malaysia and Indonesia are set to experience negative terms-of-trade shocks as commodities prices deflate. As a result, their currencies will depreciate and growth will suffer. Although Mexico is leveraged to the U.S., oil prices still matter for it. This leaves non-commodities producing economies in Asia and central Europe. The latter is too small to matter for EM benchmarks. Central Europe correlates with Europe's business cycle rather than EM. In emerging Asia, Korea and Taiwan - the largest equity market cap weights after China in the MSCI EM index - sell much more to China than to the U.S. and Europe combined. Korea's shipments to China account for 25% of total exports while those to the U.S. and Europe combined make up 22%. For Taiwan the numbers are 27% and 20%, respectively. Thailand sells to China as much as it does to the U.S. This by and large leaves only three mainstream EM economies that are not substantially exposed to China: India, the Philippines and Turkey (Table I-1). Indian and Philippine stocks are expensive, and these nations confront their own unique problems. Turkey in turn is facing major political, economic and financial predicaments. Chart I-10Industrial Metals Prices To head Lower bca.ems_wr_2017_05_03_s1_c10 bca.ems_wr_2017_05_03_s1_c10 Table I-1Export To China And U.S. Perplexing Complacency: Underappreciated EM Risk Perplexing Complacency: Underappreciated EM Risk In short, among mainstream EM countries, there are very few plays not exposed to China or commodities and offer a reasonable risk/return profile. Investors also often ask if commodities importing economies in Asia can rally in absolute terms when and as commodities prices drop. Chart I-11 illustrates the Korean and Taiwanese equity indexes have historically (in the past 20 years) been strongly correlated with oil and industrial metals prices. The reason is that commodity price swings partially reflect global growth conditions. Being heavily dependent on exports, Korea and Taiwan are highly sensitive to fluctuations in global growth. We expect global trade to slow down anew, driven by weakness in China/EM imports, even if U.S. and European demand remains resilient. We elaborated on this theme in last week's report.4 Therefore, Korean and Taiwanese export shipments are set to slow as well. We are not bearish on Korean and Taiwanese domestic demand - we are in fact overweight these bourses within the EM equity universe, with a focus on technology and domestic sectors. That said, consumer and business spending in these economies is relatively small in a global context to make a difference for other EM markets. In addition, given these economies' mature phase of development, the pace of their income and domestic demand growth will be moderate. Many EM countries have experienced excessive credit growth in the past 15 years, but their banking systems have not restructured - i.e. banks have not sufficiently provisioned for non-performing loans. Until they do so, domestic loan growth remains at risk of weakening. There has been modest deleveraging in Brazil, Russia and India (Chart I-12). However, there is no evidence that these economies have embarked on a new credit cycle. Chart I-11Korean And Taiwanese Stocks ##br##Correlate With Commodities Korean And Taiwanese Stocks Correlate With Commodities Korean And Taiwanese Stocks Correlate With Commodities Chart I-12Some Moderate Deleveraging ##br##In Brazil, Russia And India Some Moderate Deleveraging In Brazil, Russia And India Some Moderate Deleveraging In Brazil, Russia And India Case in point are Indian state-owned banks: their experience shows that deleveraging can be more protracted and painful than one might initially expect. The reason is that it takes time for banks to acknowledge non-performing loans, be recapitalized and get ready to boost loan growth again. In addition, Brazil and Russia are still commodities plays at the mercy of commodities price dynamics. Besides, Brazil needs to undergo painful fiscal adjustment/reforms. In other developing countries, bank loan growth remains elevated and bank loan-to-GDP ratios continue to rise (Chart I-13). In these economies, credit retrenchment and even a mild deleveraging has not yet occurred. Prominently, as EM currencies come under downward pressure, interest rates in many economies running current account deficits will be pressured higher. This will lead to a slowdown in bank credit growth and will depress demand. Finally, if it were not for the pick-up in Chinese imports, the EM ex-China business cycle and commodities prices would not have ameliorated in the past 12 months. Notably, excluding China, Korea and Taiwan, developing nations' retail sales volumes and new vehicle sales remain dormant (Chart I-14). Similarly, there has not been much recovery in capital spending and, consistently, imports of capital goods in EM ex-China, Korea and Taiwan (Chart I-15). Chart I-13No Deleveraging In Many EMs No Deleveraging In Many EMs No Deleveraging In Many EMs Chart I-14EM Ex-China, Korea And Taiwan: ##br##Stabilization But No Revival EM Ex-China, Korea And Taiwan: Stabilization But No Revival EM Ex-China, Korea And Taiwan: Stabilization But No Revival Chart I-15EM Ex-China, Korea And Taiwan: ##br##Not Much Of Recovery EM Ex-China, Korea And Taiwan: Not Much Of Recovery EM Ex-China, Korea And Taiwan: Not Much Of Recovery As credit growth slows or fails to pick up in these economies, domestic demand recovery will be tepid, and will certainly disappoint market expectations. Bottom Line: Given budding divergence between U.S./Europe and Chinese growth, EM ex-China growth will fail to recover and will surprise to the downside. The basis is that the pillars of the EM's business cycle are China, commodities and their own domestic credit cycle, rather than the U.S. and Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November, 23 2016, and January 18, 2017, the links are available on page 16. 2 Policy banks are China Development Bank, Agricultural Development Bank and Export-Import Bank of China. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. 4 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. Malaysia: Not Out Of The Woods Arenewed relapse in Chinese growth later this year coupled with lower commodities prices will once again expose Malaysia's vulnerabilities. Notably, 26% of Malaysia's exports are related to commodities - mainly crude oil, natural gas, petroleum products and palm oil. Another downleg in the ringgit's value along with lower commodities prices will cause domestic interest rates to rise. However, Malaysia is in no position to tolerate higher interest rates. Leverage has risen considerably in the past ten years in Malaysia, and is very high (Chart II-1A). Indeed, the country has one of the highest debt-servicing costs in the EM universe, according to BIS data (Chart II-1B). Chart II-1A...And Debt Servicing Costs High Leverage... High Leverage... Chart II-1BHigh Leverage... High Leverage... High Leverage... If the Malaysian central bank attempts to cap interest rates by injecting local currency liquidity into the system, the ringgit will plunge even further. Chart II-2 shows that in recent years local interbank rates have tended to rise when the central bank curtailed its net liquidity injection. If on the other hand the Bank Negara of Malaysia (BNM) does not inject liquidity into the banking/financial system, interest rates will rise as the currency depreciates. Interestingly, despite strong inflows into EM generally, the BNM has continued to inject local liquidity into the economy - albeit at a slower pace than in recent years - to keep local rates tame (Chart II-2). Additionally, despite the significant growth slowdown that has occurred in the past two years in Malaysia, banks' NPLs have not risen much (Chart II-3). As banks start acknowledging loan losses and setting provisions for them, their profitability will decline, capital will be eroded, and loan origination will fall. Chart II-2BNM Has Been Injecting Liquidity ##br##To Control Interest Rates BNM Has Been Injecting Liquidity To Control Interest Rates BNM Has Been Injecting Liquidity To Control Interest Rates Chart II-3Malaysian Banks Haven't ##br##Acknowledged Enough Losses Yet Malaysian Banks Haven't Acknowledged Enough Losses Yet Malaysian Banks Haven't Acknowledged Enough Losses Yet Meanwhile, even though global trade and commodities prices have picked in the past 15 months, Malaysia's economy has failed to recover. This reflects the country's underlying economic vulnerability as the borrowing/credit spree of the past decade has come to a halt: Commercial and passenger vehicle sales are shrinking. Retail trade and employment are also still anemic. Property sales volumes and housing construction approvals are collapsing (Chart II-4). Capital expenditures are depressed (Chart II-4, bottom panel). On the external side, the semiconductor/electronics sector has boomed in Asia since early 2016, but Malaysia has failed to benefit much. Indeed, the recovery in Malaysia's electronics sector has been weak compared to other technology hubs such as Taiwan and Korea. This confirms why Malaysia has been losing market share in electronics products to Korea, Taiwan and the Philippines (Chart II-5). Chart II-4Cyclical Growth Remains Anemic Cyclical Growth Remains Anemic Cyclical Growth Remains Anemic Chart II-5Malaysia Is Losing Tech Market ##br##Share To Its Asian Competitors Malaysia Is Losing Tech Market Share To Its Asian Competitors Malaysia Is Losing Tech Market Share To Its Asian Competitors Bottom Line: Continue shorting MYR versus the U.S. dollar and the Russian ruble. Equity investors should continue to underweight Malaysian stocks within an EM equity portfolio. Relative value traders should maintain our long Russian / short Malaysia equity trade. Buy/hold Malaysian CDS or underweight this sovereign credit market within an EM credit portfolio. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Don't Worry About The Tepid Data Risk assets are likely to continue to grind higher. Two of the catalysts we cited for this in our most recent Quarterly1 have half happened: European political risk is lifting now that Marine Le Pen looks most unlikely to win in the second round of the French presidential election (polls give her less than 40% of the vote); and the Trump administration announced its tax cut plan (which, though details are still sparse, we expect to be passed in some form this year). As a result, the MSCI All Country World Index hit a record high in late April and the S&P 500 is only 1% below its high. But both growth and inflation have surprised somewhat to the downside in the past couple of months. The Citi Economic Surprise Index for the U.S. has fallen sharply, though surprises remain fairly positive elsewhere (Chart 1).Q1 U.S. real GDP growth came in at an annualized rate of only 0.7%. This has pushed bond yields down (with the US Treasury 10-year yield falling back to 2.2%), consequently weakening the dollar. We are not unduly worried about the tepid data. It is mainly due to technical factors. Corporate loan growth in the U.S., for example (Chart 2), mostly reflects just the lagged effect of last year's slowdown on banks' willingness to lend, as well as energy companies repaying credit lines they tapped in early 2016 when short of working capital. The weakness in auto sales (Chart 3) is most likely caused by the end of the car replacement cycle which began in 2010, rather than reflecting any generalized deterioration in consumer behavior. Moreover, there seem to be problems with seasonal adjustment of data caused by the extreme swings in the economy in 2008 and 2009: Q1 has been the weakest quarter for U.S. GDP in six out of the past 10 years, and has on average been 2.3 ppts lower than Q2.2 There were no such distortions prior to 1996. Chart 1U.S. Growth Has Surprised To The Downside U.S. Growth Has Surprised To The Downside U.S. Growth Has Surprised To The Downside Chart 2Weaker Loan Growth Is Mostly Technical... Weaker Loan Growth Is Mostly Technical... Weaker Loan Growth Is Mostly Technical... Chart 3...And The Slowdown In Autos Is Just The End Of A Replacement Cycle ...And The Slowdown In Autos Is Just The End Of A Replacement Cycle ...And The Slowdown In Autos Is Just The End Of A Replacement Cycle A consequence of the wobbly data is that markets have become too complacent about the Fed raising rates, with futures markets now projecting only about 40 bps of hikes over the next 12 months (Chart 4). Our view is that wages will gradually move up this year, pushing core PCE inflation to 2% by year end, which will cause the Fed to raise rates twice before end-2017 and once early in 2018 (though the latter rise could be postponed if the Fed starts to reduce its balance-sheet and forgoes one quarter's hike to judge the impact of this on the market). By contrast, we do not see the ECB hiking before 2019 at the earliest, with ECB President Draghi reiterating that he sees core inflation staying low and remains concerned about the fragile banking systems in peripheral European markets and about Italian politics. We also believe Bank of Japan governor Kuroda when he says he has no plans to change the BoJ's 0% target for the 10-year JGB yield. All this implies that the dollar is likely to appreciate further in the next 12 months as interest rate spreads widen (Chart 5). Chart 4Fed Is Likely To Hike Faster Than This Fed Is Likely To Hike Faster Than This Fed Is Likely To Hike Faster Than This Chart 5Interest Differentials Suggest Further Dollar Strength Interest Differentials Suggest Further Dollar Strength Interest Differentials Suggest Further Dollar Strength The next catalyst for equities to rise further could be earnings. Q1 U.S. earnings are surprising significantly on the upside, with EPS growth of 11.7% year on year and 75% of companies beating analysts' estimates.3 BCA's proprietary model suggests that S&P 500 operating earnings this year could grow by over 20% (Chart 6). If anything, upside surprises to earnings have been even stronger in the euro zone and Japan. With none of the standard indicators signaling any risk of recession over the next 12 months (Chart 7), we remain overweight equities versus bonds. We continue to warn, though, that the Goldilocks scenario of healthy growth and stable inflation may not last for long. A combination of tax cuts, wage growth accelerating as labor participation hits a ceiling, and the Fed falling behind the curve (perhaps when President Trump - given that he recently confessed "I do like a low interest rate policy" - appoints a dovish replacement for Janet Yellen as Fed Chair) could cause inflation to rise unexpectedly next year, forcing the Fed to raise rates sharply, triggering a recession in 2019. Chart 6U.S. Earnings Could Grow 20% This Year U.S. Earnings Could Grow 20% This Year U.S. Earnings Could Grow 20% This Year Chart 7No Sign Of A Recession On The Horizon No Sign Of A Recession On The Horizon No Sign Of A Recession On The Horizon Equities: In a risk-on environment, euro zone equities should continue to outperform, due to their higher beta (averaging 1.3 against global equities over the past 20 years, compared to 0.9 for the U.S.), more cyclical earnings, and modestly cheaper valuations (forward PE is at a 18.9% discount to the U.S.). Japanese equities should also do well as interest rates rise again globally (except in Japan where the BoJ will stick to its 0% yield target on 10-year bonds), which should push down the yen and boost earnings. We remain overweight Japanese equities on a currency-hedged basis. We are underweight EM equities, which are likely to be weighed down over the next 12 months by the stronger dollar, and by a slowdown in China which should cause commodity prices to fall. Fixed Income: We expect the 10-year U.S. Treasury yield to reach 3% by year-end: a pickup in real growth, slightly higher inflation and two more Fed hikes can easily add 70 bps to the yield over the next eight months. Euro zone yields will also rise, though not by as much. This implies a negative return from G7 sovereign bonds for the first time since 1994. We continue to prefer corporate credit, with a preference for U.S. investment-grade debt over high-yield bonds (which have stretched valuations) and over European corporate debt (which will be negatively affected by the tapering of ECB purchases next year). Currencies: As described above, we do not believe that the dollar appreciation which began in 2014 is over, due to divergences in monetary policy. We would look for a further 5-10% appreciation of the dollar over the coming 12 months, though the rise is likely to be bigger against the yen and emerging market currencies than against the euro. Commodity currencies such as the Australian dollar also look vulnerable and overvalued. The British pound will be driven by the vicissitudes of the Brexit negotiations in the short-run but looks undervalued in the long run if, as we expect, the EU eventually agrees a moderately satisfactory trade deal with the U.K. Commodities: We continue to believe that the equilibrium level for oil is $55 a barrel, and that an extension of the OPEC production agreement beyond June and a drawdown in inventories in the second half will bring WTI crude back to that level - with the risk of even $60-65 temporarily if there are any unforeseen supply disruptions. We remain more cautious on industrial commodities, which will be hurt by a mild withdrawal of monetary and fiscal stimulus in China. Following its 6.9% GDP print in Q1, Chinese growth is likely to slow moderately. However, with the Party Congress coming up in the fall, growth will not be allowed to slow excessively - and, indeed, there are signs that central government spending has begun to accelerate recently (Chart 8). We remain positive on gold as a long-term hedge against the tail risk of inflation. As our recent Special Report on Safe Havens demonstrated,4 gold has historically provided good returns during recessions, particularly those associated with high inflation (Chart 9). Chart 8China Is Withdrawing Stimulus - Or Is It? China Is Withdrawing Stimulus - Or Is It? China Is Withdrawing Stimulus - Or Is It? Chart 9Gold Glisters When Inflation Rises Gold Glisters When Inflation Rises Gold Glisters When Inflation Rises Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation, "Quarterly Portfolio Outlook: No Reasons To Turn Cautious," dated 3 April 2017, available at gaa.research.com 2 For detailed analysis of the problems with seasonal adjustment, please see U.S. Investment Strategy, "Spring Snapback?" dated April 24, 2017, available at usis.bcaresearch.com 3 So far about half of U.S. companies have reported. 4 Please see Global Asset Allocation, "Safe Havens: Where To Hide Next Time?" dated April 21, 2017, available at gaa.bcaresearch.com. Recommended Asset Allocation

Dear Client, In addition to this abbreviated Weekly Report, I sent you a Special Report earlier today written by my colleague Mark McClellan of our monthly Bank Credit Analyst publication. Following up on many of the themes discussed in our latest Quarterly Strategy Outlook, Mark makes a convincing case that most of the factors that have suppressed global interest rates since the financial crisis could begin to unwind or even reverse over the coming years. Best regards, Peter Berezin, Chief Global Strategist Feature Davos Man Is Happy Chart 1Macron Leading Le Pen Macron Leading Le Pen Macron Leading Le Pen Populist forces have been in retreat of late. First came the Austrian presidential elections, which saw voters reject a populist right-wing challenger in favor of a former Green Party leader who pledged to be an "open-minded, liberal-minded, and above all a pro-European president." Then came the Dutch elections, where Prime Minister Mark Rutte won more seats than the maverick Geert Wilders. Last week the pound surged after U.K. Prime Minister Theresa May called for a fresh election. May's announcement was designed to expand the Conservative Party's majority, thus neutralizing the ability of a few hardline Tories to scuttle a Brexit deal. These uncompromising MPs would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. This week we have the results of the first round of the French presidential elections. Despite the media's absurd characterization of Emmanuel Macron as an "outsider," the former government minister was, in fact, the establishment's dream candidate: pro-business and fervently Europhile. Current polls show Macron beating Le Pen in a runoff by 21 points (Chart 1). Finally, on the other side of the Atlantic, Donald Trump has caved on most of his populist campaign pledges. He agreed to drop his requests that Congress pay for a border wall with Mexico and defund Planned Parenthood. The move is likely to avert an imminent government shutdown. In addition, Trump backed off his pledge to scrap NAFTA. This follows on the heels of his decision not to label China as a "currency manipulator," something he had promised to do during the campaign. And to top it all off, Trump released a one-page tax plan with all the goodies the Republican establishment has been craving: Lower corporate and personal tax rates and the abolition of the estate tax. Risk Assets Will Benefit... Not surprisingly, global equities have responded positively to these developments. The MSCI All-Country World Index hit a record high this week (Chart 2). A rebound in corporate earnings is helping to propel stocks higher. Our global earnings model points to further upside for profits over the coming months (Chart 3). Chart 2Global Equities At Record Highs Global Equities At Record Highs Global Equities At Record Highs Chart 3More Upside Ahead For Global Earnings More Upside Ahead For Global Earnings More Upside Ahead For Global Earnings The laggard remains the Treasury market. Trump's tax plan will add about $5 trillion to the national debt over the next decade above and beyond what the Congressional Budget Office is already projecting. Yet, the 10-year Treasury yield remains 30 basis points below where it was in early March. The market is pricing in just under two rate hikes over the next 12 months. This is below the Fed's guidance and our own expectations. We went short the January 2018 fed funds futures contract last week (Chart 4). Higher U.S. rate expectations should lead to a further widening of rate differentials between the U.S. and its trading partners (Chart 5). Mario Draghi underscored yesterday that the ECB has no plans to remove monetary stimulus anytime soon. If anything, rising inflation expectations in the euro area on the back of a firming economy could lead to lower real yields there, putting downward pressure on the euro. Chart 6 shows that the market expects real U.S. five-year yields to be only 11 basis points higher than in the euro area in 2022.1 That seems too low to us, given the euro area's bleak demographics and high debt levels. We continue to see EUR/USD reaching parity later this year. Chart 4The Market Is Lowballing The Fed The Market Is Lowballing The Fed The Market Is Lowballing The Fed Chart 5Higher U.S. Rate Expectations Will Lead To Further Widening Of Rate Differentials Higher U.S. Rate Expectations Will Lead To Further Widening Of Rate Differentials Higher U.S. Rate Expectations Will Lead To Further Widening Of Rate Differentials Chart 6The Vanishing Transatlantic Bond Spread The Establishment Strikes Back The Establishment Strikes Back ...But Populists Will Triumph In The End Steady growth and falling unemployment will reduce support for populist parties over the coming 12 months. This will help keep global equities in an uptrend. Beyond then, the clouds are likely to darken. We argued in our Q2 Strategy Outlook that global growth could begin to slow in the second half of next year.2 If that happens, support for mainstream political parties will fade. Structural forces will further bolster support for populist leaders. Chart 7 shows that Le Pen won the plurality of voters between the ages of 35 and 59. Young voters tilted towards Mélenchon, while older voters overwhelmingly went for Emmanuel Macron and François Fillon. If recent voting trends are any guide, the elderly of tomorrow will be more sympathetic to Le Pen than the elderly of today. Le Pen's populist message on the economy could resonate more with younger voters (indeed, Le Pen beat Macron among voters between the ages of 18 and 24). Chart 7Who Likes Le Pen? The Establishment Strikes Back The Establishment Strikes Back Meanwhile, worries about terrorism will undermine support for the establishment. There are 17,000 people on the French government's terrorist watch list, 2,000 of whom have fought in Syria and Iraq. Macron's feeble pledge to hire 10,000 additional police officers will do little to thwart future attacks. In the U.S., Trump's pivot towards the establishment wing of the Republican Party could prove to be short-lived. Most Republican voters have mixed feelings about Donald Trump the man. They voted for Trumpism, not Trump. Either Trump will start delivering on the promises that endeared him to blue-collar workers in states such as Ohio and Pennsylvania, or he will go down in flames in the next election. Bottom Line: Investors should overweight global equities in a balanced portfolio over the next 12 months, but look to reduce exposure in the second half of next year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Towards Parity," dated April 14, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Outlook: "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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