Gov Sovereigns/Treasurys

Highlights Chart 1Keep A Close Eye On Financial Conditions Keep A Close Eye On Financial Conditions Keep A Close Eye On Financial Conditions The market's rate hike expectations moved sharply higher during the past two weeks as a string of Fed speeches, including one by Chair Yellen, all but confirmed a March rate hike. The market is now priced for 75 basis points of hikes during the next 12 months, compared to 50 bps at the end of January. At least so far, broad indicators of financial conditions have not tightened in response to this re-rating of the Fed (Chart 1). However, there are some preliminary indications that the reflation trade is fraying at the edges. The trade-weighted dollar has appreciated +0.2% since the end of January, the 2/10 Treasury slope has flattened 9 bps and the 10-year TIPS breakeven inflation rate has declined 1 bp. The Fed is currently testing the markets with hawkish rhetoric but, with inflation and TIPS breakevens still below target, will ultimately support the reflation trade if it comes under threat. In this environment investors with 6-12 month investment horizons should maintain below-benchmark duration, remain overweight spread product and continue to position for a steeper curve and wider TIPS breakevens. Feature Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 48 basis points in February. The index option-adjusted spread tightened 6 bps on the month and, at 112 bps, it remains well below its historical average (134 bps). Our research1 shows that when core PCE inflation is between 1.5% and 2%2 investment grade corporate bonds produce an average monthly excess return of close to zero. A 90% confidence interval places monthly excess returns between -19 bps and +17 bps with inflation in this range and excess returns do not turn decisively negative until core PCE is above 2%. Given the Fed's desire to nurture a continued recovery in inflation, we are not worried about significant spread widening until inflation is sustainably above 2%. In the meantime we expect corporate bond excess returns to be low, but positive. While supportive monetary policy should ensure excess returns consistent with carry, investors should not bank on further spread compression as corporate spreads have already discounted a substantial improvement in leverage (Chart 2). Energy related sectors still appear cheap after adjusting for differences in credit rating and duration (Table 3), and our commodity strategists expect oil prices to remain firm even in the face of a stronger U.S. dollar. This week we upgrade the Wireless and Packaging sectors from underweight to neutral and downgrade the Consumer Cyclical Services sector from neutral to underweight. The former two sectors now appear cheap on our model, while the latter has become expensive. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* How Much Can Markets Take? How Much Can Markets Take? Table 3BCorporate Sector Risk Vs. Reward* How Much Can Markets Take? How Much Can Markets Take? High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 112 basis points in February. The index option-adjusted spread tightened 25 bps on the month and, at 349 bps, it is currently 170 bps below its historical average. One of our key investment themes3 for this year is that the uptrend in defaults is likely to reverse (Chart 3), mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Despite the positive outlook for defaults, we retain only a neutral allocation to High-Yield because of very tight valuations. The index option-adjusted spread is now within a hair of the average level of 340 bps that prevailed during the 2004 - 2006 Fed tightening cycle, when indicators of corporate balance sheet health were in much better shape. In fact, the index spread is now only 116 bps wider than its all-time low of 233 bps, reached in 2007. Our preferred measure of High-Yield valuation is the default-adjusted spread - the average spread of the junk index less our forecast of 12-month default losses. At present, the default-adjusted spread is 142 bps. Historically, a default-adjusted spread between 100 bps and 150 bps is consistent with positive excess returns during the subsequent 12 months 64% of the time. It is only when the default-adjusted spread falls below 100 bps that positive excess returns become unlikely. Junk has provided positive excess returns over a 12-month horizon only 13% of the time when the starting default-adjusted spread is between 50 bps and 100 bps. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in February. The conventional 30-year MBS yield fell 5 bps on the month, driven by a 7 bps decline in the rate component. The compensation for prepayment risk (option cost) increased by 1 bp, as did the option-adjusted spread. MBS spreads remain extremely tight relative both to history and Aaa-rated credit, although they have begun to widen somewhat relative to credit in recent weeks (Chart 4). More distressing is that the nominal MBS spread appears too tight relative to interest rate volatility (bottom panel). As we noted in a recent report,4 the long-run trend in interest rate volatility tends to be driven by uncertainty about the macroeconomic and political environment. In fact, rate volatility can be modeled using forecaster disagreement about GDP growth and T-bill rates. While the Fed's policy of forward guidance and a fed funds rate pinned at zero limited the amount of forecaster disagreement in recent years, this disagreement will re-emerge the further the fed funds rate moves off its lower bound. Another medium-term risk for MBS comes from the Fed ending the reinvestment of its MBS portfolio. As we described in a recent Special Report,5 the Fed is likely to allow its MBS portfolio to shrink at some point in 2018, putting further upward pressure on MBS spreads. Government Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 30 basis points in February, bringing year-to-date excess returns up to +51 bps. The high-beta Sovereign and Foreign Agency sectors outperformed the Treasury benchmark by 90 bps and 59 bps, respectively. Meanwhile, the low-beta Domestic Agency and Supranational sectors each outperformed by 4 bps. Local Authorities returned 24 bps in excess of duration-matched Treasuries. Sovereigns have outperformed Baa-rated corporate bonds year-to-date, a trend consistent with the rise in commodity prices and a trade-weighted dollar that has weakened by 1.5% (Chart 5). However, the dollar has started to appreciate in recent weeks and probably has further upside in the medium-term, especially if the Fed maintains its hawkish posture. Historically, it has been very rare for Sovereigns to outperform U.S. corporate bonds when the dollar is appreciating. After adjusting for credit rating and duration, the Foreign Agency and Local Authority sectors continue to appear cheap relative to U.S. corporate credit. In contrast, Sovereigns, Supranationals and Domestic Agencies all appear expensive. We continue to recommend overweight allocations to Foreign Agencies and Local Authorities, alongside underweight allocations to the rest of the government-related index. In a television interview last month Treasury Secretary Steven Mnuchin confirmed that GSE reform is still a priority for the new administration but that tax reform is much higher on the agenda. This means that agency spreads will likely remain insulated from any "reform risk" until next year at the earliest. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 13 basis points in February (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio has fallen 4% since the end of January and remains firmly anchored below its post-crisis average. The decline in the average M/T yield ratio was concentrated in short maturities, while ratios at the long-end of the curve actually rose (Chart 6). Accelerating fund flows and falling issuance will continue to support yield ratios in the near term. In fact, our tactical yield ratio model - based on issuance, fund flows and ratings migration - shows that yield ratios are presently very close to fair value. Although the average M/T yield ratio still appears expensive if we include the global economic policy uncertainty index as an additional explanatory variable.6 One risk to Munis is that yield ratios have already discounted a substantial reduction in state and local government net borrowing in Q1 (panel 3). While we expect this improvement will materialize in the next few quarters, net borrowing is biased upward beyond this year based on the lagged relationship between corporate sector and state and local government health.7 Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve has bear-flattened since the end of January as the market revised its Fed rate hike expectations sharply higher. Both the 2/10 and 5/30 Treasury slopes have flattened by 9 basis points since January 31. As such, our recommended position long the 5-year bullet and short the 2/10 barbell - designed to profit from a steeper yield curve - has returned -26 bps since the end of January, although it has returned close to 0 bps since it was initiated on December 20.8 As was stated on the front page of this report, the Fed's increasingly hawkish rhetoric has already caused the uptrend in TIPS breakevens to pause and the nominal Treasury slope to flatten (Chart 7). With inflation still below target these trends are not sustainable from the point of view of Fed policymakers. If the trend of decreasing TIPS breakevens and a flattening curve persists, we would expect the Fed to back away from its hawkish rhetoric. This dynamic will support a steeper yield curve at least until core PCE inflation is back to the Fed's 2% target and long-dated TIPS breakevens are anchored in a range between 2.4% and 2.5% (a range that is typically consistent with core PCE inflation at 2%). The persistent attractiveness of the 5-year bullet relative to the rest of the curve makes a position long the 5-year bullet and short a duration-matched 2/10 barbell the most attractive way to position for a steeper yield curve (panel 3). The carry buffer in the 5-year helps mitigate some of the risk of curve flattening. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent Treasury index by 18 basis points in February. The 10-year TIPS breakeven rate declined 3 bps on the month and, at 2.04%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. While the catalyst for the recent softening in TIPS outperformance seems to be the hawkish re-rating of Fed rate hike expectations, the uptrend in TIPS breakevens was probably due for a pause in any case. Breakevens had become stretched relative to our TIPS Financial Model - based on the dollar, oil prices and the stock-to-bond total return ratio (Chart 8). Diffusion indexes for both PCE and CPI inflation have also shifted into negative territory, suggesting that realized inflation readings will soften during the next couple of months. On a cyclical horizon, however, the Fed will be keen to allow breakevens to rise toward levels more consistent with its inflation target and will quickly adopt a more dovish stance if breakevens fall significantly. This "Fed put" should remain in place at least until core PCE inflation is firmly anchored around 2% and long-dated TIPS breakevens return to a range between 2.4% and 2.5%. As we detailed in a recent report,9 while accelerating wage growth will ensure that inflation remains in a long-run uptrend, the impact from wages will be mitigated by deflating import prices meaning that the uptrend will be slow. We continue to expect that year-over-year core PCE inflation will not attain the Fed's 2% target until the end of this year. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities performed in-line with the duration-equivalent Treasury index in February. Aaa-rated issues underperformed the Treasury benchmark by 2 basis points, while non-Aaa issues outperformed by 12 bps. The index option-adjusted spread for Aaa-rated ABS widened 3 bps on the month. At 50 bps, the spread remains well below its average pre-crisis level. Banks are now tightening lending standards on both auto loans and credit cards (Chart 9). While we do not think this will have much of an impact on consumer spending,10 it is usually an indication that there is growing concern about ABS collateral credit quality. While credit card charge-offs remain well below their pre-crisis levels, net losses on auto loans have in fact started to trend higher (bottom panel). We continue to recommend Aaa-rated credit cards over Aaa-rated auto loans, despite the spread advantage in autos. We will closely monitor the evolving credit quality situation, but for now continue to view consumer ABS as a very attractive alternative to other short-duration Aaa-rated spread product such as MBS and Agency bonds. The main reason being the sizeable spread advantage that has persisted in ABS for some time. At present, Aaa-rated consumer ABS offer an option-adjusted spread of 50 bps, compared to 31 bps for 30-year conventional Agency MBS and 18 bps for Agency bonds. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 34 basis points in February. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps on the month, but remains below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are firmly entrenched below their pre-crisis average. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 20 basis points in February. The index option-adjusted spread for Agency CMBS widened 5 bps on the month, and currently sits at 53 bps. The spread offered on Agency CMBS is similar to what is offered by Aaa-rated consumer ABS (50 bps) and greater than what is offered by conventional 30-year MBS (31 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.42% (Chart 11). Our 3-factor version of the model, which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.21%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.49%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2016, available at usbs.bcaresearch.com 2 Year-over-year core PCE inflation is currently 1.74%. 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 For further details on the linkage between corporate sector health and state & local government health please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon) Current Recommendation

Highlights Assessing Our Tilts: Our decision to upgrade corporate spread product versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. Fed Vs ECB: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. U.K.: Gilts have already priced in a significantly weaker U.K. economic outlook, especially with regards to consumer spending, yet inflation expectations are only now starting to peak. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts with yields already at rich levels. Feature Chart of the WeekAre Central Banks Getting ##br##Behind The Curve? Are Central Banks Getting Behind The Curve? Are Central Banks Getting Behind The Curve? A whiff of central bank hawkishness has quickly swept over the major bond markets. In the U.S., a series of Fed speeches, coming after a string of improving economic data amid booming asset markets, has turned a March Fed rate hike from a long-shot to a virtual certainty in little more than a week. In Europe, another round of stronger inflation data is emboldening some of the hawks at the European Central Bank (ECB) to more openly question if some tapering of the central bank's asset purchases will be necessary next year. Even in the U.K., the Bank of England (BoE) is letting its latest round of Gilt quantitative easing (QE) expire, although the BoE is not close to considering a rate hike, as we discuss later in this Weekly Report. Chart 2A Supportive Backdrop ##br##For Taking Credit Risk A Supportive Backdrop For Taking Credit Risk A Supportive Backdrop For Taking Credit Risk A move by the Fed next week now seems like a done deal, and the new question for investors is: how many more times the Fed will lift rates in 2017? The market is now pricing in "only" 75bps of hikes over the next year, even as the S&P 500 sits close to its all-time high and U.S. jobless claims hit a 43-year low last week (Chart 1). We still see three hikes - the Fed's current projection - to be the most that the Fed will deliver in 2017. Yet the fact that equity & credit markets have taken the rising odds of a March rate increase in stride might nudge the Fed towards even more hikes this year than currently forecast. Bond markets around the world will likely not take a shift higher in the Fed "dots" very well, although in the U.S. the immediate upside for yields remains tempered by the persistent short positioning in the U.S. Treasury market. We still expect Treasury yields to rise over the next 6-9 months, though, driven by additional increases in inflation expectations rather than a sharp repricing of the expected path of the funds rate. The biggest risk looming for global bonds, however, would come from any signal by the ECB that a taper is in the cards next year. That would likely result in wider term premiums and bear-steepening of yield curves in the major developed government bond markets. It would be a surprise if the ECB started preparing the markets for a less accommodative policy stance at this week's meeting, although questions about a taper will certainly be posed to ECB President Draghi by reporters after the meeting. Evaluating Our Recommendations As Global Growth Improves Back on January 31st, we shifted to a more pro-growth stance in our fixed income portfolio recommendations, moving our duration tilt back to below-benchmark, while downgrading government debt and upgrading corporate bond exposure.1 The key to that shift was a growing body of evidence pointing to a broadening global economic upturn. The latest round of global purchasing managers' indices (PMIs) released last week confirmed that the business cycle dynamics continue to accelerate to the upside (Chart 2). This will maintain upward pressure on bond yields and downward pressure on credit spreads. Our portfolio recommendations have generally done well since we made our shift. In Chart 3, we show the excess returns (on a currency-hedged basis) for the individual government debt markets versus the overall Barclays Global Treasury Index since the end of January. Our underweight positions in the U.S., Spain and Australia (up to February 21st, when we upgraded Aussie debt to neutral) performed well, as did our overweights in core Europe (Germany & France). Our worst performing tilts were our below-benchmark stances on Italy, which benefitted greatly from some diminished pressures on French government debt last week, and U.K. Gilts, which we discuss later in this report. In Chart 4, we show the excess returns (on a currency-hedged basis) for the major spread product markets, since January 31. Our decisions to upgrade U.S. investment grade (IG) to above-benchmark, and U.S. high-yield (HY) to neutral, have done well as U.S. corporate spreads continue to tighten in response to improving U.S. economic growth. Our relative exposures between the U.S. and Euro Area remain our biggest tilts between countries. Specifically, we remain overweight core Euro Area government debt versus U.S. Treasuries, while we are neutral U.S. HY and underweight Euro Area equivalents. On IG corporate debt, we are above-benchmark on both sides of the Atlantic. Our marginal preference, however, is for U.S. IG given the shifting changes in relative balance sheet health in the U.S. (improving, but from relatively poor levels) versus Europe (stable, but at relatively strong levels) suggested by our Corporate Health Monitors. On a currency-hedged and duration-matched basis, our relative U.S. vs Euro Area tilts have done well since our major allocation shift on January 31 (Chart 5), with Treasuries underperforming, U.S. HY outperforming and both U.S. and European IG performing similarly. Chart 3Our Recent Country Allocation Performance Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Chart 4Our Recent Spread Product Allocation Performance Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Chart 5Our Europe Vs U.S. Tilts Have Done Well Of Late Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Bottom Line: Our decision to upgrade corporate spread product risk versus government debt in the U.S., and to reduce overall recommended duration exposure, at the end of January has been performing well. Maintain these tilts, with both soft and hard economic data pointing to a broadening global economic upturn and the Fed prepared to hike rates next week. The Timing Of A Potential "Bund Tantrum" Looking ahead, timing a potential turn in our U.S. versus Europe tilts will likely remain the biggest call we make this year. With the Fed now set to raise rates again next week, and the ECB likely to deflect any talk of a taper to after the upcoming French elections (at the earliest), the bias will remain toward Treasury market underperformance in the near term. Yet the marginal pressures on inflation in both the U.S. and Euro Area suggest that a turning point in U.S./Core Europe bond spreads could arrive sooner than many expect. While realized inflation rates are moving higher in both regions, the underlying price pressures have a different look. In the U.S., headline inflation (using the Fed's preferred measure, the change in the personal consumption expenditure, or PCE, deflator) has risen to 1.89%, a mere 15bps above core PCE inflation with both measures now sitting just below the Fed's 2% target. Yet the breadth of the rise in core inflation has rolled over, according to our diffusion index (Chart 6). This suggests that the recent acceleration in core inflation, which we believe the Fed is most focused on, may take a pause in the next few months. The opposite is true in the Euro Area, where headline HICP inflation (the ECB's target measure) has soared to 1.9%, right at the ECB target of "at or just below" 2%. The gap between headline and core HICP inflation has been widening, though, as there has been very little follow through from the acceleration in headline inflation, largely driven by base effects related to previous rises in energy prices and declines in the euro, into core prices. Our Euro Area headline inflation diffusion index is moving higher, highlighting that the increase in headline HICP inflation is becoming more broadly based (Chart 7). Chart 6A Narrowing Increase In U.S. Inflation A Narrowing Increase In U.S. Inflation A Narrowing Increase In U.S. Inflation Chart 7A Broadening Increase In Euro Area Inflation A Broadening Increase In Euro Area Inflation A Broadening Increase In Euro Area Inflation The cyclical uptrend in Euro Area growth and inflation is also fairly broad-based at the country level, with the individual country PMIs and headline HICP inflation rates all in solid uptrends for the major countries in the region (Chart 8). At the same time, core inflation rates remain well contained. Various ECB members have pointed to the benign core inflation readings as a reason to stay the course on extraordinarily accommodative monetary policy settings. Yet with unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to get a consensus view on maintaining the status quo on ECB policy. Already, the German Bundesbank has been quite vocal in questioning the need for the ECB to maintain the current pace of its asset purchase program, and that pressure will only grow with German inflation now above 2%. So how close is the ECB to a potential asset purchase taper? Some clues emerge when comparing Europe now to the U.S. around the time of the Fed's 2013 "Taper Tantrum." In Chart 9, we show "cycle-on-cycle" comparisons for both the Euro Area and U.S. All series in the chart are lined up to the peak in our Months-To-Hike indicator, which measures the number of months to the first rate hike of the next interest rate cycle, as discounted in the Overnight Index Swap (OIS) curve. That indicator peaked in the U.S. in late 2012, several months before Ben Bernanke's infamous speech in May 2013 that signaled the Fed's QE appetite was beginning to wane. Chart 8A Consistent Upturn##br## In Europe A Consistent Upturn in Europe A Consistent Upturn in Europe Chart 9Less Spare Capacity In Europe Now Vs ##br##Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. In the Euro Area, the Months-To-Hike indicator peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, the indicator remains much higher than it ever was in the U.S. during the QE era, indicating how the market believes that the ECB will have to maintain zero (or lower) interest rates for longer. Yet, by some measures, the ECB is closer to reaching its policy goals then the Fed was in 2012/13. In the 2nd panel of Chart 9, we show the "unemployment gap" - the difference between the unemployment rate and the rate consistent with inflation stability - for the U.S. and Euro Area. Note that there is far less spare capacity in labor markets today in Europe than there was in the U.S. when the Fed raised the topic of a QE taper to the markets. The U.S. unemployment rate was a full three percentage points above the full employment level in 2012, while Euro Area unemployment is now only one percentage point above full employment. In the bottom two panels of Chart 9, we show the gap between headline and core inflation in both the U.S. and Euro Area, relative to the 2% inflation targets that both the Fed and ECB aim to hit. U.S. inflation was in the vicinity of the Fed's target around the time of the Taper Tantrum. While Euro Area headline inflation is similarly close to the ECB's 2% target today, core inflation is much further away from 2% than U.S. core inflation was four years ago. If the ECB focuses on headline rather than core inflation, then Europe could be getting close to its own Taper Tantrum. Yet the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to make a rush to judgement on its asset purchase program, especially given the uncertainties presented by the upcoming French elections in April & May. We are still maintaining our overweight stance on core European government debt versus U.S. Treasuries, but we are growing increasingly worried that a turning point may be on the horizon. As can be seen in the additional cycle-on-cycle comparisons in Chart 10, the benchmark 10-year German Bund is tracing out a similar path to that of the 10-year U.S. Treasury around the time of the Fed Taper Tantrum. If the ECB focuses on the tightening labor market and accelerating pace of headline inflation in the Euro Area, a "Bund Tantrum" could become the big story for global bond markets later this year. Bottom Line: Cyclical comparisons of the Euro Area today to the U.S. in the months prior to the Fed's 2013 "Taper Tantrum" show that the Euro Area is closer to full employment, with headline inflation at target, compared to the U.S. four years ago. The ECB may be facing its own tantrum pressures later in 2017. Gilt(y) Optimism? The British economy has surprised to the upside in the last few months. Policy uncertainty has collapsed, while inflation expectations have marched higher and business optimism has stabilized. Most surprising against this backdrop, Gilt returns, on a currency hedged basis, have beaten most of their developed market fixed income peers (Chart 11). Chart 10A Bund Taper On The Horizon? A Bund Taper On The Horizon? A Bund Taper On The Horizon? Chart 11Gilts Should Have Underperformed Gilts Should Have Underperformed Gilts Should Have Underperformed This outperformance cannot be linked to factors such as the usual safe-haven status of Gilts, with no signs of major financial stresses in the Euro Area that would cause money to flow into Gilts (Chart 12). Indeed, the opposite has been happening as foreigners have been net sellers of Gilts in recent months. A better explanation might come from what has become a bond-bullish linkage between the British currency, inflation, real wages and consumption. In all likelihood, investors have already incorporated most of the impact of a weak Pound on U.K. inflation expectations and Gilt yields. Yet higher expected prices continue to erode household purchasing power, leading to weaker consumer spending (Chart 13). This dynamic is bullish for bonds. Chart 12Can't Blame The Safe Haven Status This Time Can't Blame The Safe Haven Status This Time Can't Blame The Safe Haven Status This Time Chart 13Consumers Will Feel The Pinch Consumers Will Feel The Pinch Consumers Will Feel The Pinch Already, this backdrop has become widely accepted. The Bloomberg survey of economists' forecasts is calling for U.K. consumer spending growth to decelerate to 1.6% on a year-over-year basis in 2017, down from 2.8% in 2016. The BoE adopted a more dovish stance at last month's Monetary Policy Committee (MPC) meeting, citing the downside risks to consumption from high currency-driven inflation at a time of persistent spare capacity in labor markets and modest wage increases.2 This threat to U.K. growth from a more sluggish consumer should continue, at least in the short term. BCA's U.K. real average weekly earnings model is clearly pointing towards additional declines in inflation-adjusted wages (Chart 14). This should restrain consumption growth, especially as other factors boosting spending are likely to fade. For example, the gains to disposable income growth from falling interest rates are likely done for this cycle, with mortgage rates having little room to decline further from the current 2.5% level (Chart 15). Also, consumer credit is now expanding 10% year-over-year - a pace that is most likely unsustainable with household debt still at high levels relative to income and the savings rate having fallen close to pre-recession levels (Chart 16). As a result, U.K. consumers are unlikely to continue stretching their financial situation to support spending. Chart 14Real Wages Will Constrain Consumption Real Wages Will Constrain Consumption Real Wages Will Constrain Consumption Chart 15Little Room For Lower Mortgage Rates Little Room For Lower Mortgage Rates Little Room For Lower Mortgage Rates Chart 16Structural Limits On Consumer Credit Growth Structural Limits On Consumer Credit Growth Structural Limits On Consumer Credit Growth Additionally, the housing market could dent consumer confidence in the near term. Since the beginning of 2014, all measures of house price inflation have rolled over, while mortgage approvals have moved sideways (Chart 17). Signs of increased weakness are appearing and could force households to revise their spending habits downward. There are also potential risks coming from the business side, despite some more positive data of late. BCA's U.K. capex indicator, composed of several survey measures, points to a cyclical improvement in capital spending in the next few quarters. At the same time, net lending to non-financial institutions is growing at a robust rate (Chart 18), suggesting that credit availability is not an impairment for U.K. businesses. Chart 17Housing: From Tailwind To Headwind? Housing: From Tailwind To Headwind? Housing: From Tailwind To Headwind? Chart 18Some Optimism Is Warranted... Some Optimism Is Warranted... Some Optimism Is Warranted... However, the situation remains very fragile. The upcoming Brexit negotiations will keep animal spirits well contained. Firms have become more risk averse and less willing to take balance sheet risks according to the Deloitte CFO survey (Chart 19). Until the details on the U.K.'s future economic links to Europe are resolved, corporate decision-makers will be dissuaded from making long-term investments in productivity-enhancing capital such as plant and machinery. In turn, the continued lack of productivity gains will further depress U.K. corporate profitability (Chart 19, bottom panels). This uncertain environment will mean suppressed hiring intentions, greater slack in the economy and decreasing inflationary pressure. Consequently, the BoE should remain patient. The accommodative policy measures introduced last August after the Brexit vote have been working so far. Rock bottom real yields and highly expansionary money supply growth have spurred domestically generated inflation. While the BoE's latest Gilt QE program is expiring, there is no rush to hike rates until core inflation has reached the 2% threshold or until headline inflation tops out at 2.7% in Q1 2018, as the BoE predicts.3 As such, the probability of a rate hike this year, which has collapsed from 55% to 17% since January, will fall even further, to the benefit of Gilts (Chart 20). Chart 19...But The Brexit-Induced Stalemate ##br##Effects Still Prevail ...But The Brexit-Induced Stalemate Effects Still Prevail ...But The Brexit-Induced Stalemate Effects Still Prevail Chart 20More Time Needed ##br##For The BoE More Time Needed For The BoE More Time Needed For The BoE This week, we are upgrading our recommended stance on Gilts from below-benchmark to neutral. We have maintained an underweight posture since October 18th of last year, primarily driven by our expectation that rising U.K. inflation would put upward pressure on Gilt yields. Now that the main force driving inflation higher - the exchange rate - is bottoming out and possibly set to reverse, we have to change tack. On that note, our colleagues at BCA Geopolitical Strategy have recently laid out a very compelling bullish case for the Pound.4 They disagree with the assessment that further volatility in the currency is warranted because of the Brexit process. They oppose the market narrative that: Europeans will seek to punish the U.K. severely for Brexit, to set an example to their own Euroskeptics; Exiting the common market is negative for the country's economy in the short-term; Remaining legal uncertainties about Brexit could derail the process. In their view, two events that occurred in January - the U.K. Supreme Court decision that the U.K. parliament must have a say in triggering Article 50 and Prime Minister May's "Brexit means exit" speech - have reduced political uncertainty regarding Brexit. The first because parliament would ultimately be bound by the popular referendum. The second because the main cause of European consternation - the U.K. asking for special treatment with respect to the common market - was taken off the table. Thus, going forward, Europe will exact a price, but it will not be severe. And the negative economic repercussions of leaving will only be fully registered in the coming years. If our colleagues are right, an overweight position in Gilts could be tempting, as a stronger Pound would decrease inflation expectations, pushing nominal yields lower. This case is even stronger given the economic uncertainties we've laid out above. Despite their convincing arguments, we prefer to take a cautious approach, while waiting to see on what ground the Brexit negotiations will start. Moreover, Gilt valuations now seem rich, with spreads versus U.S. Treasuries at historic lows. Thus, we are only upgrading to a neutral allocation to Gilts for now. In our model portfolio (shown on Page 16), we are funding the increased Gilt allocations by equally reducing the U.S. and German exposure, given the upward pressure on yields in those markets described earlier in this Weekly Report. Bottom Line: The U.K. economy has surprised to the upside and inflation expectations have reacted in line with the domestic currency weakness. There is now a greater chance that both of those trends will reverse, to the benefit of Gilts. Raise U.K. bond exposure to neutral, from underweight. More clarity on the Brexit negotiations status is necessary to develop a firmer conviction on Gilts, especially with yield already at rich levels. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31, 2017, available at gfis.bcaresearch.com 2 The BoE lowered its estimate of the full-employment level of the U.K. unemployment rate, consistent with accelerating wage growth, from 5% to 4.5% at the February MPC meeting. 3 Please see "Inflation Report", February 2017, Bank Of England, available at http://www.bankofengland.co.uk/publications/Pages/inflationreport/2017/feb.aspx 4 Please see BCA Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?", dated January 25, 2017, available at gps.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Will The Hawks Walk The Talk? Will The Hawks Walk The Talk? Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

How Long Is The Sweet Spot? Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Historically High Valuations Historically High Valuations Chart 2Time For A Pull-Back? Time For A Pull-Back? Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Hard Data Starting To Recover Too Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Orders To Follow Capex Intentions Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Labor Costs Putting Pressure On Prices Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Fed Policy Still Accomodative Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Retail Investors Not So Bullish Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid Equity Flows Are Still Tepid Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs EM Equities Correlated With China PMIs EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Divergent Views On U.S. Bonds Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Optimism Need Not Stop USD's Rise Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights U.S. Treasuries - Fair Value: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. U.S. Treasuries - Technicals: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market and possibly sets the stage for another leg higher in yields. China: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Feature Bonds rallied strongly late last week without any obvious economic catalyst. Now that the dust has settled we find the 10-year U.S. Treasury yield trading at 2.34%, 7 bps below our estimate of fair value (Chart 1). Chart 12-Factor U.S. Treasury Model 2-Factor U.S. Treasury Model 2-Factor U.S. Treasury Model Updating Our U.S. Treasury Model That fair value estimate comes from our 2-factor U.S. Treasury model, based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. In our view, these two factors capture the most important macro drivers of U.S. bond yields. Stronger global growth, as proxied by the Global Manufacturing PMI, tends to push yields higher. However, to the extent that stronger global growth coincides with an appreciating U.S. dollar, the amount of monetary tightening that needs to be achieved through higher interest rates is limited. This caps the upside in long-dated U.S. bond yields. Put differently, it is not just the magnitude of the global growth impulse that matters for U.S. bond yields, but also the breadth of the recovery. The more broad-based the recovery, the less upward pressure on the U.S. dollar and the higher U.S. Treasury yields can rise. Last week we received Flash PMI estimates for the U.S., Eurozone and Japan that we can use to estimate the Global PMI for February. According to the Flash estimates, the U.S. PMI declined slightly in February, but this was more than offset by accelerations in both the Eurozone and Japan. Altogether, these three regions account for 48% of the Global PMI and, assuming PMIs in all other countries remain flat, we can calculate that the global PMI will nudge higher from 52.7 in January to 52.9 in February. Of course one month of data is much less important than the longer run trend. Taking a step back, we see that manufacturing PMIs are trending higher in every major economic bloc (Chart 2). Our diffusion index also shows that the global manufacturing recovery is more broadly based than at any time during the past three years (Chart 2, top panel). The synchronized nature of the recovery is also reflected in the behavior of the U.S. dollar, which has not appreciated during the past month even though Fed rate hike expectations have shifted up (Chart 3). The message from the survey of bullish dollar sentiment - the series that is included in our Treasury model - is more mixed. Bullish dollar sentiment plunged from elevated levels in January but has recovered somewhat during the past few weeks (Chart 3, panel 2). Meantime, U.S. Treasury spreads over German bunds and JGBs are also sending mixed signals. Short-maturity spreads have widened alongside increased U.S. rate hike expectations, while long-maturity spreads have been well contained (Chart 3, bottom 2 panels). Chart 2Synchronized Global Recovery Synchronized Global Recovery Synchronized Global Recovery Chart 3Keep Watching The Dollar Keep Watching The Dollar Keep Watching The Dollar Global bond investors should closely monitor trends in the U.S. dollar, bullish sentiment toward the dollar, and U.S. Treasury spreads over bunds and JGBs. Each of these indicators provides information about the breadth of the economic recovery. If Fed rate hike expectations remain firm, or even move higher, and that trend is not matched by a stronger dollar or wider Treasury spreads, then that would signal that the global recovery is becoming more synchronized, suggesting additional upside for bond yields. Bottom Line: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. Chart 4Positioning Becoming More Balanced Positioning Becoming More Balanced Positioning Becoming More Balanced Treasury Technicals Less Stretched This brings us back to last Friday's bond rally. Puzzlingly, the 2-year U.S. Treasury yield declined 6 bps and the 10-year yield fell 7 bps on a day without any significant economic or political news. In fact, Treasury yields managed to decline even though rate hike expectations embedded in the overnight index swap curve were unchanged and the probability of a March rate hike priced into fed funds futures actually increased from 31% to 33%! The unusual disconnect between Treasury yields and rate hike expectations is probably related to the expiry of the March bond futures contracts. Last week, traders had to decide whether to let their March contracts expire or roll them over into June. Positioning data show that speculators carried large net short positions into last week (Chart 4), so it is possible that it was the capitulation of these large short positions that drove yields lower on Friday. More timely data from the skew between payer and receiver swaptions show that swaption investors are no longer betting on rising rates (Chart 4, panel 4). Net speculative positions in Treasury futures could follow suit when the data are released later this week. In addition, our composite sentiment indicator has just recently ticked back above the zero line (Chart 4, panel 2). Bottom Line: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market, and possibly sets the stage for another leg higher in yields. China's Bond Market Balancing Act Chart 5Easy Money Spurs Chinese Growth Easy Money Spurs Chinese Growth Easy Money Spurs Chinese Growth In the context of the 2-factor U.S. Treasury model presented above, there are two reasons why developments in China matter for U.S. bond markets. The first is that China accounts for the single largest weighting in the Global Manufacturing PMI, so stronger growth in the Chinese manufacturing sector will pressure bond yields higher, all else equal. But the Chinese economy can also influence U.S. bond yields if changes in the RMB exert meaningful influence on the trade-weighted U.S. dollar. For example, faster Chinese growth pressures U.S. bond yields higher, but some of that upward pressure could be mitigated if that strong growth is engineered through a rapid depreciation of the RMB relative to the U.S. dollar. On the first point, China's manufacturing PMI is in a clear uptrend although the recent contraction in the government's fiscal expenditures is a potential warning sign (Chart 5). Our China Investment Strategy service views the fiscal contraction as a risk but still expects the Chinese economy to remain buoyant this year.1 This is because Chinese monetary conditions remain supportive of further gains in the manufacturing sector, and the rebound in China's PMI that began early last year is more tied to easing monetary conditions - a weaker exchange rate and falling real interest rates - than to increased fiscal spending. On the second point, while a weaker trade-weighted RMB has helped spur the recovery in Chinese manufacturing, the impulse from a weaker RMB has so far not been potent enough to move the needle on the trade-weighted U.S. dollar (Chart 6). From the perspective of U.S. fixed income markets a continuation of this trend would be the most bond-bearish outcome. Chinese monetary policy remains easy enough to spur economic growth but not so easy that it causes the U.S. dollar to spike. For the time being at least, China has been actively selling Treasuries in order to mitigate the extent of its currency depreciation (Chart 7). If China were to suddenly stop selling Treasuries, then the RMB would likely depreciate sharply. This would actually have an ambiguous impact on U.S. Treasury yields since it would probably lead to both a stronger U.S. dollar and faster global growth. Chart 6USD So Far Not Impacted By RMB USD So Far Not Impacted By RMB USD So Far Not Impacted By RMB Chart 7China Is A Treasury Seller China Is A Treasury Seller China Is A Treasury Seller More likely, however, is that China will continue to manage the gradual depreciation of its currency unless it is forced to take more dramatic action in the face of a negative growth shock. Our China Investment Strategy team notes that the annual People's Congress in early March should offer some important clues about the Chinese government's growth priorities and policy direction going forward. Bottom Line: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature Recently we have received a number of client questions about the Fed's balance sheet. When will the Fed start to shrink its balance sheet (if at all)? If the Fed does decide to shrink its balance sheet, how long will that process take? How will the Fed control interest rates in the years ahead? And most importantly, how will these decisions impact financial markets? To answer these questions, this week we are sending you a Special Report titled "Cleaning Up After The 100-Year Flood" that was first published on June 10, 2014. This report explains how monetary policy is conducted at an operational level, and also how the dramatic expansion of the Fed's balance sheet forced the Fed to modify its approach. But first, we have some additional thoughts on how the Fed's balance sheet is likely to evolve during the next few years. The Fed's Stated Plan The most up-to-date guidance we have received about the Fed's balance sheet plans comes from Janet Yellen's recent Congressional testimony: The FOMC has annunciated that its longer run goal is to shrink our balance sheet to levels consistent with the efficient and effective implementation of monetary policy. And while our system evolves and I can't put a number on that, I would anticipate a balance sheet that's substantially smaller than at the current time. In addition, we would like our balance sheet to again be primarily Treasury securities, whereas as you pointed out, we have substantial holdings of mortgage-backed securities. From this, and similar statements from other Fed officials, we conclude that the Fed will allow its balance sheet to shrink once the fed funds rate is somewhere in the range of 1% to 1.5%.1 Surveys also show that the median primary dealer expects the Fed will change its balance sheet policy when the target fed funds rate is 1.38%. As such, and under reasonable assumptions for the pace of rate hikes, we think it is very likely that the Fed will start to let its balance sheet shrink sometime in 2018. MBS First, Treasuries Maybe Later Yellen's statement to Congress also makes clear that the Fed would be more comfortable with a balance sheet that consists entirely of Treasury securities. For this reason, the central bank will start by simply ceasing the reinvestment of its Agency bond and MBS portfolios. At least initially, the Fed will continue to reinvest the proceeds from its maturing Treasury portfolio. Yellen also left open the possibility that reinvestment could be "tapered" rather than just halted altogether. While this is possible, and in fact 70% of primary dealers think that reinvestments will be phased out over time while only 14% think they will be ceased all at once, it seems to us like a needless complication. We expect that reinvestments of Agency bonds and MBS will end all at once sometime in 2018. As for the Fed's holdings of Treasury securities, it is much less clear whether the Fed will allow these balances to run down. The accompanying Special Report describes in detail the differences between the Fed's pre-crisis mode of operation, when bank reserves were scarce, and the Fed's current mode of operation with large bank reserve balances. As of now, the Fed has stated that it intends to eventually drain bank reserves from the system and return to its pre-crisis mode of operation, but there are several possible advantages to running a system with an outsized Fed balance sheet and large bank reserve balances. Chart 1Reserves Can Be Drained Fairly Quickly Reserves Can Be Drained Fairly Quickly Reserves Can Be Drained Fairly Quickly None other than Ben Bernanke pointed out a few of those reasons in a blog post last fall.2 In our view, the most compelling is that regulatory changes have increased private sector demand for safe, short-maturity, liquid assets in recent years. If the Treasury department is unwilling to supply T-bills in sufficient numbers, then the Fed can supply safe, short-maturity, liquid assets to the market by purchasing long-maturity Treasury securities and replacing them with bank reserves. Of course, we take the Fed at its word when it says that it would like to eventually drain excess bank reserves from the system. But even in that case, the steady growth of currency in circulation means that bank reserves will decline over time even if the Fed keeps the asset side of its balance sheet flat. For example, Chart 1 shows what would happen to bank reserves if the amount of currency in circulation grows at a conservative 5% per year pace, and if the Fed decides to allow its Agency bond and MBS portfolios to run off at the beginning of next year while keeping its Treasury portfolio flat. We assume that MBS runs off the Fed's balance sheet at a pace of $15 billion per month, slightly below the recent pace of MBS reinvestment. During the past three years, the Fed has reinvested between $20bn and $40bn MBS each month with an average monthly reinvestment of $32bn. In this scenario, outstanding bank reserves would decline to zero by the end of 2025. At that point the Fed would have to start adding to its Treasury holdings just to keep pace with the amount of currency in circulation. Bottom Line: While it is very likely that the Fed will allow its Agency bond and MBS portfolios to run off starting in 2018, it is much more uncertain whether it will ever cease the reinvestment of its Treasury holdings. If the Fed does allow its Treasury holdings to run down as well, it will have to start buying Treasuries again before 2025. Investment Implications Treasuries As our U.S. Bond Strategy service has written several times,3 considered in isolation it is unlikely that any decision by the Fed to allow its Treasury holdings to run off will have much of on an impact on the Treasury curve. To see why, we need to consider the process by which the Fed currently rolls over maturing Treasury securities at auction. At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426bn in 2018 and $378bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 2). However, the fact that this process is intermediated by the Treasury department means we also have to consider potential changes to fiscal policy and the U.S. government's financing mix. For instance, since running down the Fed's Treasury portfolio would also reduce the amount of bank reserves in the system, it is very likely that the Treasury department would seek to increase issuance of T-bills to compensate for the banking sector's loss of safe, short-maturity liquid assets. At present, bill supply as a percent of total Treasury debt is near a multi-decade low (Chart 3) and any increase in T-bill issuance would limit the impact of Fed balance sheet run-off on long-dated Treasury yields. Chart 2Fed Runoff Will Increase Issuance To Public... Fed Runoff Will Increase Issuance To Public... Fed Runoff Will Increase Issuance To Public... Chart 3... But Mostly Through T-Bills ... But Mostly Through T-Bills ... But Mostly Through T-Bills Bottom Line: When forecasting Treasury issuance and any potential impact on yields we must consider both the Fed's balance sheet and fiscal policy together. In our view, whatever the government's financing requirement in the years ahead, a considerable portion will be met through increased T-bill issuance, limiting the impact on long-dated Treasury yields. Mortgage-Backed Securities As our U.S. Bond Strategy service has recently written,4 the unwinding of the Fed's MBS portfolio poses a considerable threat to MBS spreads for two reasons. First, the transfer of MBS from the Fed to the private sector will put upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility will increase pressuring MBS spreads wider (Chart 4). The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 5). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 6), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 4MBS Spreads Are##br## Linked To Vol MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol Chart 5Annual MBS Excess Returns##br## Vs. Net Supply Since 1989 The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 6Adjusted Net Issuance Will ##br##Turn Positive In 2018 Adjusted Net Issuance Will Turn Positive In 2018 Adjusted Net Issuance Will Turn Positive In 2018 Bottom Line: The unwinding of the Fed's MBS portfolio will pressure MBS spreads wider through increased supply and increased demand for volatility. Note: Please see the U.S. Bond Strategy Special Report, titled "Cleaning Up After The 100-Year Flood", dated June 10, 2014 available at usbs.bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 In a Q&A from June 2015 New York Fed President William Dudley floated 1% to 1.5% as a potentially reasonable range for the fed funds rate before the Fed considers changing its balance sheet policy. https://mninews.marketnews.com/content/feds-dudley-qa-markets-should-not-be-surprised-liftoff 2 https://www.brookings.edu/blog/ben-bernanke/2016/09/02/should-the-fed-keep-its-balance-sheet-large/ 3 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017. And also U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015. Both available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com Cleaning Up After The 100-Year Flood In this Special Report we consider how the dramatic expansion of the Fed's balance sheet has influenced the conduct of monetary policy from an operational perspective. Massive reserve balances have made the federal funds market largely irrelevant, but the Fed's new overnight reverse repo facility will allow it to tighten policy when the time comes. The Fed will likely provide new guidelines for its exit strategy before the end of 2014. We anticipate how these guidelines will be modified to reflect the challenges of implementing monetary policy with a large balance sheet. Large reserve balances do not pose an inflation threat, but they do have implications for the state of banking sector regulation and the policy tools at the Fed's disposal. Chart 1What Are Implications Of Fed's Epic Intervention? The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Feature The Federal Reserve resorted to a number of very aggressive and extraordinary monetary policy measures to deal with the failure of Lehman Brothers, the subsequent financial crisis and Great Recession. The result has been a flood of liquidity that has supported asset prices and spurred the recovery, yet has left the central bank balance sheet exponentially larger than at any time in its 100-year history (Chart 1). In formulating its exit strategy the Fed will finally be forced to grapple publicly with the aftereffects of its dramatic intervention in financial markets, which has complicated how monetary policy is implemented at an operational level. This Special Report is divided into three sections. In the first section, Before The Storm, we provide some background on the process of money creation and explain how the Fed implemented monetary policy prior to the Great Recession. In the second section, The Flood Waters Rise, we consider how monetary policy is implemented today in light of the dramatic expansion of the Fed's balance sheet. In the third section, Building On Higher Ground, we examine the way forward for the Fed, describe how the exit is likely to be managed and discuss the potential problems with this approach. 1. Before The Storm Prior to the financial crisis, the Fed expressed the stance of monetary policy via a target for the federal funds rate. The federal funds rate is the rate at which banks borrow and lend reserves to each other in the overnight market. The Fed conducted its day-to-day operations with the goal of supplying all the reserves demanded by the banking sector, while steering the fed funds rate toward its target. To understand how this was accomplished, we first require some background on the money creation process. Money Creation: More Than Just A Printing Press Contrary to what many believe, the process of money creation does not begin at the Federal Reserve. Rather, it begins in the banking system at the point of loan origination and ends at the Fed (Figure 1). The process is set in motion when a bank makes a new loan. This loan creates a new asset on the aggregate balance sheet for the banking system. The newly created money typically ends up as a deposit, either at the same bank or elsewhere in the banking system.1 The increase to the asset side of the banking sector's balance sheet is offset by an equal increase on the liability side. Only then does the Fed enter the picture. In a fractional reserve system, banks must hold reserves equal to a proportion of their deposits. Therefore, in the pre-QE world illustrated in Figure 1, any increase in deposits also creates demand for more reserves. Crucially, only the Fed is able to supply the banking sector with the needed reserves. The Fed will increase the supply of reserves either by purchasing Treasury securities or lending money in the repo market. This increase on the asset side of the Fed's balance sheet is balanced by an increase in reserves on the liability side. The creation of new bank reserves is the final step in the money creation process. Figure 1The Money Creation Process The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 2QE Has Not Encouraged Lending The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet This is not to suggest the Fed is powerless to control the rate of money creation. On the contrary, Fed policy is the most influential determinant of the rate of money growth. One important distinction, however, is that the Fed exerts control over the pace of money creation because it controls the overnight interest rate. The interest rate, in turn, is the most important driver of bank lending. Changes in the level of bank reserves not associated with changes in interest rates, QE for example, have no effect on credit growth (Chart 2). The Pre-Crisis Fed Funds Market How then, prior to the Great Recession, was the Fed able to maintain the fed funds rate at its target, while still satisfying the banking system's demand for reserves? It accomplished this task by maintaining what it calls a "structural deficiency" in the supply of bank reserves. In practice this means the Fed was careful to supply no more than the quantity of reserves demanded, so that each day it would typically add to the reserve supply to accommodate the newly created demand. As a practical matter, the Fed increases the supply of reserves by either buying securities or lending money in the repo market. Both of these transactions enter the Fed's balance sheet as an asset, which must be offset by a liability, in this case an increase in bank reserves. The Fed can also reduce the supply of reserves by either selling securities or borrowing in the repo market (using the securities it owns as collateral, deemed a reverse repo from the point of view of the borrower). Although due to the "structural deficiency" in the reserve market, the Fed would typically transact to increase reserve balances. Chart 3The Pre-Crisis 'Channel System' The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet If, for example, the Fed wanted to increase the fed funds rate. It would be slow to accommodate the increase in demanded reserves throughout the day. Banks in need of reserves to meet intra-day payment processing needs would bid up the fed funds rate towards the new target. Effective communication of the target fed funds rate also aided this process. Since the target for the fed funds rate was known in advance, and the banking sector believed the Fed would supply all necessary reserves at that target rate, most federal funds transactions tended to occur at rates very close to the target. By the end of the day, however, the Fed must always supply the exact amount of reserves demanded by the banking sector if it wants to maintain control of the fed funds rate. If the Fed were to supply more reserves than the banking system required, banks would try to lend the unwanted excess reserves in the fed funds market, driving the federal funds rate lower to the interest rate paid on excess reserves (IOER), which was zero prior to 2008. Or, consider the opposite case where the Fed supplies too few reserves. In this instance banks would clamor to borrow reserves to meet their regulatory requirement. This incremental demand would drive the federal funds rate higher to the Fed's discount window lending rate, which is always available for banks to access in times of severe stress. The IOER and discount window rate thus created a channel for the fed funds rate (Chart 3), within which the Fed could nudge the rate toward target by being either too quick, or too slow to accommodate increases in demanded reserves throughout the day. Bottom Line: A "structural deficiency" in reserve balances prior to 2008 allowed the Fed to conduct monetary policy by setting a target for the fed funds rate. Also, it is the level of interest rates, and not the level of reserves, that determines the rate of money creation in the economy. 2. The Flood Waters Rise The Federal Reserve began large scale asset purchases (quantitative easing) in late 2008, dramatically increasing the asset side of its balance sheet and consequently the supply of bank reserves (Figure 2). Suddenly, the banking system found itself with far more reserves than it demanded. Predictably, trading in the fed funds market dried up and the fed funds rate was driven toward its lower bound, the IOER.2 The Fed's target for the federal funds rate quickly became irrelevant. Figure 2Illustrative Post-Crisis Balance Sheets For The Fed And The Aggregatve Banking System*: ##br##An Explosion In Excess Reserves The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet In the presence of excess bank reserves, the Fed needs a mechanism to control the lower bound of overnight lending rates. In theory, the IOER could serve as a floor beneath the fed funds rate because banks should not be willing to lend reserves at a rate lower than what can be earned at the Fed. Yet the fed funds rate has consistently traded below the IOER since 2008 (Chart 4). The reason for this violation is that the IOER is only available to depository institutions with reserve accounts at the Fed. Other suppliers of short maturity funds, mostly the GSEs, are still willing to transact at lower rates (Chart 5). Chart 4In Need ##br##Of A Floor The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 5Fed Funds Market Smaller, ##br## And Dominated By GSEs The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Chart 6Reverse Repo Facility Is New Floor On ##br##Rates Money Markets Under The Microscope The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet A new facility is required, that is capable of absorbing all of the supply of overnight funds including that emanating from outside the traditional banking system. The Fed answered this requirement by creating a fixed rate overnight reverse repo (RRP) facility. Once fully implemented, the Fed will stand ready to borrow overnight in unlimited amounts, at a rate that it chooses (i.e. is set independently of market forces). By making this facility available to a larger set of counterparties than the IOER, including money market funds and the GSEs, the Fed now has a "hard floor" on rates that it will be able to use to raise interest rates when the time comes. Even though it is still in a testing phase, the RRP already appears to be acting as a floor for overnight rates (Chart 6). Bottom Line: The stockpile of excess reserves created by the Fed's large scale asset purchase program has made the federal funds market largely irrelevant. The Fed is now only able to implement monetary policy by placing a floor under short-term interest rates, the RRP. 3. Building On Higher Ground From an operational perspective, there are two possible ways forward for the Fed as it prepares to lift rates. One option would be to return to the pre-crisis method of operation described in the first section. To do this, the Fed would first have to drain all excess reserves from the banking system by either selling securities, or deploying some of the tools on the liability side of its balance sheet, such as term deposits.3 This would re-launch the federal funds market and the Fed could return to setting policy in its traditional manner, by targeting the fed funds rate. Unfortunately, there are simply too many excess reserves in the system to make this a viable strategy, at least for the next several years. Moreover, the pace of asset sales required to drain excess reserves in a timely manner would lead to large spikes in the Treasury term premium. Instead, the Fed will almost certainly choose to maintain large reserve balances and operate monetary policy by lifting the floor RRP rate. Specifically, the Fed will set the RRP rate equal to (or slightly below) the IOER. It will then hike rates by increasing both in tandem. The Fed may still choose to set a target for the fed funds rate at a level somewhat above the RRP to maintain consistency in its communications, but this rate will be meaningless. We outline the likely sequence of the Fed's exit strategy in the following Box. Box The Exit Strategy Revisited The Fed first articulated the likely sequence of the exit strategy in the minutes to the June 2011 FOMC meeting.4 That sequence was as follows: Cease reinvestment of principal on securities holdings. Modify forward guidance on the path of the federal funds rate, and initiate reserve draining operations (e.g. term deposits). Begin raising the target federal funds rate. Begin sales of securities holdings, with a goal of returning the balance sheet to a more traditional size within two to three years. The above sequence suggests the Fed was planning to first drain excess reserves and then conduct monetary policy operations in the fed funds market, as it did prior to QE. This strategy has now been abandoned, and we expect to receive a modified exit sequence before the end of the year. The revised sequence will be consistent with the implementation of policy using a floor system, with large excess reserves, and could look something like: Modify forward guidance on the path of interest rates (including IOER, RRP and fed funds). Begin raising interest rates. First by raising the RRP rate to slightly below the IOER, and then by raising both rates in tandem. A few months after rate hikes begin; cease reinvestment of principal on Agency and Agency MBS holdings. Much later; cease reinvestment of principal on Treasury securities. The Fed will probably cease reinvestment of its MBS holdings prior to its Treasury holdings, and will then let its MBS holdings run-off passively to zero. The Fed will also probably let some of its Treasury holdings run-off passively, but could decide to maintain a permanently larger balance sheet, depending on the success of the RRP and floor system. In the next few years, as its balance sheet begins to shrink through passive run-off, the Fed may decide to drain the remaining excess reserves and return to its traditional operating method as outlined in Section1 above. Either way, U.S. monetary policy will operate under a "floor system", using the RRP rate, for at least the next few years. This new method of operation comes with several potential drawbacks, which we address below. Excess Reserves Are "Dry Powder" For The Banking System Chart 7Drivers Of Bank Lending The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Many have speculated that banks have been choosing to sit on large excess reserve balances. The thinking is that eventually the economy will reach a turning point and banks will decide to convert their excess reserves to loans en masse, leading to a surge in bank lending, and eventually, inflation. This implies that the presence of large excess reserve balances would force the Fed to hike rates more quickly than in their absence. This concern stems from a misunderstanding of the money creation process described above. The Fed could fall "behind the curve" and normalize policy too slowly, which could ultimately lead to higher inflation. However, this would simply be a consequence of keeping interest rates too low for too long. The presence of excess reserves does not in itself create a desire to lend and thus poses no additional inflation risk. For one thing, the banking system in aggregate is powerless to reduce the amount of excess reserves without the Fed also taking action to reduce the supply. As shown in Figures 1 and 2, the supply of excess reserves is determined solely on the Fed's balance sheet. There is no danger of excess reserves "leaking out" into the economy. More importantly, however, is that the process of money creation begins with the origination of a loan and ends when the Fed increases the supply of reserves. The catalyst for the process, the amount of bank lending, is determined by (Chart 7): loan demand banks' perceived profitability from additional lending banks' concerns about taking too much risk on the balance sheet, putting their viability at risk regulatory requirements concerning capital and liquidity The Fed exerts control over these four factors through its interest rate policy, but not through changes in the balance of excess reserves. Prior to 2008, the lack of excess reserves did not act to constrain bank lending, rather the Fed chose to encourage or discourage lending by decreasing or increasing the interest rate. Similarly, the large excess reserve balances since 2008 have not provided an incentive to lend. Excess Reserves and Bank Regulation One implication of the Fed having sole control over the supply of bank reserves is that, through QE, it has effectively forced reserves onto bank balance sheets. These reserves obviously factor into banks' calculations concerning required regulatory ratios for liquidity and capital. Liquidity Coverage Ratio Chart 8Fed Purchases Pushed ##br##Term Premium Lower The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet Under the proposed liquidity coverage ratio (LCR), banks must maintain a balance of high-quality liquid assets (such as bank reserves and Treasury securities) equal to their expected net cash requirement during a 30-day period. In theory, should the Fed ever decide to reduce the supply of excess reserves, banks could have trouble meeting the LCR requirement. In removing reserves, however, the Fed would also be selling securities. Banks falling short of their LCR requirement would be natural buyers for the securities offloaded by the Fed. Thus, the Fed's operating decisions will probably not exert any influence over banks' ability to meet their liquidity requirements. The LCR, however, does have implications for the equilibrium level of the Treasury term premium. Much as the Fed's Treasury purchases pressured the term premium lower (Chart 8), any future Treasury sales could be expected to unwind this effect. Even so, bank demand for those same Treasury securities would mitigate some of the upside for the term premium. Supplementary Leverage Ratio Large U.S. banks face a supplementary leverage ratio (SLR) which requires them to hold capital equal to at least 5% of total assets, not risk-weighted. In other words, large excess reserves force banks to hold more capital, which could have an adverse economic impact. Banks falling short of the SLR can either raise capital, or reduce assets. If they are either unable or unwilling to raise capital, then the large balance of excess reserves thrust upon them by the Fed could in theory crowd out bank lending. In other words, if the banking sector refuses to increase capital, then the onus falls on the asset side of the balance sheet to adjust to SLR standards. Since the banking sector in aggregate is unable to reduce reserve balances, any desired contraction in total assets could conceivably translate into an incentive to reduce the pace of bank lending. As currently proposed the SLR does not appear to be too big a hurdle for the largest U.S. banks. It is very likely they will be able to meet the requirement through retained earnings and new equity issuance. Nevertheless, it still provides a potential drag on bank lending that would not exist under the traditional model of monetary policy operations. Collateral Shortage Chart 9RRP Alleviates Collateral Shortage The Way Forward For The Fed's Balance Sheet The Way Forward For The Fed's Balance Sheet One side effect of the Fed's large scale asset purchases is that they have removed a lot of high-quality collateral from the financial system. Chart 9 shows that during periods when the Fed is adding to its balance sheet, the amount of collateral in the tri-party repo market declines. As the supply of collateral dwindles, repo rates are also pressured lower. The problem is that once repo rates approach the zero lower bound, counterparties have an increasing incentive to fail on delivery of repo contracts. Given the widespread use of repo financing, persistent repo fails have the potential to undermine liquidity in financial markets. Thankfully, the Fed's new tool for controlling the overnight interest rate, the RRP facility, solves this problem. In a reverse repo transaction, a counterparty purchases securities from the Fed with the understanding that it will sell them back the next day, earning the RRP rate in the process. This means the private sector once again gains access to collateral that had been cordoned off on the Fed's balance sheet. This should have the effect of keeping the repo rate above the floor set by the RRP, and well above zero. Repo fails have already levelled off and should begin to decline once the RRP facility is fully implemented. Financial Stability Concerns We have seen that monetary policy operates under a floor system when there are large reserve balances. One complication is that the U.S. is operating with two different floors, the IOER and the RRP. Due to its availability to a wider selection of counterparties, the RRP is the true floor on rates. From a monetary policy perspective, the easiest way forward is to set both rates at the same level and hike them in tandem. However, in a recent speech5 New York Fed President Dudley pointed out that from a financial stability perspective an RRP rate equal to the IOER could result in money flowing out of institutions eligible to receive IOER and into the less regulated shadow banking sector. It is therefore probable the Fed will choose to maintain the RRP at a level slightly below the IOER as rate hikes commence. We maintain focus on the RRP as the true floor on rates. President Dudley also made the case that the Fed's RRP facility could have positive implications for financial stability. He observed that with a Fed-backed short-term safe asset now more widely available, it could crowd out the creation of money-like liquid assets by the private sector. Those privately created liquid assets, such as commercial paper, are more prone to fire sales during times of stress. In a recent paper,6 John Cochrane agreed forcefully with this sentiment. Due to its potential for eliminating privately created money-like liquid assets, Cochrane referred to a monetary policy regime operating with large reserve balances as "a very desirable configuration of monetary affairs." The downside of the Fed providing a short-term safe asset is that it could encourage runs into the RRP during times of crisis. President Dudley rightly concludes that this is more of a technical hurdle that could be managed using caps on usage of the RRP facility. Bottom Line: The Fed will be able to operate monetary policy with large reserve balances, using the RRP as a floor on interest rates for several years while it decides by how much to run down its balance sheet and whether it should revert to its traditional fed funds rate target. Investors should remember that large reserve balances, by themselves, do not pose an inflation risk. Whether or not inflation becomes a problem will depend on the Fed's foresight to raise interest rates in a timely manner. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Alternatively it could be held in cash. This would be reflected on the banking sector's balance sheet as an increase in loans and a decrease in reserves, and on the Fed's balance sheet as an increase in currency in circulation and a decrease in reserves. 2 The Fed began paying interest on excess reserve balances on October 6, 2008. 3 The Fed's current Term Deposit Facility (TDF) temporarily drains reserves from the banking system by receiving funds from the banking sector for a period of 7 days, paying 26 basis points of interest. The early stages of the Fed exit strategy will rely more heavily on the overnight RRP facility rather than the TDF. But term deposits could be deployed once the Fed's balance sheet has returned closer to its traditional size, and the Fed decides it wants to drain the remaining excess reserves and return to its pre-crisis method of operation. 4 http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20110622… 5 "The Economic Outlook and Implications for Monetary Policy" available at http://www.newyorkfed.org/newsevents/speeches/2014/dud140520.html 6 Cochrane, John H. Monetary Policy with Interest on Reserves. Available at http://media.hoover.org/sites/default/files/documents/2014CochraneMonet…

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

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights The Fed & Yields: Positive U.S. growth and inflation momentum is maintaining the credibility of the Fed's 2017 rate hike plans. U.S. bond yields, in particular, and global yields, in general, will remain under upward pressure in this environment, despite the aggressive short positioning in the U.S. Treasury market. Maintain a below-benchmark portfolio duration stance. "Soft" vs. "Hard" Data: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The cyclical outlook Down Under has become murkier of late, even with the RBA starting to shift in a more hawkish direction. We are taking profits on our recommended pro-growth tilts in Australia. Feature The positive momentum on global growth continues to put upward pressure on bond yields, despite the large short positioning already in place in the government bond markets. The benchmark 10-year U.S. Treasury yield returned to 2.5% at one point last week, led by a rash of better-than-expected data on U.S. retail sales and inflation, combined with hawkish comments from numerous Fed officials (Chart of the Week). Markets started to more seriously consider a March Fed rate hike, although we still see June as the more likely date for the Fed's next tightening move. As we have discussed in several recent reports, it is a surge in global economic survey data that suggests that a broad-based upturn currently underway. While this is all good news for risk assets, there is some concern among investors that a pick-up in growth has been slow to appear clearly in the "hard" economic data related to final demand. Without a boost in actual economic activity, and not just "feel good" surveys, the pro-growth momentum currently embedded in equity and bond markets may melt away as rapidly as it was built up. Mark McClellan, the Chief Strategist at BCA's flagship publication, The Bank Credit Analyst, is releasing a report this week that digs into the differences between "soft data" (i.e. surveys) and "hard data" (i.e. employment and production).1 We present some excerpts from that report in the following section. Global Growth Pickup: Fact Or Fiction? Investors have taken some comfort from the fact that leading indicators are trending up across most of the developed and emerging economies. BCA's Global Leading Economic Indicator is moving higher and will climb further in the coming months given that its diffusion index is well above 50 (Chart 2). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook. Chart of the WeekNo Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. Chart 2A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart 3). Importantly, the improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Indices (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. The good news is that there is more to the cyclical upturn than hope. The improved tone in the forward-looking data is now clearly showing up in some measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, we start with some bad news. There has been a worrying loss of momentum in job creation in recent months (Chart 4). While employment gains have accelerated in Japan, Canada and Australia, the payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart 3Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Chart 4Global Employment Growth Cooling Off Global Employment Growth Cooling Off Global Employment Growth Cooling Off Also on the positive side, households are opening their wallets a little wider according to the retail sales data (Chart 5), where growth has accelerated sharply in all the major economies except U.K. and Australia (NOTE: we discuss the Australian bond outlook later in this Global Fixed Income Strategy report). Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart 6). The acceleration of imported capital goods for our 20-country global aggregate corroborates the stronger new orders reports (bottom panel). Chart 5On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! Chart 6Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across all of the major advanced economies (Chart 7). Production growth has been particularly robust in the Eurozone, U.K. and Japan. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart 8). Chart 7A Global Manufacturing Upturn A Global Manufacturing Upturn A Global Manufacturing Upturn Chart 8A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration At the moment, the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. The Soft Data Chart 9Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that President Trump's election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey are all measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. To test the reliability of the growth message from the "soft data", we employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart 9). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter of 2017. We expect growth of close to 3% in the U.S. and a little over 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 2% in the first quarter based on these indicators. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Stronger Chinese capital spending in 2017 will boost imports and thereby support activity in China's trading partners, particularly in Asia. Conclusions We have little doubt that a meaningful global growth acceleration is underway. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. American CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts or trade wars. This economic backdrop is positive for risk assets and bearish for government bonds. Bottom Line: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The Equation Gets More Complicated Two weeks ago, the Reserve Bank of Australia (RBA) unsurprisingly left its cash rate unchanged at 1.5%. The post-meeting statement by RBA Governor Philip Lowe was considered hawkish by economic analysts. Nonetheless, the market reaction has been relatively muted, with the Australian government bond yield curve steepening by only 5 bps, and the Aussie dollar remaining stable, since the meeting. Pricing in the OIS curve suggests that the RBA will probably remain on hold throughout 2017, but the implied odds of a rate hike are rising, standing now at 20%. The RBA's assessment of the current global economic backdrop was relatively constructive, pointing to above-trend growth expectations in a number of advanced economies. Domestically, the RBA foresees a boost to Australian export growth from the resource sector, an end to the decline in mining investment and a pick-up in non-mining capital spending.3 With such a tone, the central bank might have set up the market for some disappointments. The new forecast of economic growth around 3% for the next couple of years seems overly optimistic. This is higher than the median expectation of economists surveyed by Bloomberg, who foresee 2.5% and 2.8% growth for 2017 and 2018, respectively. The IMF does not expect growth to reach 3% until 2019. Granted, several parts of the economy have shown very robust performances of late. The service sector PMI has surged to pre-crisis levels. The NAB survey of business conditions also shot higher last week. Goods exports have exploded at a 40% annual growth rate, causing the December trade balance to jump to $3.5bn, nearly double the consensus $2.0bn estimate (Chart 10). Those jumps in activity are hard to ignore. From a big picture perspective, however, Australian economic data has not been surprising to the upside, unlike the trend in in the rest of the world over the past few months (Chart 11). This is intriguing, since an easy monetary policy, loose bank credit conditions, improving profit expectations and a reflationary impulse coming from China were all tailwinds that should have supported Australian growth; this was our view last year.4 Now, those favorable factors have started to reverse, raising the chances of a cyclical economic downturn. Chart 10Surging Numbers Surging Numbers Surging Numbers Chart 11Surprisingly Unsurprising Surprisingly Unsurprising Surprisingly Unsurprising Foremost, overall labor market conditions are uninspiring (Chart 12): Although the monthly employment change for January did positively surprise, at 13.3k versus an expected 10k, the pace of job creation remains under 1% year-over-year, which is low by historical standards. The diverging trend between plunging full-time and steady part-time job growth indicates a sub-optimal labor market. The labor force participation rate declined from 65.2 to 64.6 in 2016, suggesting an increasing amount of discouraged workers. Underemployment has not budged in the last two years and is stuck at historically high levels. As result, a rise in labor market slack poses a risk for the Australian consumer; wage growth has already been in a downtrend since 2011 (Chart 12, bottom panel). The construction sector further confirms our apprehensions on the true strength of the economy. Households believe that it is not a good time to buy a home, while building approvals for new dwelling units fell from bubbly levels at the end of last year. At the same time, speculative money, which was supposed to have been curbed by macroprudential policy measures, has returned to the housing market (Chart 13). Lower supply and increased speculation could push residential prices even higher, inflating debt burdens, and leaving households with fewer dollars to consume. Chart 12Consumption: Set To Deteriorate Consumption: Set To Deteriorate Consumption: Set To Deteriorate Chart 13The Foundations Are Shaking The Foundations Are Shaking The Foundations Are Shaking Externally, the Chinese reflationary mini-boom - which boosted the prices of iron ore and other commodities exported by Australia last year - will probably retreat to some extent in 2017. Although China's overall cyclical momentum remains solid, according to our GFIS China Checklist,5 government spending growth has severely relapsed, potentially signaling an end to last year's largesse (Chart 14). With that in mind, it has become difficult to envision a continuation of the positive effects from the terms of trade shock experienced by Australia in 2016. In a similar vein, but domestically-driven, Australia's credit growth has become a headwind. Between 2013 and 2015, business credit growth was expanding, creating a positive impulse for the economy. Unfortunately, this trend changed tack in 2016, with slowing credit growth now representing a negative economic force (Chart 15). With Australian banks having suffered declining profits and rising bad debt charges in the last few quarters, credit conditions could tighten going forward. This is especially worrisome since personal credit was already contracting in 2016. Chart 14China Mini-Boom Could Be Over China Mini-Boom Could Be Over China Mini-Boom Could Be Over Chart 15Negative Credit Impulse Negative Credit Impulse Negative Credit Impulse top of all this, the IMF is projecting that Australia's fiscal thrust - the change in the primary government budget balance - will be negative in each of the next five years (Chart 16). As such, this economy could run out of supporting impulses in the short to medium term. Summing it all up, we agree with the current market pricing of interest rates, given the economic uncertainties. The RBA will most likely remain on hold for the foreseeable future. The story remains the same; the central bank wants to depreciate the overvalued Aussie dollar, but excesses in the housing market prevent them from weakening the currency through interest rate cuts (Chart 17). Now, the declining cyclical outlook will only complicate the equation. Chart 16Negative Fiscal Impulse Negative Fiscal Impulse Negative Fiscal Impulse Chart 17The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver Investment Implications Our updated and more balanced economic view of Australia leads us to neutralize our recommended pro-growth Australia bond tilts: Asset allocation. As discussed above, the previously favorable factors supporting the Australian economy are progressively reversing. This is not the case in most of the other bond markets where additional cyclical upward pressure on global yields is anticipated. To reflect this view, today we are upgrading our recommended Australian bond exposure to neutral, from below-benchmark, within global hedged bond portfolios. This underweight position produced +188bps of excess return versus the global benchmark since inception in June 2016. Duration. The 10-year Australian government bond yield, 1-year forward, is 3.04%, 25bps above the current yield of 2.79%. There is a good chance that yields will rise at a faster pace than implied by the forwards at times over the course of the year, given the improving global growth and inflation backdrop. However, these instances will be opportunities to extend duration within dedicated Australian fixed income portfolios. Current Australian government bond valuation has become very cheap and is now at a level that has been associated with the beginning of positive absolute performance in the past. Moreover, the 10-year inflation breakeven is already pricing in a fair amount of inflation increases; those expectations will be hard to surpass, especially considering the low starting point (Chart 18). Curve. In May 2016, we initiated an Australian butterfly curve trade, going long the 2-year/6-year barbell versus the 4-year bullet. At the time, the 2/4/6 part of the government bond yield curve was kinked, with the 4-year sector trading very expensive versus the 2-year and 6-year maturities, reflecting the perception of a dovish stance by the RBA. then, the market has priced out these rate cut expectations, as we expected, and this part of the curve has bear steepened (Chart 19). Today, we close this trade at a +36bps profit. The RBA's future potential actions - or, more likely, inaction - are now properly discounted in the curve and reflect our neutral stance on the RBA. Chart 18Time To Buy Australian Bonds Time To Buy Australian Bonds Time To Buy Australian Bonds Chart 19Taking Profits On Our 2/4/6 Butterfly Trade It's Real Growth, Not Fake News It's Real Growth, Not Fake News Credit trades. Developing economic uncertainties warrant more cautiousness towards Australian credit. In March 2016, we recommended going long Australian semi government debt versus federal government bonds as an initial way to play what was, at the time, a relatively constructive view on the Australian economy.6 Now, given the increased economic risks, we are closing this relative value trade with a +133bps profit. Mark McClellan, Senior Vice President markm@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President rrobis@bcaresearch.com 1 Please see The Bank Credit Analyst, Section II, "Global Growth Pickup: Fact Or Fiction?," dated March 2017, available at bca.bcaresearch.com 2 Machinery orders used for Japan 3 http://www.rba.gov.au/media-releases/2017/mr-17-02.html 4 For details, please see BCA Global Fixed Income Strategy Weekly Report, "Last Minute Recommendations Before The Brexit Vote," dated June 21, 2016, available at gfis.bcaresearch.com 5 For details concerning this indicator, please see BCA Global Fixed Income Strategy Weekly Report, "How To Assess The "China Factor" For Global Bonds," dated November 11, 2016, available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters," dated March 29, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It's Real Growth, Not Fake News It's Real Growth, Not Fake News Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Dear Client, In addition to our regular Weekly Report, we sent you a Special Report on Wednesday prepared by my colleague Marko Papic, BCA's chief geopolitical strategist, assessing the election landscape in Europe this year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Global growth has accelerated, corporate earnings are rebounding, and leading indicators suggest that these positive trends will persist over the remainder of the year. This supports our cyclically bullish view on global equities. Looking further out, the impulse to growth from the easing in financial conditions that began in early 2016 will fade, setting the stage for a slowdown in 2018. If growth does falter next year, easier fiscal policy could provide an offsetting tailwind. However, there continues to be a large gap between what politicians are promising and what they can realistically deliver. What is different this time is that spare capacity is much lower than it was during previous mid-cycle slowdowns. Thus, while global bond yields could eventually dip, they remain in a secular uptrend. Feature The Elusive Correction We have been arguing since last fall that stronger global growth will help fuel a variety of reflationary trades.1 This part of our view has panned out nicely. What has surprised us is just how relentlessly the market has traded that view. With the exception of a few small wobbles, the S&P 500 has basically marched higher since the morning following the U.S. presidential election. Reflecting this development, the VIX fell to near record low levels earlier this week (Chart 1). The market's failure to take a breather has sabotaged our efforts to have our cake and eat it too - to maintain an overweight stance on global equities, while also profiting from the occasional correction. In contrast to our last three tactical hedges - which generated a cumulative return of 42% - our latest hedge is now down 9%. That's a lot of red ink. Out of pure risk management considerations, we will close this trade if the loss breaches 10%. Nevertheless, most indicators continue to warn of a looming correction. In particular, our U.S. equity strategists' new "Complacency-Anxiety" index is at an all-time high, suggesting that stocks have entered a technical overshoot phase (Chart 2).2 Chart 1VIX Is Near Record Lows VIX Is Near Record Lows VIX Is Near Record Lows Chart 2Complacency Reigns Complacency Reigns Complacency Reigns Cyclical Picture Still Solid In contrast to the short-term outlook, the 12-month cyclical picture for risk assets still looks reasonably good. Measures of current activity are rebounding as animal spirits begin to kick in (Chart 3). Falling unemployment and stronger wage growth are causing households to open their wallets. Against the backdrop of decreasing spare capacity, firms are reacting to this by increasing investment spending. Capital goods orders in the G3 economies have jumped higher in recent months, and capex intention surveys are pointing to further upside (Chart 4). Chart 3Current Activity Indicators Are Rebounding Current Activity Indicators Are Rebounding Current Activity Indicators Are Rebounding Chart 4An Upswing In Capex An Upswing In Capex An Upswing In Capex Corporate earnings have also accelerated on the back of faster economic growth. Consensus estimates call for global EPS to expand by 12% in local-currency terms this year, with the S&P 500 registering 10.4% growth, the STOXX Europe 600 gaining 14.3%, Japan's TOPIX adding 12.5%, and MSCI EM leading the pack at 16%. Outside the U.S., year-to-date earnings revisions have generally been positive, particularly in Japan and EM (in the U.S., 2017 EPS estimates have ticked down a modest 0.8%). BCA's in-house earnings models are consistent with this optimistic profit picture (Chart 5). What accounts for this fortuitous turn of events? A number of reasons help explain why growth accelerated in the second half of 2016: The drag on global growth from the plunge in commodity sector investment ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7 percent off the level of U.S. GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 6). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus, helping to reflate the economy. Global growth benefited with a lag from the easing in financial conditions that began in earnest in early 2016. Government bond yields fell to record low levels in July. In addition, junk bond spreads collapsed, dropping from a peak of 7.9% in February to 4.3% by year-end (Chart 7). Higher equity prices, particularly in a number of beaten down emerging markets, also helped. Chart 5Broad-Based Acceleration In Corporate Earnings Broad-Based Acceleration In Corporate Earnings Broad-Based Acceleration In Corporate Earnings Chart 6Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 7Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen Corporate Borrowing Costs Have Fallen How Much Longer? Chart 8Improvement In Global ##br##Leading Economic Indicators Improvement In Global Leading Economic Indicators Improvement In Global Leading Economic Indicators The key question for investors is how long the good times will last. Right now, most leading indicators that we follow are signaling that the expansion will endure for the remainder of this year (Chart 8). As we look towards 2018, however, things get murkier. Conceptually, it is the change in financial conditions that matters for growth. While the ongoing rally in global equities and continued narrowing in credit spreads has contributed to some easing in financial conditions since the U.S. presidential election, this has been partly offset by higher government bond yields. A stronger dollar has also led to an incremental tightening in the U.S., as well as in some emerging markets with high levels of U.S. dollar-denominated debt. As such, it is likely that the positive "impulse" to economic growth from the easing in financial conditions that took place last year will begin to dissipate towards the end of this year. Fiscal Policy To The Rescue? If growth does slow next year, easier fiscal policy could provide an offsetting tailwind. The fiscal thrust for developed economies turned positive in 2016, the first year this happened since 2010 (Chart 9). However, it remains to be seen whether this trend will continue. There is little support among Republicans in Congress for a big infrastructure program. It once seemed possible that Chuck Schumer and his fellow Democrats could find common ground with President Trump on this issue, but that is looking less likely with each passing day, given the level of vitriol in Washington. Broad-based tax cuts are a certainty, but the risk is that they will be coupled with cuts to government spending. Empirically, the latter have a larger "multiplier effect" on GDP than the former. To complicate matters, the introduction of a border adjustment tax - something to which we assign 50% odds - could generate significant near-term dislocations for the global economy.3 Meanwhile, much of Trump's regulatory agenda is in limbo. A repeal of Dodd-Frank is off the table. Senate Republicans do not have the 60 votes needed to scrap it. The Volcker rule is here to stay. On the other side of the Atlantic, the European Commission has recommended a further loosening in fiscal policy this year, but member states themselves are actually targeting somewhat smaller fiscal deficits (Chart 10). As is often the case, budgetary overruns are likely, but with the Greek bailout program now back on the ropes, Germany and a number of other countries may begin to dial up the austerity rhetoric. Chart 9Will Fiscal Policy Continue To Ease? The Reflation Trade Rumbles On The Reflation Trade Rumbles On Chart 10European Commission Recommending Greater Fiscal Expansion The Reflation Trade Rumbles On The Reflation Trade Rumbles On Uncertainty over the slew of European elections slated for this year could also weigh on business sentiment. Marine Le Pen is likely to place first in the initial round of the French presidential election, but faces an uphill battle in the subsequent runoff. Nevertheless, betting markets are assigning a one-in-three chance of Le Pen becoming president - similar to the odds they were assigning to a Brexit "yes vote" and a Trump victory (Chart 11). Italy also remains a risk, as my colleague Marko Papic, BCA's chief geopolitical strategist, discussed in this week's Special Report.4 Anti-euro sentiment is now stronger there than in any other major European economy (Chart 12). Chinese fiscal policy has already tightened significantly, with the year-over-year rate of change in government spending falling from a high of 25% in November 2015 to zero at present (Chart 13). So far the Chinese economy has held up well, but there is a risk that this may change. Despite Trump's backpedaling on the "One China" question, we expect the Trump administration to declare China a currency manipulator later this year. This will pave the way for higher tariffs on a variety of Chinese goods, which could lead to retaliatory measures by China. Chart 11Brexit, Then Trump... Is Le Pen Next? Brexit, Then Trump... Is Le Pen Next? Brexit, Then Trump... Is Le Pen Next? Chart 12Italy: Anti-Euro Sentiment Is A Risk Italy: Anti-Euro Sentiment Is A Risk Italy: Anti-Euro Sentiment Is A Risk Chart 13China: Fiscal Stimulus Is Fading China: Fiscal Stimulus Is Fading China: Fiscal Stimulus Is Fading Investment Conclusions Chart 14Diminished Slack In The Global Economy Diminished Slack In The Global Economy Diminished Slack In The Global Economy Global growth continues to be strong, and is likely to stay that way for the remainder of this year. However, there is a heightened risk that the global economy will falter in 2018. We remain cyclically overweight global equities and underweight government bonds, but are not dogmatic about this view. As the discussion above suggests, plenty of things could derail the reflation trade. If evidence begins to mount that a slowdown is coming earlier than we think, we will turn more bearish on stocks. Given that equities are technically overbought at present, we would not fault anyone for taking some money off the table. If growth does slow in 2018, does this mean that bond yields will fall back towards last year's lows? We don't think so. For one thing, a major deflationary commodity bust of the sort we endured in 2014-15 is not in the cards. In addition, there is less slack in the global economy now than there was last year, or for that matter, anytime since early 2008 (Chart 14). As we discussed in our Q1 Strategy Outlook, potential GDP growth is likely to remain structurally depressed across much of the world, owing to slower productivity and labor force growth.5 Lower potential growth means that excess capacity could continue to be absorbed even if growth slows somewhat from its current well-above trend pace. In the U.S., this absorption of excess capacity is nearly complete, with most labor market indicators suggesting that the economy is approaching full employment (Chart 15). In this vein, we would heavily discount the decline in average hourly earnings in January's employment report. Chart 16 shows that this was mainly driven by an anomalous drop in compensation in the financial sector. Broader measures continue to point to brewing wage pressures (Chart 17). We expect the Fed to raise rates three times this year, one more hike than the market is now pricing in. If this happens, the dollar is likely to strengthen modestly over the remainder of the year. Chart 15U.S. Economy Approaching ##br##Full Employment U.S. Economy Approaching Full Employment U.S. Economy Approaching Full Employment Chart 16Financial Sector Dragging ##br##Down Hourly Earnings In The U.S. Financial Sector Dragging Down Hourly Earnings In The U.S. Financial Sector Dragging Down Hourly Earnings In The U.S. Chart 17U.S.: Broad Measures Pointing ##br##To Rising Wage Pressures U.S.: Broad Measures Pointing To Rising Wage Pressures U.S.: Broad Measures Pointing To Rising Wage Pressures Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 5 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades