Inflation/Deflation

Highlights We discuss three "battles" that will shape the investment landscape in the euro area over the remainder of the decade. Battle #1: Reflation Versus Deleveraging - Reflation will triumph over the next 12 months. For the time being, this justifies an overweight position in euro area equities. Beyond then, the outlook is likely to darken. Battle #2: Hawks Versus Doves - The doves will win. Germany will reluctantly accept an overheated economy and higher inflation. Stay short the euro. Battle #3: Globalists Versus Populists - Marine Le Pen will lose this year's election, but Europe's populist parties will finally gain the upper hand by the end of the decade. Buy gold as a long-term hedge. Feature Market Update Global equities are technically overbought in the short term, but the longer-term cyclical (12-month) trend remains to the upside. Chart 1 illustrates the "reflation trade" in a nutshell. The Citigroup global economic and inflation surprise indices have surged and now stand at their highest combined level in the 14-year history of the series. While tracking estimates for Q1 U.S. GDP growth have fallen, this is mainly because of negative contributions from government spending, net exports, and inventories. Taken together, these three factors have shaved about 1.4 percentage points off of Q1 growth according to the Atlanta Fed's GDPNow model (Chart 2). Private final domestic demand is still growing at a reasonably robust 2.6% pace, and forward-looking indicators such as the ISM indices suggest that this number could rise over the next few quarters. Chart 1The Reflation Trade In One Chart The Reflation Trade In One Chart The Reflation Trade In One Chart Chart 2Underlying U.S. Growth Is Still Healthy Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny As such, it is not too surprising that U.S. equities have had little trouble digesting the prospect of a March Fed rate hike. The market is still pricing in less than three rate increases this calendar year. Four hikes would not be out of the question. Investors should remain positioned for a stronger dollar and higher Treasury yields. We continue to favor higher beta developed markets such as the euro area and Japan over the U.S. on a currency-hedged basis. The Battle For Europe History is often shaped by great battles. Sometimes these are of the military variety. But often they transcend physical conflict, pitting competing ideas, interests, and trends against one another. In the remainder of this week's report, we discuss three economic and political battles that will determine Europe's fortunes over the next 12 months and beyond. Battle #1: Reflation Versus Deleveraging The euro area grew faster than the U.S. in 2016, the first time this has happened since 2008. While the U.S. is likely to resume pole position in 2017, we still expect the euro area economy to expand at an above-trend pace. That should be enough to keep unemployment on a downward trajectory. The euro area economic surprise index remains in positive territory. The composite PMI rose to 56 in February - the highest level since April 2011 - with the forward-looking "new orders" component hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart 3). In addition, private-sector credit growth has sped up to the fastest pace since the 2008-09 financial crisis (Chart 4). All this is good news for the region. Investors should overweight euro area equities on a currency-hedged basis over the next 12 months. Chart 3Euro Area Growth Holding Up Well Euro Area Growth Holding Up Well Euro Area Growth Holding Up Well Chart 4Euro Area: Accelerating Private-Sector ##br##Credit Growth Euro Area: Accelerating Private-Sector Credit Growth Euro Area: Accelerating Private-Sector Credit Growth Beyond then, things look murkier. The ECB's Bank Lending Standards survey showed a modest tightening in lending standards for business loans in Q4 of 2016 (Chart 5). Private-sector debt levels also remain elevated across the region, which is likely to dampen credit demand (Chart 6). Both of these factors suggest that loan growth could begin to moderate later this year. Chart 5Slight Tightening In Lending Standards ##br##For Business Loans And Mortgages In Q4 Of 2016 Slight Tightening In Lending Standards For Business Loans And Mortgages In Q4 Of 2016 Slight Tightening In Lending Standards For Business Loans And Mortgages In Q4 Of 2016 Chart 6Still A Lot Of Debt Still A Lot Of Debt Still A Lot Of Debt If the positive impulse from rising credit growth does begin to fade, GDP growth will fall off. Whether that proves to be just another run-of-the-mill "mid-cycle slowdown" or something more nefarious will depend on the policy response. On the fiscal side, the period of extended austerity has ended. The fiscal thrust in the euro area turned positive last year, the first time this has happened since 2010. The European Commission is advising member states to loosen fiscal policy further this year, but the governments themselves are targeting a modest tightening (Chart 7). With a slew of elections slated for this year, budget overruns will be hard to avoid. Nevertheless, barring a significant economic slowdown, no major European economy is likely to launch a large fiscal stimulus program anytime soon. Thus, while fiscal policy will not be a drag on growth, it will not provide much of a tailwind either. Chart 7European Commission Recommending Greater Fiscal Expansion Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny This puts the ball back in the ECB's court. As we discuss next, monetary policy is likely to stay highly accommodative. That should help extend the cyclical recovery into 2018. Battle #2: Hawks Versus Doves Jean Claude Trichet's decision to raise rates in 2011 would have gone down as the most disastrous blunder the ECB ever made, were it not for his even more disastrous decision to raise rates in 2008. Mario Draghi has gone out of his way to avoid repeating the mistakes of his predecessor. Nevertheless, the risk is that the improving growth backdrop instills a false sense of complacency. There is no doubt that Draghi has become more confident about the economic outlook. The ECB revised up its growth and inflation projections for 2017-18 at this week's meeting and signaled that it was unlikely to extend its targeted longer-term refinancing operations, or TLTROs. The ECB is also likely to further reduce the value of its monthly asset purchases in 2018 with a view towards phasing them out completely by the end of that year. It is possible that these steps could trigger a "taper tantrum" in European government debt markets of the sort the U.S. experienced in 2013. If that were to happen, we would see it as a buying opportunity. As Draghi stressed during his press conference, wage growth is anemic. Without faster wage growth, inflationary pressures will remain muted. Granted, euro area headline inflation reached 2.0% in February. However, this was mainly the result of base effects stemming from higher food and energy prices. Our expectation is that headline inflation will fall back close to 1% by the end of the year. This is where core inflation currently stands. One should also keep in mind that the trade-weighted euro has depreciated by 8% since mid-2014 (Chart 8). To the extent that a weaker euro has put upward pressure on import prices, this has caused core inflation to be higher than it would otherwise have been. In contrast, the trade-weighted U.S. dollar has appreciated by 24% over this period. Yet, despite the diverging path between the two currencies, core inflation in the euro area remains noticeably lower than in the U.S. This is true even if one excludes housing costs from the U.S. CPI in order to make it more comparable to the European estimate of inflation. Excluding shelter, U.S. core inflation is currently 43 basis points higher than in the euro area (Chart 9). The point is that the Fed is much further along the path to monetary policy normalization than the ECB. Chart 8A Stronger Dollar Has Restrained U.S. Inflation... A Stronger Dollar Has Restrained U.S. Inflation… A Stronger Dollar Has Restrained U.S. Inflation… Chart 9...Yet Core Inflation In The U.S. ##br##Is Still Higher, Even Excluding Housing ...Yet Core Inflation In The U.S. Is Still Higher, Even Excluding Housing ...Yet Core Inflation In The U.S. Is Still Higher, Even Excluding Housing If that were all to the story, it would be enough to justify the ECB's wait-and-see approach. But there is so much more. Start with the fact that the euro area's poor demographics, high debt levels, and dysfunctional institutions all imply that the neutral rate - the interest rate consistent with full employment - is lower there than in the U.S. How does one ensure that real rates can fall to a low enough level in the event of an economic slowdown? One solution is to target a higher inflation rate. If inflation is running at 1% going into a recession, it might be impossible to bring real rates down much below -1%. But if inflation is running at 3%, real rates can fall to as low as -3%. This implies that the ECB should actually target a higher inflation rate than the Fed. Then there are the internal constraints imposed by the common currency. Countries with flexible exchange rates can adjust to adverse economic shocks by letting their currencies depreciate. That is not possible within the euro area. If one or a few countries in the region are suffering while others are not, the unlucky ones have to engineer an "internal devaluation." This requires that wages and prices in the ill-fated countries decline in relation to those in the better-performing ones. However, if inflation is already low in the latter, outright deflation may be necessary in the former, something that only a deep recession can achieve. The travails experienced by the peripheral countries over the past eight years brought home this lesson in stark and painful terms. Will Germany accept higher inflation? There is little in its recent history to suggest that it won't. Mario Draghi was not the odds-on favorite to become ECB president. That job was supposed to go to Axel Weber, the former president of the Bundesbank. Weber met with Angela Merkel on February 10, 2011. During this meeting with the chancellor, he made it clear that he did not support the ECB's emergency bond buying. Merkel balked and so the next day Weber tendered his resignation. Six months after that, ECB board member and uber-hawk Jürgen Stark quit, leaving the ECB more firmly in the control of the doves.1 Chart 10Germans Turning Radically Europhile Germans Turning Radically Europhile Germans Turning Radically Europhile Merkel's preference for a less hawkish ECB leadership wasn't solely based on altruistic feelings towards her European compatriots. Politically, Merkel knew full well that Germany would be blamed for the breakup of the euro area. Economically, German taxpayers also stood to lose a lot from a breakup. It is easy to forget now, but Germany spent 8% of GDP during the global financial crisis on bailing out its own banks. All that effort would have been for naught if German banks had been forced to write off billions of euros in loans that they had extended to peripheral Europe. Critically, the demise of the euro would have also saddled German exporters with a much more expensive Deutsche Mark, thus blowing a hole through the country's gargantuan current account surplus. The calculus has not changed much over the last six years. Germany may not welcome higher inflation, but the alternative is much worse. If anything, the polls suggest that German voters have become even more Europhile since the euro crisis ended (Chart 10). This gives Draghi even more free rein. For investors, this implies that the ECB is unlikely to raise rates for the next two years, and perhaps not until the end of the decade. As inflation expectations across the euro area drift higher, real rates will fall. This will push down the value of the euro. We expect EUR/USD to approach parity over the course of this year. Battle #3: Globalists Versus Populists First Brexit, then Trump, and now Le Pen? The spread between French and German 10-year government bond yields briefly touched 68 basis points in February, the highest level since the euro crisis (Chart 11). While the spread has edged down since then, investors remain on edge. Betting markets are currently assigning a one-in-three chance that Le Pen will become president, close to the odds that they were giving Donald Trump before his surprise victory (Chart 12). Chart 11Investors Worried About The Coming ##br##French Election Investors Worried About The Coming French Election Investors Worried About The Coming French Election Chart 12Will Le Pen Rule? Wanna Bet? Will Le Pen Rule? Wanna Bet? Will Le Pen Rule? Wanna Bet? There is little doubt that populism is in a secular "bull market." However, that doesn't mean that every populist politician is going to win every single election. For all their faults, U.S. nationwide presidential election polls were not that far off the mark. The RealClearPolitics average had Clinton up by 3.2% going into the election. She won by 2.1 points. Where the polls fell flat was at the state level. They completely underestimated Trump support in the Rust Belt states of Pennsylvania, Ohio, Michigan, and Wisconsin. That's not an issue in France, where the presidential vote is tallied at the national level. Le Pen currently trails Macron by 26 percentage points in a head-to-head contest (Chart 13). It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. The only way that Le Pen could win is if one of the two leftist candidates drops out.2 However, given the animosity between Benoit Hamon and Jean-Luc Mélenchon, that is almost inconceivable. And even if that did occur, the odds would still favor Macron slipping into the final round. As such, investors should downplay risks of a populist uprising this year. Beyond then, things are likely to get messier. At some point, Europe will face another downturn, either of its own doing or the result of an external shock. Many voters have been reluctant to vote for populist leaders out of fear that the ensuing economic turmoil could leave them out of a job. But if they have already lost their jobs, that reason goes away. Chart 14 shows the strong correlation between unemployment in various French départements, and support for Marine Le Pen's National Front. If French unemployment rises, her support is likely to increase as well. The same goes for other European countries. Chart 13Macron Leads Le Pen By A Mile Macron Leads Le Pen By A Mile Macron Leads Le Pen By A Mile Chart 14Higher Unemployment Would Benefit Le Pen Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny In addition, worries about large-scale immigration from outside Europe will continue to work to the advantage of populist leaders. Recent immigrants and their children have sometimes struggled to integrate into European society. This has manifested itself in the form of low labor participation rates, poor educational achievement, elevated involvement in criminal activity, and high welfare usage. The problem has been especially acute in European countries with very generous welfare states (Chart 15). Chart 15Many Immigrants To Europe Are Lagging Behind Three Battles That Will Determine The Euro Area's Destiny Three Battles That Will Determine The Euro Area's Destiny The reaction of establishment parties to mounting concerns about immigration has been completely counterproductive. Rather than acknowledging the problems, they have sought to censor uncomfortable "hatefacts" and stage show trials of populist leaders - such as the one Marine Le Pen will likely be subjected to for her alleged crime of tweeting graphic photos of terrorist atrocities. This strategy will backfire and the result will be a wave of populist victories towards the end of the decade. With that in mind, investors should consider buying some gold as a long-term hedge. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see BCA Geopolitical Strategy, “Europe: Game Was Changed A Long Time Ago,” in a Monthly Report, “Fortuna And Policymakers,” dated October 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, “Europe – Election Update, France,” in a Weekly Report, “Donald Trump Is Who We Thought He Was,” dated March 8, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The Fed's evident desire to lift its policy rate next week - presumably to get out ahead of inflation that has yet to show up in its preferred gauge - will weigh on gold. Oil ... not so much. This is because fundamentals once again are asserting themselves in the evolution of oil prices, something that has been evident even before markets balanced last year. Gold, meanwhile, remains exquisitely sensitive to Fed policy expectations and their effects on the USD and real rates, as with other currencies. Energy: Overweight. We are looking to re-establish our long WTI Dec/17 vs. short Dec/18 spread if it trades in contango again, i.e., if Dec/17 is less than Dec/18. We believe the combination of OPEC and non-OPEC adherence to their production Agreement will remain high, and demand likely will remain stout. Base Metals: Neutral. Spot copper is down ~ $0.10/lb on COMEX over the past week. We expect transitory supply issues in Chile and Indonesia to be resolved, and reflationary stimulus in China to wane going into the 19th National Congress of the Communist Party in the autumn, and, with it, copper demand. We remain neutral. Precious Metals: Neutral. Gold is weakening as the Fed's March meeting approaches next week, given the overwhelming expectation for a 25bp rate hike. We remain long volatility, expecting fiscal-policy uncertainty in the U.S. to be resolved over the next few months, and Fed policy drivers to become more focused. Ags/Softs: Underweight. We are not expecting significant changes in the USDA's estimates of stocks globally, and therefore remain underweight. Feature The choreographed messaging of voting and non-voting FOMC members asserting the need for a policy-rate hike over the past two weeks succeeded in pushing markets' expectations for such action to 88.6% as of Tuesday's close, up from 44.6% at the end of February. This despite the fact that the Fed's preferred inflation gauge - core PCE - has yet to show any sign of pushing up and thru the Fed's target of 2% growth yoy (Chart of the Week). Nor, for that matter, has core PCE shown any tendency to remain above 2% yoy growth over the past two decades (Chart 2). Chart of the WeekThe Fed's Preferred Inflation ##br##Gauge Still Quiescent The Fed's Preferred Inflation Gauge Still Quiescent The Fed's Preferred Inflation Gauge Still Quiescent Chart 2Core PCE Has Been ##br##Quiescent For Decades Core PCE Has Been Quiescent For Decades Core PCE Has Been Quiescent For Decades Between mid-December 2016 and the end of last month, gold prices rallied ~11.3% largely on the expectation the Fed would not raise rates until at least June, and, even then, would be constrained by uncertainty over what Congress and the Trump Administration would offer up in terms of fiscal policy later this year. Now, with the Fed succeeding in raising the market's expectation of a March rate hike, gold markets are left to re-calibrate the number of hikes to expect this year, and the likely implications for the USD and real rates. We believe the Fed will execute three rate hikes this year, but this will be highly dependent on how markets react to the now fully priced-in hike markets expect next week. Synchronized Growth, Inflation And Feedback Loops It is likely the Fed feels confident accelerating its rates normalization because, for the first time since the Global Financial crisis, we are getting a globally synchronized recovery in GDP. All else equal, this will give the U.S. central bank a bit of headroom to experiment with an earlier-than-expected rate hike. This synchronized growth also will provide a positive backdrop for commodity demand this year and next (Chart 3). The possibility of highly stimulative - or even just moderately stimulative - fiscal policy in the U.S. at a time when the economy is apparently at or close to full employment, will be positive for aggregate demand, and could be inflationary if its principal result is to lift real wages in the U.S. In addition to synchronized growth, we also are seeing evidence of synchronized inflation in the largest economies in the world (Chart 4). Chart 3Synchronized Global Growth ##br##Could Embolden The Fed Synchronized Global Growth Could Embolden The Fed Synchronized Global Growth Could Embolden The Fed Chart 4Synchronized Inflation Globally ##br##Likely Caught The Fed's Attention Synchronized Inflation Globally Likely Caught The Fed's Attention Synchronized Inflation Globally Likely Caught The Fed's Attention This synchronized growth and inflation is, we believe, important to the Fed, in that its effects constitute something of a global feedback loop. As we have noted in earlier research, the Fed is much more sensitive to how its policy actions affect other economies, given the deepening of global supply chains over the past two decades or so. Equally, policymakers are well aware the evolution of monetary policy and economic growth in other economies affects the U.S. growth and policy variables important to the Fed.1 Absent a policy shock in the U.S., Europe or China, the backdrop for EM growth should remain positive for at least 2017, even with reflationary stimulus waning in China, a left-tail risk to commodity prices that we identified in last week's publication.2 We expect the Fed's policy normalization to be tempered by continued monetary accommodation globally, which will be supportive of growth at the margin. This will keep global oil demand growth on track to average 1.50 - 1.60mm b/d this year and next, and, importantly for inflation and inflation expectations, keep EM oil demand growing. The income elasticity of per-capita oil consumption in EM economies typically is ~ 1.0, meaning a 1% increase in EM incomes is associated with a 1% increase in EM oil demand.3 EM growth accounts for close to 85% of the growth we expect in global oil demand this year. This is important, given EM oil demand, which we proxy with the U.S. EIA's non-OECD oil consumption time series, to be a common factor that explains the evolution of the CPI series shown above (Chart 5). EM oil demand is able to explain the synchronization of inflation in the three largest economies in the world is because incremental growth is occurring in the EM economies, and this is driving global growth. We continue to expect high compliance in the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia at the end of last year, which will, against the backdrop of continued global growth, cause inventories to fall and for markets to backwardate. We believe last week's increase in U.S. crude oil inventories to be the last big build, and expect the decline to begin later this month. On average vessels leaving the Persian Gulf destined for the U.S. have a 45- to 50-day sailing period depending on multiple factors such route, weather and sea conditions. Therefore, the recent increase in U.S. crude oil inventories can be linked to the arrival of the final fleet of vessels in concert with the pre-OPEC agreement production surge undertaken by the GCC. Evidence of this phenomenon is apparent in the ~500k b/d increase in U.S. crude oil imports (374k b/d coming from Iraq) over the prior week. We expect OECD oil stocks to start declining this month and fall some 300mm bbl before the end of 2017. This supply-demand dynamic will continue to dominate financial-market influences on oil prices, as we argued in last week's publication (Chart 6).4 Gold, on the other hand, will continue to take its cue from Fed policy and policy expectations, particularly as regards expectations for the USD, which should strengthen at the margin, given the Fed's new-found hawkishness, and real rates, which also should strengthen (Chart 7). Chart 5EM Oil Demand Continues##br## To Drive Inflation EM Oil Demand Continues To Drive Inflation EM Oil Demand Continues To Drive Inflation Chart 6IF KSA And Russia Can ##br##Coordinate Production... IF KSA And Russia Can Coordinate Production... IF KSA And Russia Can Coordinate Production... Chart 7Gold Will Continue To Take##br## Its Cue From Fed Policy Gold Will Continue To Take Its Cue From Fed Policy Gold Will Continue To Take Its Cue From Fed Policy Bottom Line: Oil prices will continue to be dominated by supply-demand-inventory fundamentals, with monetary policy effects on the evolution of prices taking a secondary role. Gold prices will continue to take their cue from Fed policy and policy expectations. We look to re-establish our long Dec/17 WTI vs. short Dec/18 WTI spread if it trades thru flat (i.e., $0.00/bbl). Given our gold view, we remain long volatility via the put spreads and call spreads we recommended February 23 - i.e., long Jun/17 $1,200/oz puts vs. short $1,150/oz puts, and long $1,275/oz calls vs. short $1,325/oz calls. The position was up 15% as of Tuesday's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Reports "Global Inflation and Commodity Markets," dated August 11, 2016, and "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," dated August 4, 2016, available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Gold's Known Unknowns, And Fat Tails," dated February 23, 2017, available at ces.bcaresearch.com. 3 Oil consumption frequently is employed to approximate EM income growth, given the income elasticity of demand for oil is ~ 1.0, meaning a 1% increase in income (GDP) produces an increase in demand for oil of approximately 1.0%. The OECD notes, "Non-OECD countries are found to have a higher income elasticity of oil demand than OECD countries. On average across countries, a one per cent rise in real GDP pushes up oil demand by half a per cent in OECD countries over the medium to long run, whereas the figure is closer to unity for most non-OECD countries." Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Days Of Oil Future's Past: Mean Reversion," dated March 2, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

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

Highlights President Trump has the opportunity to influence the Fed much more than past presidents, by virtue of the number of FOMC seats to fill and due to the likelihood that his nominations are likely to be confirmed. It would not be unprecedented for monetary policy to become politicized. In the current environment, the risk is that any loss of independence/politicization of the Fed would lead to higher inflation. Monitoring Trump's nominations will be the best way to gauge whether this is a legitimate worry for financial markets. Inflation will stay sufficiently benign in 2017 so that no more than three rate hikes occur in 2017. Feature Last week, a series of hawkish FOMC speeches caused expectations for a Fed rate hike in March to spike (Chart 1). On Friday, Yellen confirmed that a rate hike is likely in March as long as the data remains sufficiently strong. And Fed Governor Lael Brainard also signaled that a rate hike in mid-March is a high-probability outcome. What makes Brainard's hawkish comments particularly noteworthy is that she is well known to have very dovish leanings. She joins Fed Presidents Dudley and Williams, who also raised the prospect of raising rates this month earlier in the week. Chart 1March Rate Hike Expectations Surge March Rate Hike Expectations Surge March Rate Hike Expectations Surge In light of the recent Fed commentaries, our U.S. Bond Strategists now believe that a rate hike in March has a high likelihood. It will take a weak nonfarm payrolls report on Friday to stay the Fed's hand on March 15. As we note on page 7, the sudden hawkish shift to the Fed's rhetoric is somewhat at odds with the recent data, which do not call for any increased urgency to raise interest rates. For this reason, we believe it is premature to revise up the number of rate hikes likely to occur in 2017: we do not expect that economic and inflation performance will warrant a rate hike each quarter. Thus, we do not expect that overly tight monetary policy will be a risk to financial markets this year. This week, we focus on a longer-term threat to the monetary backdrop: the possibility of a more politicized Fed, and the implications for inflation. There has long been a healthy dose of suspicion in Congress about the Fed's role and conduct. But throughout Trump's campaign and now as president, the volume has been turned higher. There are several legislative proposals in recent years that have the potential to be advanced/passed during the next Presidential term: Audit The Fed: Audit the Fed legislation would require the Government Accountability Office (GAO) to audit the Fed's monetary policy decisions. The Fed's financial statements are already audited, and the GAO can examine most other Fed operations, but monetary policy decisions are currently exempt from needing Congress approval. This is the legislation that would be potentially most transformative for monetary policy, since it would subject the Fed to political pressure on monetary policy. Please see discussion below. The FORM Act: A main feature of the Fed Oversight Reform and Modernization Act (FORM) is the so-called Taylor Rule requirement, which would require Fed officials to establish a mathematical formula to guide their interest-rate decisions, and require them to report to Congress if they deviate from the rule. We discussed the Taylor rule and the FORM Act in Detail in the February 13th Weekly Report (Chart 2). The bill also would allow the GAO to audit the Fed's policy decisions; widen membership of the Fed's rate-setting committee; require the Fed Chair to testify more frequently; and place new restrictions on the Fed's emergency lending powers. Chart 2 landscapeA "Rules-Based" Fed Would Be A Tighter Fed A "Rules-Based" Fed Would Be A Tighter Fed A "Rules-Based" Fed Would Be A Tighter Fed Following a mechanical rule would severely limit the Fed's flexibility in determining the appropriate path of monetary policy. Bailout Prevention Act: This measure is designed to curtail the Fed's powers to lend to financial firms in an emergency. The 2010 Dodd-Frank law put some restrictions in place, but lawmakers on both sides of the aisle aren't satisfied the Fed has taken the necessary steps to implement those restrictions. Chart 3WWII Policy Expansion WWII Policy Expansion WWII Policy Expansion The Fed's ability to respond during crisis would henceforth be limited. Fed Capital Stock: This measure aims at requiring the Fed to pay back capital that banks paid to be members of the Fed system. The bill was introduced in 2015 after Congress voted to lower the dividend the Fed pays banks on that capital to help pay for federal highway programs. All of the above legislation will, if passed, have an impact on financial assets. However, Audit The Fed threatens to be by far the most transformative: as we discuss below, a slippage of independence of the U.S. monetary authority would have long-term consequences for the ability of policymakers to control inflation. At The Intersection Of The Fed And The Treasury: Inflation The Federal Reserve is part of the public sector. Its "chief executive" is a government appointee, and politicians have the power to legislate changes to central banks' structure, responsibilities, and mandates. Independence generally is interpreted as meaning that central bankers are free to conduct day-to-day monetary policy without any interference or influence from politicians, i.e. they have operational independence, not legal independence. It was not until The Banking Act of 1935 that the Treasury Secretary and the Comptroller of the Currency were removed from the Fed's governing board.1 The main argument for an independent central bank is that money supply decisions should be made independent of the political process. In other words, monetary policy should not be influenced by short-term political considerations. This is especially true for indebted economies: when debt/GDP levels are rising, the temptation for governments to fix government balance sheets via inflation grows. Indeed, it is not a coincidence that episodes of proximity between centrals and government coincide with periods of inflation, and that these periods almost always occur after periods of fiscal largesse (Chart 3). It would not be unprecedented for monetary policy to become politicized. During WWII, the Fed played an important role in financing defense-bloated budget deficits. And during the Nixon era, Chairman Arthur Burns was justifiably accused of running an overly-expansionary policy to aid the re-election prospects of the President (Chart 4). At a speech last week to a joint session of Congress, President Trump took a more conciliatory tone than in the past on all facets of governing, and did not even mention the Federal Reserve. There were few details on his plans, but the President's repeated mention of infrastructure and "national rebuilding" highlights that an infrastructure spending bill will happen. A major jump in defense spending also appears assured, as are tax cuts for the corporate and household sector. Of primary concern is how the current Administration will choose to finance its fiscal expansion. The temptation to finance higher deficit spending with easy money may be too great. Moreover, with so many vacant spots to fill on the FOMC, it might be far easier to align the Fed with Trump's interests than passing new legislation. Chart 4Impact Of Monetary Shifts Impact Of Monetary Shifts Impact Of Monetary Shifts Diluting Independence Through The Back Door The discussion on pages 2-3 focused on a potential loss of independence of the Fed via the legislative process. But passing Audit The Fed and other similar bills require a supermajority (60 votes) in the Senate. In January of last year, the Audit the Fed bill could not cross that hurdle. The easier route to bringing the Fed closer in line with the Treasury may simply involve staffing decisions. Recall that the FOMC committee is made up of seven Federal Reserve governors plus five regional Fed Presidents. FOMC members are nominated by the U.S. President and confirmed by the Senate. The full term of a Governor is 14 years and appointments are staggered so that one term expires each even-numbered year. In theory, only one new voting member should be replaced every second year. However, over the course of 2015/16, Obama delayed making nominations. Subsequently, his nominations were not approved by the (Republican) Senate. There are currently three Governor positions available (out of the possible seven). Two vacancies have existed since 2014, and Daniel Tarullo has resigned, effective April 5, 2017. Of the voting regional Fed Presidents, two (Atlanta and Richmond) will be replaced by mid-2018. Regional Fed Presidents are chosen by the Federal Reserve Bank's board of directors and these directors are representatives from member banks. Thus, the President does not have sway over the two Regional bank replacements. However, it is quite likely that the current Vice-Chair Stanley Fischer will retire at the end of his term in June 2018, as possibly Janet Yellen will as well, thus giving President Trump the opportunity to choose a majority of FOMC voting members by the middle of 2018. There is tremendous potential for Trump to put his stamp on the Federal Reserve. What could a Trump-induced Fed look like? There are plenty of names that are circulating. In the Box 1 on page 9, we provide a shortlist of possible candidates. Note that the candidates we list are what we classify as "typical" FOMC nominations. That is, their backgrounds and CVs fit the profile of recent FOMC members. Of course, these members range in hawkishness/dovishness, and so picking a few that rate more hawkishly (dovishly) could speed up (slow down) the march toward higher rates. It is worth noting that our list of candidates are Republican and, based on their track record, would favor a more hawkish bias. A bigger risk to financial markets is that Trump chooses multiple members outside of this pool of candidates, as this would mark a departure from the status quo/inject uncertainty. After all, the President has not shown a particular appreciation for economists in general. For example, President Trump has delayed appointing a Chair to the Council of Economic Advisers and has made it clear that in any case, the Chair will not be part of the President's cabinet (breaking the seven-decade tradition). A diversity of thinking could be a good thing, as one or two new voices would surely bring new ideas and perspectives to the Fed. But we see two major issues. First, six new board members over the next year or so will represent a tremendous changing of the guard at one time. If the President chooses to look outside traditional candidates to fill the majority of the vacant seats, then the FOMC committee is likely to lack experienced policymakers. Politics aside, by 2018, it is possible that only four of the twelve voting FOMC members will be veterans on the committee. Second, as we mentioned above, past presidents have not had to deal with the same temptation to meddle in monetary policy: Trump has been handed the opportunity to influence the Fed much more than past presidents, by virtue of the unprecedented number of FOMC seats to fill and the likelihood that his nominations are likely to be confirmed. Whether he decides to do so is unclear, but it is a risk that investors should bear in mind. A melding of powers between the Treasury and the Federal Reserve, should it occur, would be a very powerful structural inflationary force and would be a regime shift from the past couple of decades. Monitoring upcoming appointments over the next several months will help to understand to what extent this is a legitimate risk. Note, however, that for the year ahead, our view of inflation is unchanged; we simply do not believe that the U.S. economy is facing enough supply constraints to generate meaningful inflation pressures. Last week's data reinforces our view. Economy Update: Goldilocks, Continued Last week's major data releases supports our view of an economy that is running neither too hot nor too cold. True, the monthly rise in core PCE (0.3%) was strong, but once again, was driven by only a few components and does not represent broad-based inflation pressures (Chart 5). In particular motor vehicle and apparel prices shot higher, but our diffusion indicator, which measures the number of components with rising versus falling inflation rates, fell into negative territory. It is now widely known that over the past three years, U.S. government statistics softened systematically in the first quarter of the calendar year, while inflation reports tend to be strong in the opening months of the year. Recent consumer spending data continue to follow this yearly trend; PCE spending was on the soft side. We are not overly worried about this weak number, as the bulk of data from other sources continues to paint a much more upbeat picture. For example, the ISM manufacturing and services surveys ticked higher again in February (Chart 6). Respondents' comments were very upbeat. 17 out of 18 industries reported growth, and importantly, the more forward looking component of the survey - new orders - shot higher to near cyclical highs. Chart 5Benign Inflation Outlook Intact Benign Inflation Outlook Intact Benign Inflation Outlook Intact Chart 6Economic Momentum Intact Economic Momentum Intact Economic Momentum Intact In sum, the recent economic data reports continue to point to continued economic expansion. Q1 data disappointments have become the norm, but we continue to expect the economy to achieve real GDP growth greater than 2.5% in 2017. The bond market now expects the Fed to raise interest rates in March; Fed communication has certainly turned in that direction over the past few days. Although the timing of the next rate hike could indeed be pushed forward to March, our economic forecast for 2017 implies that more than three rate hikes this year is still unlikely. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 For more historical background on the politicization of monetary policy, please see Bank Credit Analyst Special Report "The Politicization Of Monetary Policy: Should We Care?," April 15, 2013. Box 1 Potential New FOMC Members President Trump's view of the Fed appears to be flexible - he has expressed a wide range of opinions about the central bank and its Chair. Unlike Trump's inconsistent views about interest rates, he has been more steady in his belief that Fed positions should be filled by Republicans. Our bias is to expect President Trump's Federal Reserve nominations to be a greater mix of traditional versus non-traditional central banking profiles. Below, we present a shortlist of mainstream Republican economists that may fill a vacancy on the FOMC. It is worth highlighting that a majority of these names have a hawkish bias, which could help mitigate the risk of a more politicized Fed being inherently more inflationary. Our list is by no means exhaustive. John Taylor (Hawkish bias): Taylor is most widely known for The Taylor Rule. He has recently criticized the Fed for being behind the curve, although has not explicitly advocated for a policy change. He also served as Under Secretary of Treasury for International Affairs from 2001 to 2005. Kevin Warsh (Hawkish bias): A former Morgan Stanley banker (and BCA Conference speaker!) has been forthright with his views that higher interest rates would actually be good for the U.S. economy. Glenn Hubbard (Neutral): Hubbard is Dean of Columbia Business School and has advocated a "wait and see" approach for monetary policy in face of current fiscal uncertainty. Hubbard headed the Council of Economic Advisers under the Bush Administration. Tom Hoenig (Hawkish bias): Hoenig is current FDIC Vice-Chair and former Kansas City Fed President. In the latter position, he was a voting member of the FOMC. Throughout 2010, Hoenig was the lone dissenter on the committee, voting always in favor of a rate hike and for the Fed to move away from ultra-accommodative policy. He is also a harsh critic of "too big to fail".

Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Three Controversial Calls, Five Months On Three Controversial Calls, Five Months On Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Japan: Low Household Saving Rate And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Investors Still Not Entirely Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Global Bank Shares Have Bounced Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Factors Supporting Bank Stocks Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 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. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The supply of U.S. dollar outside America has been curtailed, yet there is large pent-up demand for dollars. This warrants another upleg in the greenback. The Trump administration's desire to shrink America's current account deficit will be very deflationary for the rest of the world, and mildly inflationary for the U.S. Such policies, if adopted, will exaggerate the paucity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. The RMB is at risk because Chinese banks have created too many yuan, and deposit rates in real terms have turned negative as inflation has risen. Our negative view on EM has been and continues to be driven by our outlook on EM/China domestic demand, commodities prices and the U.S. dollar - not growth in advanced economies. Feature In recent weeks we met with clients in Asia and Australia. This week's report addresses some of the more common questions that we were asked to address. Question: You have written about "global U.S. dollar liquidity shortages." Why have these "global dollar shortages" occurred given the Fed expanded its balance sheet enormously from 2008 until 2014? How does one measure "global dollar shortages," and what does it mean for financial markets? By "global U.S. dollar shortages," we refer to deficiency in U.S. dollars outside the U.S., where U.S. dollar supply growth has fallen short of growth in demand for the greenback. We have the following pertinent observations on this issue: U.S. dollar shortages in the global banking system (eurodollar market) can be represented by U.S. banks' and other financial firms' claims on foreigners. This measure has been shrinking since early 2015 (Chart I-1). This corroborates the fact that U.S. banks, prime money market funds and other financial institutions have been unable/unwilling to supply dollars to the eurodollar market. This is consistent with rising LIBOR rates, which still continue to climb. U.S. non-financial entities' foreign assets have also fallen in the past year and a half but they are much smaller than banks and other financial institutions claims. As to U.S. banks' and other financial firms' claims on EM, they have also been shrinking since early 2015 (Chart I-2). Chart I-1Weak Supply Of U.S. Dollars To Rest ##br##Of World By U.S. Financial Institutions Weak Supply Of U.S. Dollars To Rest Of World By U.S. Financial Institutions Weak Supply Of U.S. Dollars To Rest Of World By U.S. Financial Institutions Chart I-2Shrinking Supply Of U.S. Dollars ##br##To EM By U.S. Financial Institutions Shrinking Supply Of U.S. Dollars To EM By U.S. Financial Institutions Shrinking Supply Of U.S. Dollars To EM By U.S. Financial Institutions Another way that the U.S. emits dollars to the rest of the world is by running a current account deficit. The U.S. current account deficit as a share of global GDP is now much smaller now than it was before the Great Recession (Chart I-3). This also means a smaller U.S. dollar supply relative to the size of the world economy. On the demand side, the widening in cross currency basis swaps indicates structural demand for U.S. dollar funding among euro area and Japanese investors (Chart I-4). Chart I-3The U.S. Emits Less ##br##Dollars To World Via Trade The U.S. Emits Less Dollars To World Via Trade The U.S. Emits Less Dollars To World Via Trade Chart I-4Pent-Up Demand For Dollars From Japanese ##br##And European Fixed-Income Investors Pent-Up Demand For Dollars From Japanese And European Fixed-Income Investors Pent-Up Demand For Dollars From Japanese And European Fixed-Income Investors These investors have been opting for exposure to dollar assets due to the higher yield on U.S. dollar fixed-income instruments - but they have been reluctant to take on exchange rate risk. In brief, they have avoided getting long exposure to the U.S. dollar. The reluctance to accept the exchange rate risk by European and Japanese investors means they are not bullish on the dollar. This goes against the widespread opinion among investors that the overwhelming majority of global investors are bullish on the U.S. currency. By hedging the exchange rate risk - in this case the risk of potential greenback depreciation - these investors are giving up a considerable portion of higher yield that they obtain in U.S. fixed-income market. In fact, if these basis swaps continue to widen or remain wide it might make sense for European and Japanese fixed-income investors to buy U.S. fixed-income securities and not hedge the currency risk. If and when these investors stop hedging their exchange rate risk, the U.S. dollar will appreciate versus the euro and the yen. Provided European and Japanese fixed-income investors are sizable players in global fixed income and hence currency markets, they have the potential to make a difference in exchange rate markets. In short, there is potential pent-up demand for U.S. dollars from these European and Japanese institutions. Such a widening in basis swaps is also consistent with the above observations that U.S. banks have been reluctant to take the other side of this trade - i.e., offer U.S. dollars to European and Japanese investors - even though it is a very profitable opportunity. Finally, the drop in EM central banks' foreign exchange reserves reflects demand for U.S. dollars in their economies, primarily in China (Chart I-5). The Chinese central bank has sold U.S. securities to meet mushrooming demand for U.S. dollars from Chinese households and companies. This entails there has been and remains considerable pent-up demand for dollars by mainland companies and households. With respect to the supply of currency, it is important to note that it is up to commercial banks - not the central bank - to create money. Central banks provide liquidity for commercial banks, but it is the latter that creates money.1 In a nutshell, by undertaking QE, the Fed provided reserves for U.S. commercial banks (Chart I-6), yet the latter have been reluctant to create too much money. Banks create money by originating loans and other types of claims. Chart I-5China: Selling U.S. Securities To ##br##Meet Domestic Demand For Dollars China: Selling U.S. Securities To Meet Domestic Demand For Dollars China: Selling U.S. Securities To Meet Domestic Demand For Dollars Chart I-6The Fed's Balance ##br##Sheet In Perspective The Fed's Balance Sheet In Perspective The Fed's Balance Sheet In Perspective U.S. banks have been very conservative in money creation especially outside America. In the U.S., banks shrunk their balance sheets and loans in the 2009-2011 period. That is why the Fed's QE programs have not led to inflation. Notably, U.S. banks' total assets - including bank loans - and broad money (M2) growth have lately rolled over (Chart I-7). This worsens the lingering dollar scarcity outside the U.S., which should in turn prop up the value of the dollar. The reasons why U.S. banks and financial institutions have been conservative is due to their own deleveraging objectives and because of regulatory changes in the financial industry. In regard to interest rates, U.S. nominal and real (inflation-adjusted) interest rates are very low yet they are high relative to European and Japanese real rates (Chart I-8). Given a relatively tight labor market, odds are that U.S. interest rate expectations will rise further in both absolute and relative terms. This will cause the dollar to appreciate. Chart I-7U.S. Banks Control ##br##The Supply Of U.S. Dollars U.S. Banks Control The Supply Of U.S. Dollars U.S. Banks Control The Supply Of U.S. Dollars Chart I-8U.S. And German ##br##Inflation-Adjusted Interest Rates U.S. And German Inflation-Adjusted Interest Rates U.S. And German Inflation-Adjusted Interest Rates Bottom Line: The pace of supply of dollars beyond the U.S. is falling short of growth in demand for this currency. Typically, this warrants greenback appreciation. Question: What about the U.S. administration's preference for a weaker dollar to improve America's trade position? Won't the greenback depreciate as the Trump administration expresses its desire for a weaker currency? Certainly U.S. officials can verbally influence the exchange rate and drive markets for a (short) period of time. Yet fundamentals and flows will re-assert themselves and the greenback will ultimately appreciate even if its rally is delayed by policymakers. The new U.S. administration intends to run mercantilist policies to create jobs in America and doing so will shrink the current account deficit. Nevertheless, a narrowing U.S. current account deficit ultimately entails diminishing flows of U.S. dollars to the rest of the world, which is bullish for the greenback. In brief, the U.S. administration can delay the dollar rally, but it will not be able to prevent it if and when it shrinks the U.S. current account deficit. This will be enormously deflationary for the rest of the world and ultimately for the global economy. The supply of dollars outside U.S. borders will become even more dearth. As their exports tumble, manufacturing-heavy Asian and European economies will have to run even more stimulative policies - reduce their real interest rates further - to offset such a deflationary shock to their economies. In the case where the Trump administration successfully manages to weaken the U.S. dollar, the ensuing boost to U.S. manufacturing and employment will be mildly inflationary given the already relatively tight labor market. Thereby, trade protectionism or policy-driven currency depreciation, if these occur, will lift U.S. inflation and U.S. interest rates will go up. Rising U.S. interest rates and lower interest rates throughout the rest of the world will propel the dollar's value higher. On the whole, in the case of U.S. trade restrictions, the exchange rates have to adjust to mitigate deflation in the rest of world and cap inflation in America. This ultimately entails a stronger U.S. dollar and weaker currencies abroad. A final note on exchange rates valuation. Based on unit labor costs, the U.S. dollar is not yet expensive (Chart I-9A). The same measure for other currencies is also shown in Chart I-9A and Chart I-9B. Chart I-9AReal Effective Exchange ##br##Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Chart I-9BReal Effective Exchange ##br##Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Financial markets tend to overshoot and undershoot before a major trend reversal. We believe the U.S. dollar is in a genuine bull market and will likely become more expensive before topping out. Bottom Line: The U.S.'s desire to shrink its current account deficit is very deflationary for the rest of the world. Such policies, if adopted in the U.S., will exaggerate the scarcity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. Question: The RMB/USD exchange rate has been stable lately. Does this mean the authorities have reasserted their control over the exchange rate and will not allow it to depreciate? The authorities in China have partial and temporary control over the exchange rate. Ultimately, it will be Chinese households and companies that drive the exchange rate, barring full-out government controls over all export/import transactions, money transfers as well as financial and capital account flows. If mainland households and companies opt to convert a small portion of their liquid savings (deposits at banks) into foreign currency, there is little the authorities can do to defend the RMB, barring a complete closing of balance-of-payments transactions to companies and households. The primary risk to the yuan exchange rate is not currency valuation but an overflow of yuan in the system - i.e., excess supply of RMBs is the main factor that will cause currency depreciation. Unlike U.S. banks, Chinese banks have created too many yuan. Broad money (M2) in China has risen from RMB 48 trillion as of December 2008 to RMB 158 trillion currently - i.e., it has surged by 3-fold. M2 has risen from 150% to 210% of GDP in the past eight years (Chart I-10). In the meantime, the ratio of foreign exchange reserves to M2 has dropped to 14% (Chart I-11). Chart I-10Chinese Banks Have ##br##Created Too Many Yuan Chinese Banks Have Created Too Many Yuan Chinese Banks Have Created Too Many Yuan Chart I-11China: Foreign Reserves Are ##br##Small Relative To Money Supply China: Foreign Reserves Are Small Relative To Money Supply China: Foreign Reserves Are Small Relative To Money Supply The latter ratio implies that if Chinese companies and households decide to convert 14% of their deposits at banks into foreign currencies and the People's Bank of China (PBoC) sells its international reserves to offset it, the latter will simply evaporate. We are not suggesting this will actually happen. The point to emphasize is that mainland banks have created so much money that even the country's US$ 3 trillion foreign exchange reserves are not sufficient to back those deposits up. Chinese households and companies may already be sensing there is too much in the way of RMBs floating around, and intuitively may not trust the currency. They have paid astronomical multiples for real assets like property in China, and have recently been willing to shift assets into foreign currencies/assets. Importantly, the one-year deposit rate at banks is 1.5% in nominal terms but in real terms it has now become negative as inflation has picked up. Chart I-12 (top panel) demonstrates that the deposit rate deflated by core inflation is negative for the first time in the past 10 years. The bottom panel of Chart I-12 shows that the deposit rate deflated by headline CPI inflation is also negative. Interestingly, any time the real deposit rate turned negative in the past, the central bank hiked interest rates. It is impossible to know whether the latest pick up in China's inflation represents a temporary spike or is the beginning of a major and lasting uptrend (Chart I-13). We are surprised by how fast and sharply inflation has risen lately, given the growth improvement has so far been modest. Chart I-12China: Real Deposit ##br##Rates Have Turned Negative China: Real Deposit Rates Have Turned Negative China: Real Deposit Rates Have Turned Negative Chart I-13China: Inflation ##br##Is Rising, For Now China: Inflation Is Rising, For Now China: Inflation Is Rising, For Now The trillion- dollar question is what is the true output gap in China and, correspondingly, whether the latest rise in inflation is genuine and lasting or simply a statistical aberration. No one including Chinese policymakers knows the answers to these very essential questions. What type of adjustment China embarks on depends on monetary policy and banks in China. As and if Chinese banks slow down money creation, economic growth will tumble and deflationary tendencies will resurface. This scenario is good for creditors - households and companies with large amounts of deposits - because deposit rates in real terms will rise again. Yet this is a bad outcome for indebted companies, capital spending and employment. If mainland banks continue to create money at a double-digit pace as they have been doing, inflation will likely become persistent and durable. These dynamics are positive for debtors as real borrowing costs will drop further/stay negative, and growth will hold up. However, in such a case, negative real rates will buttress capital outflows and pressure the value of the RMB. By and large, the Chinese authorities are facing a profound choice: Policymakers can choose to help debtors (indebted companies) by accommodating continuous money supply expansion by banks, i.e., opt for negative real interest rates. The outcome will be much stronger downward pressure on the RMB. The latter will depreciate at a double-digit pace annually in the next several years. They can opt to force the banking system to slow down the pace of money/credit creation. This will lead to some sort of debt deflation. Money growth and inflation will drop and the currency will not be at a risk of major depreciation. Yet, economic growth/profits/employment will tumble. A third choice for the authorities is to resort to full-out government controls over all trade, transfers as well as financial and capital account transactions - i.e., take the country back to socialism. Only in such a case can the authorities control the exchange rate and interest rates simultaneously - i.e., they can inflate the credit bubble away while preventing households from converting their liquid savings into foreign currency. In brief, this entails financial repression, and it will erode the real value of Chinese deposits. It is not clear to us whether this is a politically more viable option than allowing some bankruptcies/layoffs and debt deflation. Besides, this will devastate China's vibrant private sector as businessmen and high-income employees become reluctant to invest and expand as they observe the real value of their savings/wealth decline. Chart I-14U.S. Dollar And Commodities ##br##Prices Unusual Decoupling U.S. Dollar And Commodities Prices Unusual Decoupling U.S. Dollar And Commodities Prices Unusual Decoupling As if there were not enough domestic challenges, Chinese policymakers are also facing a hawkish Trump administration on the issue of trade and the exchange rate. Putting it all together, we conclude it will be extremely difficult for the Chinese authorities to navigate through these challenges. One area where we disagree with many investors is that the Chinese authorities have a viable plan and strategy. Given the above constraints, there are no easy choices and it is hard to know which route the Chinese government will take. The latest bout of stability in the RMB has been due to a notable shutdown in outflows. Yet this is a temporary solution. The inability to convert liquid savings into foreign currency will only make households and companies more set on converting their yuan. Odds are that capital outflows will skyrocket on any relaxation of recent harsh restrictions. Bottom Line: In any country, the monetary authorities cannot simultaneously control the price of money (interest rates), the quantity of money, and thereby the exchange rate. This will prove to be true in China too. We continue betting on further RMB depreciation. Question: Why do you not think this commodities rally has further to go, given supply has been curtailed and demand is picking up as global growth improves? The strength in commodities prices in recent months when the U.S. dollar has been firm is a major departure from historical correlations (Chart I-14). Remarkably, oil forward prices have recently dropped and global energy share prices have relapsed in absolute terms, even though the spot price has held up (Chart I-15). This foretells that the marketplace does not believe in the sustainability of the current spot price level of crude. As to industrial metals, our hunch is that Chinese demand will weaken again as the nation's credit and fiscal impulse relapses (Chart I-16). Besides, the recent resilience in copper has been due to supply disruptions that may be temporary. Chart I-15Has Sell Off In Oil Market Begun? Has Sell Off In Oil Market Begun? Has Sell Off In Oil Market Begun? Chart I-16China's Growth To Peak Later This Year China's Growth To Peak Later This Year China's Growth To Peak Later This Year Notably, hopes that U.S. infrastructure spending - even if such spending turns out to be considerable - will boost demand for industrial metals are misplaced, because the U.S. is a small consumer of metals. China consumes six to seven times more copper, nickel, zinc, aluminum, tin and lead than the U.S. Hence, we view industrial metals as a pure play on China's capital spending. Bottom Line: We expect a combination of a stronger dollar, weaker Chinese growth and elevated oil inventories to produce a major reversal in industrial metals and oil prices. Chart I-17EM Stocks And U.S. ##br##TIPS Yields: Negative Correlation EM Stocks And U.S. TIPS Yields: Negative Correlation EM Stocks And U.S. TIPS Yields: Negative Correlation Question: Is your negative stance on EM contingent on weakness in DM growth? No, our negative stance on EM is not contingent on a relapse in DM growth. Some combination of the following key factors will trigger and drive weakness in EM risk assets: Higher U.S. real rates or a stronger U.S. dollar. Chart I-17 demonstrates the strong negative correlation between higher U.S. TIPS yields and EM share prices in the recent years. Lower commodities prices. Renewed weakness in China's economy. Our negative view on EM has and continues to be driven by our views on EM/China domestic demand/credit cycles, commodities and the U.S. dollar. Investment Conclusions Chart I-18EM/China Plays Are At Critical Juncture EM/China Plays Are At Critical Juncture EM/China Plays Are At Critical Juncture Exchange rates have been critical to financial market dynamics in recent years. This is unlikely to change. Odds favor another upleg in the U.S. dollar and a weaker RMB. As such, the outlook for EM risk assets is poor. EM currencies will be driven by a stronger dollar, a weaker RMB and lower commodities prices. EM share prices as well as global mining, and machinery stocks are at a critical juncture (Chart I-18). China-plays may soon start reacting to the PBoC's recent modest tightening as well as regulatory credit curtailment and begin to sell off in anticipation of weaker growth later this year. Global equity portfolios should continue underweighting EM stocks. Similarly, global credit (corporate bonds) portfolios should underweight EM sovereign and corporate credit. Finally, the outlook for weaker currencies does not bode well for EM local currency bonds. However, for fixed income investors we have several swap rate trades, relative value recommendations and yield curve positions that are published regularly in our Open Position Table on page 16. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to Trilogy of Special Reports on money/loan creation, savings and investment, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and "China's Money Creation Redux And The RMB," dated November 23, 2016, links available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Despite our tactical bullish stance, the cyclical outlook remains firmly negative for the yen, with a 12-month target for USD/JPY above 120. The BoJ is currently committed to an inflation overshoot, with this solid commitment, a strong economy will be able to lift inflation expectations, depress real interest rates, and hurt the yen. The key improvements pointing to higher inflation expectations are: Already positive inflation expectation dynamics, the closing of the output gap, the removal of the fiscal drag, the tightness in the labor market, and the end of the private-sector deleveraging. The tactical environment suggests that nimble traders with short investment horizons should stay short USD/JPY for now. Longer-term investors may want to add to short bets on the yen on further weaknesses. Feature We have espoused a cyclically bearish stance on the yen since September when the BoJ began targeting the price of money instead of the quantity of money, aiming for stable JGB yields around 0%.1 More recently, we have been buyers of the yen on a tactical basis. Here, we are reviewing whether this tactical call should morph into a cyclical bullish stance on the yen or whether the primary trend for the yen still points lower. Ultimately, we expect USD/JPY to punch through 120 on a 12 month basis. The Liquidity Trap Our framework to analyze the yen rests on one key assumption: Japan remains mired in liquidity trap dynamics. As we have pointed out before, the key symptom of this disease is evident in the Land of the Rising Sun: Loan demand has become irresponsive to changes in private sector borrowing costs (Chart I-1). In this environment, we can experience strange dynamics. As we argued in details a few months ago, when both in a liquidity trap and at the lower bound of interest rates, the demand for money is infinite, and interest rates are independent of the level of output in the economy.2 In other words, a decrease in exports, government spending, or investment, hurts demand without affecting nominal interest rates (Chart I-2, middle panel). However, in the long run, decreases in aggregate demand exert downward pressure on prices, and thus, lower inflation expectations today (Chart I-2, bottom panel). The opposite is true for a positive demand shock. Chart I-1The Symptom Of Disease The Symptom Of The Disease The Symptom Of The Disease Chart I-2The Thing That Should Not Be JPY: Climbing To The Springboard Before The Dive JPY: Climbing To The Springboard Before The Dive In this topsy-turvy world, a negative shock to growth, by decreasing inflation expectations, pushes up real interest rates, and thus the exchange rate. Meanwhile, a positive shock increases inflation expectations, pulling down real rates and the exchange rate as well. This is fundamental as USD/JPY continues to trade closely in line with real rate differentials between the U.S. and Japan (Chart I-3). Chart I-3USD/JPY: No Money Illusion Here USD/JPY: No Money Illusion Here USD/JPY: No Money Illusion Here This is even truer now that the Bank of Japan is both trying to keep 10-year JGB yields near 0%, and has promised to keep a very accommodative monetary policy in place until inflation has overshoot the price stability target of an average inflation rate of 2% over the whole business cycle. In other words, the BoJ's inflation target is near symmetrical and monetary policy will only harden once previous inflation undershoots below 2% have been compensated by an extended period of inflation overshoot. Also, we expect the BoJ to stay committed to this policy. Not only does Abenomics remain popular in Japan, but we expect Kuroda to be re-appointed to lead the BoJ. Moreover, the last two members of the policy committee not appointed by Abe will see their terms end in 2017. After this year, the BoJ committee will fully represents Abe's wishes. Under this framework, the key to expect the yen to fall is therefore not valuation, nor the current account outlook - two factors pointing to a higher yen - but whether or not the economy and inflation expectations can improve durably on a cyclical basis. In the next section, we explore the key positive economic developments underpinning our negative JPY stance. Bottom Line: As the BoJ is strongly committed to maintaining an extremely dovish stance until inflation overshoots by a wide-enough margin to compensate for previous undershoots, key economic improvements in Japan should lead to higher inflation expectations, falling Japanese real interest rates, and a much weaker yen. The Five Samurais We see five reasons to remain bearish the JPY: Inflation expectation dynamics, the closing output gap, the disappearance of the fiscal drag, the labor market tightness, and the end of the Japanese private sector's deleveraging. Factor 1: Inflation Expectations Are Already Unhinged Even before the BoJ aggressively targeted 0% JGB yields, Japanese inflation expectations were on an improving path. During the 2012 summer, markets began correctly anticipating the December electoral victory of Shinzo Abe, apprehending that his BoJ was about to massively ramp up quantitative easing. Japanese 5-year/5-year forward CPI swaps soon decoupled from the rest of the world and the U.S. (Chart I-4). Chart I-4The BoJ Policy Has Already Borne Fruit The BoJ Policy Has Already Borne Fruits The BoJ Policy Has Already Borne Fruits Chart I-5The Mechanics Of Price-Level Targeting JPY: Climbing To The Springboard Before The Dive JPY: Climbing To The Springboard Before The Dive So strong has the perceived commitment of the BoJ to higher inflation been that Japanese inflation expectations never tanked the way U.S. ones did after 2014. These dynamics contributed to keep Japanese real rates depressed relative to U.S. ones. Moreover a virtuous circle was created where lower real rates supercharged the USD/JPY's rally, lifting it by more than 60% from 77 in September 2012 to 125 in June 2015, and this further supported Japanese inflation expectations. In the summer of 2015, as EM and commodity prices began imploding on the growing expectation of a Chinese economic hard landing, Japanese inflation expectations did relapse, strengthening the yen rally. But again, unlike in the U.S., Japanese CPI swaps never fell to new lows, pointing to some improving dynamics for the domestic component of Japanese inflation expectation formations. Going forward, we expect Japanese inflation expectations to move further up. The price level targeting mechanism put in place by the BoJ last fall reinforces inflationary dynamics (Chart I-5). Any anticipated tightening in monetary policy in response to economic improvements has been pushed further away in the future, in a world where inflation may be higher locally and globally. Additionally, if global and local inflation rises, because nominal interest rates are pegged at low levels, the increase in inflation expectations puts additional downward pressure on real rates, further stimulating the domestic economy, further weakening the yen, and further boosting inflation expectations. The circuits for positive feedback loops are being laid in place. Factor 2: The Output Gap Based on the OECD's estimates, the Japanese output gap has now moved into positive territory for the first time since 2007-2008, the last episode where Japan experienced anything close to inflation (Chart I-6). Prior to then, the last time the Japanese output gap was as positive as it will be in 2017 was in 1993, among the last years when Japanese core inflation was still above 1%. While this reflects the global phenomenon of low productivity growth, the low level of supply expansion in Japan has been augmented by the 2% decline in the labor force since 1998. This means that the capacity constraints in the Japanese economy are easy to reach even if average real GDP growth has only been 0.8% since 2010. The cyclical improvements in the business cycle only point toward an increasingly positive output gap and rising inflationary pressures. To begin with, business confidence and PMIs are all very robust (Chart I-7). Chart I-6No More Slack In Japan No More Slack In Japan No More Slack In Japan Chart I-7Japanese Businessmen Feel Good Japanese Businessmen Feel Good Japanese Businessmen Feel Good The strength of the U.S. ISM index suggests that Japanese exports have more upside (Chart I-8) as well. Not only does a stronger Japanese trade balance contributes to a larger positive output gap, but also, strong export growth has often been the key precursor to higher capex in Japan (Chart I-8, bottom panel). Finally, the credit dynamics remain supportive. Bank loan growth has not slowed much, despite the large tightening in Japanese monetary conditions in 2016. With conditions now easing in the country, we expect the credit impulse, which has bottomed around the zero line, to re-accelerate going forward, supporting excess demand above potential GDP growth (Chart I-9). Together, all these factors suggest that the improvement in the Japanese shipments-to-inventory ratio witnessed since March 2016 will continue to lift Japanese inflation expectations higher (Chart I-10). Chart I-8Strong Japanese Exports ##br##Will Filter To Capex Strong Japanese Exports Will Filter To Capex Strong Japanese Exports Will Filter To Capex Chart I-9The Japanese Credit ##br##Impulse Will Rebound The Japanese Credit Impulse Will Rebound The Japanese Credit Impulse Will Rebound Chart I-10Upward Momentum In ##br##Japanese Inflation Expectations Upward Momentum In Japanese Inflation Expectations Upward Momentum In Japanese Inflation Expectations Factor 3: Fiscal Policy Another key factor that has hampered the Japanese economy since 2013 has been the large fiscal belt-tightening experience by the country. In the wake of the 2011 Tohoku earthquake, the government primary deficit blew up to 7.7% of potential GDP in 2011. It will hit 3.5% for 2017, but the IMF does not forecast much more narrowing of the government budget gap (Chart I-11). This signifies that the great brake that slowed the Japanese economy and prevented a rise in inflation is being lifted. In fact, we expect the Japanese government deficit to increase again. First, Abe's upper house electoral victory last summer was built on a campaign of larger government spending. Second, with an approval rating of 56% four years into his premiership, Abe remains a highly popular prime minister for a country plagued by 15 changes of government since 1990. This is a vote of confidence by the Japanese public toward his "Abenomics" program. Finally, military spending is likely to increase. As recently as 2005, Japan's and China's defense budgets were the same; today, China outspends Japan by four times (Chart I-12). In an increasingly unstable Asia-Pacific region, where China, Russia, and North Korea are all conducting more independent foreign policy agendas, Japan will be forced to fend for itself with more military spending, underscoring the relatively hawkish agenda of the Abe administration on this front. This will require more spending by Tokyo in this arena. Chart I-11Vanishing Japanese##br## Fiscal Drag Vanishing Japanese Fiscal Drag Vanishing Japanese Fiscal Drag Chart I-12The Geopolitical Imperative To Increase ##br##Japanese Government Spending The Geopolitical Imperative To Increase Japanese Government Spending The Geopolitical Imperative To Increase Japanese Government Spending Factor 4: The tightening Labor Market The Japanese labor market has now become very tight and key supply-side adjustments are behind us. The job-openings-to-applicants ratio stands at July 1991 levels, the last time when Japan was able to generate any durable wage growth. Additionally, the level of participation of women in the labor force is very elevated. The employment-to-population ratio for prime-age females stands at 74%, well above the 71.4% level of the U.S. today, and just as high as the U.S. in 2000, when that ratio was at its highest (Chart I-13). Additionally, despite a shrinking labor force and population, the total number of employed individuals stands at 65 million, the highest level since 1999 (Chart I-14). Hiring growth is also experiencing its most vigorous upswing in 20 years. Unsurprisingly, nominal wages have been growing since 2013, the longest upswing since 2004 to 2006, and wages are now at their highest level since 2009 (Chart I-14, middle panel). Chart I-13The Japanese Labor Market Is Very Tight (I) The Japanese Labor Market Is Very Tight (I) The Japanese Labor Market Is Very Tight (I) Chart I-14The Japanese Labor Market Is Very Tight (II) The Japanese Labor Market Is Very Tight (II) The Japanese Labor Market Is Very Tight (II) With the economy remaining robust, the output gap being closed, and the fiscal drag disappearing, this tightening in the labor-market should lead to additional wage gains in Japan. As the labor market slack dissipates further, we expect Japanese employment growth to slow and wages to accelerate their upward path. It is true that the Japanese labor market duality still constitutes a structural damper on Japanese wages, but for now, the very important positive cyclical factors noted above should overpower this long-term negative. Only with additional reform of the labor market will this duality dissipate structurally. Factor 5: End Of The Private Sector Deleveraging The last factor that has turned the corner in Japan is the evolution of the private sector's deleveraging. Non-financial private debt fell from 220% of GDP in 1994 to 160% of GDP today, after having stabilized since 2009 (Chart I-15). At these levels, the Japanese non-financial private debt to GDP is in line with the worldwide average of 157%, much below China's 210%, as well as below the levels recorded in Canada, Australia, New Zealand or Sweden. This development is key for many reasons. First, since 2011, Japanese households have in fact re-levered, with their debt load rising by 6.5% since their trough. This means that Japanese households are generating demand in excess of their earnings, and are therefore a source of inflation in the country. Second, the end of deleveraging has coincided with an end to the decline in Japanese land prices that has put downward pressure on all prices since 1991 (Chart I-16). Finally, the rising debt load of the Japanese government is no longer just a compensating mechanism for the deficiency in demand created by the private sector's sector deleveraging. In fact, like for households, government dissaving is now purely adding to the aggregate demand of Japan, and at the margin, is inflationary. Unsurprisingly, since 2012, periods of accelerating growth in the Japanese broad money supply have now been associated with periods of weakness in the yen (Chart I-17). This highlights the fact that money creation is now generating some increase in inflation expectations as the private sector is not furiously building its savings anymore and as the Kuroda BoJ is not leaning against inflationary developments. Chart I-15Private Sector Deleveraging Is Over Private Sector Deleveraging Is Over Private Sector Deleveraging Is Over Chart I-16Land Prices Are Not A Source Of Deflation Anymore Land Prices Are Not A Source Of Deflation Anymore Land Prices Are Not A Source Of Deflation Anymore Chart I-17Money Matters Money Matters Money Matters Putting It All Together In our view, in an environment where Japan is beginning to generate domestic inflationary pressures of its own, where the output gap is now positive, where the government is not putting a brake on growth anymore, where the labor market is at its tightest in decades, and where private sector deleveraging is not an handicap anymore, any improvement in global growth is likely to result in further increases in Japanese inflation expectations. Our sister service, Global Investment Strategy is long Japanese CPI swaps, a trade we agree with. In the context of FX, with the BoJ firmly on an easing path, rising Japanese inflation expectations will only depress Japanese real rates, exactly as the Fed becomes more aggressive. As a result, on a 12-18 months basis, the downside for the yen is very large. What About Trump? Chart I-8Japan FDI Profile JPY: Climbing To The Springboard Before The Dive JPY: Climbing To The Springboard Before The Dive President Trump wants to see a lower dollar to achieve his goal of creating manufacturing jobs in the U.S. Much ink has been spilled on the potential emergence of a Plaza 2.0 accord. We disagree. The U.S. has very little leverage to boost the value of the yen. The Bank of Japan's policy is designed to generate domestic inflationary pressures, the yen is only a casualty of this policy. In fact, with inflation expectations having been so low for so long, no country in the world can better justify having a very loose monetary policy setting than Japan. Also, the 97% surge in the yen that followed the Plaza accord of 1985 caused Japanese interest rates to stay too low relative to the state of the economy. As a result, a massive debt bubble ensued that lifted the economy further, but then prompted the bust which Japan still pays for. Today, the Japanese are unlikely to want to repeat the same mistake. While we do think that deleveraging has ended in Japan, a country with a falling population is unlikely to begin a new private-sector debt supercycle either. Finally, China continues to be an economy that saves too much. This means that China can either allocate these savings domestically through the debt market or export them internationally through its current account surplus. We expect Chinese authorities, who are already very worried by the high debt load in China to choose the second option for the next two years. As a result, BCA foresees further declines in the RMB over the next 12 to 18 months. In this environment, the Japanese would find it very difficult to remain competitive in the Chinese market if their currency rises as the RMB weakens.3 That being said, Trump will want some concessions out of the Japanese. Already, the February 10 meeting between the U.S. president and PM Abe is giving us a glimpse of things to come. Japanese non-tariff barriers on U.S. products are likely to decrease, potentially in the agricultural and automotive field especially. Additionally, Japan still runs a large current account surplus and therefore, a large capital account deficit. We expect Japanese FDIs in the U.S. to only grow going forward. The main beneficiary is likely to be the automotive sector as it would be the key mechanism for Japanese firms to avoid paying large tariffs / punitive taxes and still access the vital U.S. market (Chart I-18). Moreover, this fits well within Trump's agenda as it creates manufacturing jobs in the U.S. Call it a win-win situation if you will. Not Time To Close Short USD/JPY Yet Despite this very negative cyclical view on the yen, we remain committed to our tactical short USD/JPY position: For one, positioning on the yen remains too extreme (Chart I-19). Second, as argued by our European Investment Strategy service, we may be on the cusp of a mini down cycle in the credit impulse, suggesting a temporary deceleration in the G10.4 The recent collapse in quarterly credit growth in the U.S. points exactly in this direction (Chart I-20). Because U.S. 10-year bond yields are so tightly linked to global economic surprises, negative surprises could put temporary downward pressure on Treasury yields (Chart I-21). A move lower in yields would be very supportive of the yen, even if only for a few months. Chart I-19Speculators Are Still Too ##br##Short JPY Tactically Speculators Are Still Too Short JPY Tactically Speculators Are Still Too Short JPY Tactically Chart I-20Falling Short-Term Credit##br## Impulse In The U.S. Falling Short-Term Credit Impulse In The U.S. Falling Short-Term Credit Impulse In The U.S. Chart I-21Falling Surprises Can##br## Temporarily Help Bond Prices Falling Surprises Can Temporarily Help Bond Prices Falling Surprises Can Temporarily Help Bond Prices Third, the dollar correction is not over. Sentiment and positioning on the dollar represent tactical hurdles that need to be overcome before the greenback can resume its ascent. Also French OAT / German bunds spreads are at distressed levels, having only been higher at the height of the euro crisis in 2012, and not far off the levels experienced during the ERM crisis of the early 1990s (Chart I-22). This suggests that the risk of a Le Pen presidency is now well known. We agree that the impact of such an event would be enormous, but the 34.5% odds currently assigned to it on Oddschecker are too great, especially now that Bayrou - a centrist politician - is not entering the race and putting his support behind Macron. Finally, the dollar has followed a textbook wave pattern since October. A continuation of this pattern suggests that the DXY has downside toward 97-98 (Chart I-23). Chart I-22OAT / Bund Spreads Price In A Lot Of Negatives OAT / Bund Spreads Price In A Lot Of Negatives OAT / Bund Spreads Price In A Lot Of Negatives Chart I-23A Textbook Wave Pattern In The Dollar A Textbook Wave Pattern In The Dollar A Textbook Wave Pattern In The Dollar The ultimate factor in favor of the continuation of the yen correction is the higher degree of complacency that has settled globally. Our Global Complacency indicator, based on the G10 stock-to-bond ratio, commodity prices, and the VIX is at an extremely elevated level warning of a potential risk-off event globally. Any rollover in this very mean-reverting indicator would prompt a further weakness in USD/JPY as well as AUD/JPY, especially if the BoJ doesn't increase stimulus in the meantime (Chart I-24). Chart I-24AUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Unless The BoJ Eases Further, Too Much Complacency Equals Tactically Long JPY Unless The BoJ Eases Further, Too Much Complacency Equals Tactically Long JPY Chart I-24BUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Unless The BoJ Eases Further, Too Much Complacency Equals Tactically Long JPY Unless The BoJ Eases Further, Too Much Complacency Equals Tactically Long JPY Bottom Line: Tactical investors should continue shorting USD/JPY for the moment. More cyclical players can begin deploying capital to short the yen as the cyclical outlook for this currency remains dire, but better opportunity to sell this currency are likely to emerge over the coming months. A dollar-cost averaging strategy seems wise at this point. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see the Foreign Exchange Strategy Weekly Report, "How do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016, available at fes.bcaresearch.com 2 Please see the Foreign Exchange Strategy Weekly Report, "Down The Rabbit Hole", dated April 15, 2016, available at fes.bcaresearch.com 3 For a more detailed discussion on the RMB, please see the Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?", dated February 24, 2017, available at gis.bcaresearch.com 4 For a more detailed discussion of the mini-cycle, please see the European Investment Strategy Weekly Report, "Slowdown: How And When?", dated February 2, 2017, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The U.S. economy is giving a green light to the Fed to hike. Headline CPI is at 2.5% annually, and core CPI is at 2.3%; Retail sales beat expectations at 0.4% MoM; The core CPI measure is evidence that the U.S. economy is fundamentally strong and dynamic. Real GDP now stands 11% above its pre-recession peak, and it is approaching the Congressional Budget Office's estimate of potential output. The unemployment and output gap are also close to their long-term levels. With the economy closing in on its potential, it is only natural that FOMC participants "expressed the view that it might be appropriate to raise the federal funds rate again fairly soon" in the Minutes. Although a risk of disappointment from Trump's fiscal proposal is possible, the economy's momentum will continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro area remains robust, with this week's data showing a strong outperformance: German, French and overall euro area PMI increased and beat expectations across all measures, with the exception of France which only outperformed on the Composite measure; Euro area producer prices strengthened to a 2.4% annual pace; After seeing some downside from worries about a Le Pen victory, markets have calmed François Bayrou, a centrist, announced an alliance with presidential candidate Emmanual Macron, adding a resistance to the euro's downside. Substantial volatility can still be expected, however, as a Le Pen victory is not completely out of the realm of possibility, which means that the euro can see some weakness in the near term. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Positive signs continue to emerge in Japanese data: Industrial production yearly growth came in at 3.2% Nikkei Manufacturing PMI came in at 53.5, outperforming expectations Japan's Leading Economic Index came at 104.8, the highest level since 2015 These economic developments are good news for the BoJ, as it shows them that their price level targeting and yield curve control measures seem to be working. However the objective of these measures is not to achieve these marginal improvements in the economy. The objective is to catapult Japan out of the liquidity trap it is in, which means that these measures will likely stay in place for a while. Therefore, on a cyclical basis we remain short the yen, as we expect USD/JPY to reach 120 on a 12 to 18 month horizon. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data has painted a mixed picture for the U.K. Industrial and manufacturing production yearly growth came in at 4.3% and 4% respectively. Both measures blew past expectations. Also, in spite of the dramatic fall in the pound, Inflation seems to be relatively contained, as both core and headline numbers came in below expectation at 1.8% and 1.6% respectively. However not everything is good news. Yearly growth for retail sales and retail sales ex fuel underperformed expectations coming at 1.5% and 2.6%, respectively. Additionally, wage growth has been limited, as average weekly earnings yearly growth came below expectations at 2.6%. We continue to be bullish on the pound, particularly against the euro as any additional political risks caused by Brexit are now well known by participants, making the pound very cheap, especially if one takes into account real rate differentials. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD has been the top performing currency against the USD out of the G10, having appreciated 7.11% since the beginning of the year. This rally is increasingly tenuous. Full-time employment has struggled to pick up, while part-time employment increased by 4%. This will hamper wage growth and consumption going forward. This is important as consumption is already 58% of the economy. Meanwhile, net exports have made a negative contribution to GDP growth for almost two years. In fact, Australian exports to China subtracted 1% of GDP growth last year, due to a decline in commodity prices. Going forward, a limited upside in commodity prices and an end to the Chinese easing cycle can exacerbate this decline. On a technical basis, AUD/USD has sustained momentum since the beginning of the year, with the RSI displaying overbought levels since mid-January. The cross is also approaching a key resistance level, pointing to growing risks ahead. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data for New Zealand has not been particularly positive and have weighed on the kiwi: Retail sales underperformed, growing by 0.8% QoQ against expectations of 1.1%. Business NZ PMI fell to 51.6 from last month's 54.5. Nevertheless, a closer look at the data paints a much brighter picture: the decline in NZ PMI seems to have been primarily due to bad weather conditions, which means that the strong fundamentals of the kiwi economy should show up in the data once seasonal factors start to dissipate. Therefore, we are bullish on the NZD versus the AUD, as the structural backdrop for these countries could not be further apart, yet the market is now pricing less than a 10 basis points difference from here until the end of the year. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian employment numbers came out seemingly strong, with a net change in employment of 48,300 and a decrease in the unemployment rate to 6.8%. However, these numbers mask numerous underlying inconsistencies. The decrease in unemployment was the result of a robust part-time employment growth of 5.6%, not the 0.3% growth in full-time employment. Wage growth remains subdued, with average hourly earnings of permanent workers currently increasing at a 1% annual pace, compared to 3.3% a year ago. Furthermore, hours worked have declined by 0.8%, exacerbating the weakness of full-time employment's contribution to activity. Retail sales underperformed expectations, contracting at a 0.5% monthly pace; the measure excluding Autos also contracted at a 0.3% pace. Increasing household debt and festering labor market complications are likely to weigh on consumer confidence. An uncertain outlook on trade developments is an additional handicap to future CAD strength. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 During the last couple of weeks, fear of a Eurosceptick government in Europe's second biggest economy, has lowered EUR/CHF below the implied floor that the SNB has had for the last couple of years. Indeed, last week, as La Pen surged on French presidential polls, this crossed reached 1.063, its lowest level since August 2015. This is bad news for Switzerland, as economic data continues to indicate that the country has not been able to shake off the shackles of deflation: Headline inflation outperformed expectations as it finally exited deflationary territory, coming in at 0%. Industrial production contracted by 3.3% on a year on year basis Given this deflationary backdrop, the SNB will continue to try to limit the downside for this cross. However, on the months leading to the French elections, the floor will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Inflation seems to be abating in Norway as core and headline inflation numbers fell sharply from last month reading, coming in at 2.1% and 2.8% respectively. This is the result of various factors: First, the inflation caused by the collapse of the krone is starting to fade away. From 2014 to 2016, the krone collapsed along with oil prices. This selloff in the krone passed through inflation to the Norwegian economy via rising imported goods, with a lag. Today, roughly one year after the NOK bottomed, the effects of the currency on inflation is starting to dissipate. Furthermore, labor market dynamics in Norway are anything but inflationary as wage growth is contracting by 4% and although unemployment is low, the Norges Bank has pointed out that is in largely caused by a fall in the participation rate. Thus, given that high inflation is receding, the Norges Bank will keep its easing bias for the time being. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The February 2017 Monetary Policy Statement illustrated a clear dovish stance. Governors and economists at the Riksbank are paranoid about risks emanating from a strong currency and political developments. Tensions from a recently strong SEK have created worries about a potential slowdown in inflation. The Bank has therefore reiterated the possibility of an intervention if the Krona's appreciation is too rapid, making it a very real possibility. A questionable political outlook from the U.S. and the euro area has further hampered the Riksbank's optimism. The euro area is a particular risk since it represents a large source of Sweden's growth, and any damage to the monetary union will have a catastrophic effect on Sweden. Because of these reasons, the Riksbank explicitly stated that it is "still prepared to make monetary policy more expansionary if the upward trend in inflation were to be threatened and confidence in the inflation target weakened." Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Price inflation is paradoxically deflationary for European consumers, because there is no feedthrough from price inflation to wage inflation. Whenever price inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession. The same is true in the U.K. Do not expect a structural sell-off in high-quality bonds. Go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250. Feature We have a love-hate relationship with inflation. Love, if the inflation refers to our wages. Hate, if the inflation refers to our weekly grocery bill. Put another way, inflation is good for our purchasing power when wages are going up faster than prices; it is bad when prices are going up faster than wages. Unfortunately, recent inflation has been unequivocally bad for European purchasing power. Through the past 7 years, euro area nominal wages have been growing at a remarkably steady 1-2% clip. Whereas price inflation has swung between -0.5% and 3% (Chart I-2). Therefore, whenever price inflation has stayed close to 0% (the true definition of price stability), real wages have grown very healthily. But whenever inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession (Chart of the Week). Chart I-1The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession Chart I-2Nominal Wages Have Been Growing At A Remarkably Steady 1-2% Nominal Wages Have Been Growing At A Remarkably Steady 1-2% Nominal Wages Have Been Growing At A Remarkably Steady 1-2% The same is true in the U.K. There has been no feedthrough from price inflation to wage inflation (Chart I-3 and Chart I-4). If anything, an inverse relationship has existed. Hence, whenever inflation has declined, it has boosted real wages. And whenever inflation has risen, it has choked real wages (Chart I-5 and Chart I-6). Chart I-3Very Little Connection... Very Little Connection... Very Little Connection... Chart I-4...Between Price Inflation And Wage Inflation ... Between Price Inflation And Wage Inflation ... Between Price Inflation And Wage Inflation Chart I-5When Price Inflation Has Declined,##br## It Has Boosted Real Wages When Price Inflation Has Declined, It Has Boosted Real Wages When Price Inflation Has Declined, It Has Boosted Real Wages Chart I-6When Price Inflation Has Increased,##br## It Has Choked Real Wages When Price Inflation Has Increased, It Has Choked Real Wages When Price Inflation Has Increased, It Has Choked Real Wages Households Dislike 2% Price Inflation An argument we frequently hear is that highly indebted economies need higher inflation to 'inflate away their high debts'. But this logic only works if inflation is boosting the incomes of those burdened with the high debt, such as households. The problem, as we have just seen, is that there has been very little connection between the price inflation that central banks are targeting and the wage inflation that eases households' debt burdens. To its credit, the Bank of England recognises this paradox. "Continued moderation in pay growth and higher import prices following sterling's depreciation are likely to mean materially weaker household real income growth over the coming few years" 1 Inflation is ultimately a transfer of resources from those paying the higher prices to those receiving them. In a closed economy, the winners and losers might balance out. However, Europe is a large net importer of food and energy, whose demand is inelastic and whose prices are denominated in dollars. Therefore, currency weakness transfers resources from domestic consumers to foreign producers. As the BoE goes on to say: "Over the next few years, a consequence of weaker sterling is that the higher imported costs resulting from it will boost consumer prices... and the hitherto resilient rates of household spending growth will slow as real income gains weaken." Exactly the same dynamic applies to the euro area as a consequence of the weaker euro. The difference is that sterling's Brexit-induced slump was out of the BoE's control, whereas the euro's weakness is a direct consequence of the ECB's extreme and experimental monetary easing. The ECB is keen to tell us about the benefits of its extreme monetary easing; it is less keen to tell us about the costs. However, we believe that the benefits have diminished while the costs are rapidly rising. And absent a major shock, the ECB should end its risky experiment. What's Up With Wage Growth? The intriguing question is: why has there been little connection between price inflation and wage inflation? The BoE observes that pay growth has remained persistently subdued by historical standards - strikingly so in light of the decline in the rate of unemployment to below 5%. This outcome is likely to reflect a substantial decline in the 'equilibrium unemployment rate', the point at which wage pressures start to bubble up. The explanation comes from the type of jobs created in recent years. ECB research points out that the dynamics of wages not only reflect changes in wages at the individual level, but are also influenced by changes in the composition of employment. "The structure of recent employment creation may have contributed to low wage growth in the euro area. Since the second quarter of 2013, employment creation in the euro area has been stronger in sectors associated with relatively lower wage levels and wage growth rates. This employment composition effect puts a drag on average wage growth." 2 Automation and Artificial Intelligence (AI) are major drivers of this composition effect. Moreover, as we argued in The Superstar Economy: Part 2,3 the effect has much further to run. "Many of the jobs that AI will destroy - like credit scoring, language translation, or managing a stock portfolio - are regarded as skilled, have limited human competition and are well-paid. Conversely, many of the jobs that AI cannot (yet) destroy - like cleaning, gardening, or cooking - are relatively unskilled and are low-paid." With well-paid jobs being displaced by low-paid jobs, job creation itself might still seem very healthy and the unemployment rate might be falling to levels associated with 'full employment' - prompting some people to warn that wage inflation is about to take off. Except it won't, for two reasons: first, the AI-displaced formerly well-paid workers are downshifting to lower-paid work; second, the added supply of labour competing for the lower-paid work keeps a lid on the wages for that lower-paid work. In the U.S., the Federal Reserve Board of San Francisco points out that: "As long as employers can keep their wage bills low by replacing or expanding staff with lower-paid workers, labour cost pressures for higher price inflation could remain muted for some time." 4 A further point is that if employment creation is in jobs with lower wages, wage growth, and job security, then it will also constrain credit growth. Lacking income growth or security, households will be unwilling to borrow and banks will be unwilling to lend. Absent strong credit growth, we subscribe to a monetarist conclusion: a generalised and sustained inflation - a wage-price spiral - cannot take hold. Some Investment Considerations For the foreseeable future, there will be little feedthrough from price inflation to wage inflation. So whenever price inflation picks up - as is now happening in the U.K. and the euro area - it will choke real wages. Therefore paradoxically, price inflation will be deflationary for European consumers. This will prevent a structural sell-off in high-quality bonds. For a U.K. equity portfolio at this juncture, it means tilting towards international exposure. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250 - especially given that sterling could come under renewed pressure after the U.K. formally files for its divorce from the EU (Chart I-7). For a broader European equity portfolio, prefer non-financials over financials. A very easy way to implement this is to go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50 (Chart I-8). Chart I-7Overweight The International Dollar-Earning ##br##FTSE100 Versus The FTSE250 Overweight The International Dollar-Earning FTSE100 Versus The FTSE250 Overweight The International Dollar-Earning FTSE100 Versus The FTSE250 Chart I-8Overweight The Broad Eurostoxx600##br## Versus The Bank-Heavy Eurostoxx50 Overweight The Broad Eurostoxx600 Versus The Bank-Heavy Eurostoxx50 Overweight The Broad Eurostoxx600 Versus The Bank-Heavy Eurostoxx50 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the Bank of England Monetary Policy Summary and minutes of the Monetary Policy Committee meeting on February 1, 2017. 2 From the ECB Economic Bulletin, Issue 3 / 2016: Recent wage trends in the euro area. 3 Published on January 19, 2017 and available at eis.bcaresearch.com 4 From the FRBSF Economic Letter March 7, 2016: What's Up with Wage Growth? Fractal Trading Model* This week's recommendation is a commodity pair-trade: long tin / short copper. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long Tin / Short Copper Long Tin / Short Copper * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations