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

Highlights Chart of the WeekCopper Term Structure, Inventories##br## Are Not Reflecting Scarcity Copper Term Structure, Inventories Are Not Reflecting Scarcity Copper Term Structure, Inventories Are Not Reflecting Scarcity Transitory supply disruptions and financial demand have kept copper prices buoyant, but these influences will wane. A surge in inventories (Chart of the Week), coupled with slower Chinese demand growth as reflationary policies wind down, will prevent a sharp rally in copper prices. A stronger USD also will weigh on base metals in general, copper in particular. Energy: Overweight. We continue to expect oil inventories to draw throughout the rest of this year and next and are positioned for a backwardated forward curve in WTI. We are adding to our long Dec/17 vs. short Dec/18 WTI spread, which, as of our Tuesday mark to market, is up 183.33% since it was elected on Mar 13/17, and going long Dec/17 Brent vs. short Dec/18 Brent position basis tonight's close, as a strategic position. We also are adding a tactical position in WTI, buying $50/bbl calls vs. selling $55/bbl calls for July, August and September delivery basis tonight's close. Base Metals: Neutral. We remain neutral base metals longer term. Transitory supply disruptions in copper markets will subside, while reflationary stimulus in China will wane, keeping a lid on prices near term (see below). Precious Metals: Neutral. Gold rallied 3.7% following the Fed's rate hike last week. We expect this to reverse as the Fed ratchets up its hawkish rhetoric. Our long volatility position in gold - i.e., long a June put spread vs. long a June call spread - is down 27.5%, following the post-FOMC meeting rally. Ags/Softs: Underweight. We remain bearish, and are comfortable on the sidelines going into the month-end planting-intentions report from the USDA. Higher output of corn and beans in South America and a well-supported USD keep us bearish. Feature Actions taken by Chinese policymakers to slow the property market, wind down reflationary policies, and resume the pivot to services- and consumer-led growth will be critical to the evolution of copper demand, hence prices. Near term, we expect transitory supply disruptions in key mines in Chile, Peru and Indonesia will be addressed, and ore output will be restored. A stronger USD will present a headwind to copper demand, and will lower local production costs in Chile, Peru, Indonesia and elsewhere. Supply And Demand Shocks In the short-term (i.e. 2-3, months), copper prices should remain supported by the disruptions at Escondida in Chile, Grasberg in Indonesia, and more recently at Peru's biggest mine, Cerro Verde. Additionally, flooding in Peru is disrupting copper mining and transport operations beyond Cerro Verde, forcing the declaration of force majeure. BHP Billiton's third meeting with union officials at its Escondida mine failed to end to the strike. This is the world's largest mine - producing ~ 1.1mm MT/yr, or 5% of world supply. Escondida hasn't produced any copper since the strike began on Feb 9/17. This has reduced Chilean copper output 12% yoy as of February, and reduced Chile's GDP by ~ 1%. Unions this week showed interest in resuming talks with management, however. A settlement between PT Freeport Indonesia (PT-FI) and the Indonesian government re export permitting for Grasberg output has yet to materialize. PT-FI produced ~ 500k MT last year. As of this week, PT-FI restarted producing around 40% of its capacity. Lastly, strike action at the Cerro Verde mine is set to end today by order of the Peruvian government, but union officials said the strike would resume Friday if no agreement is reached with management. Cerro Verde produced ~ 500k MT of copper last year; the mine currently produces 50% of its capacity, after replacement workers were hired by the company. The lost output of these three mines accounts for ~ 10% of the global copper mine output. These developments clearly represent a transitory, albeit unexpected, supply shock with effects that should start to dissipate as these issues are resolved. It is worthwhile noting that copper is trading lower in the wake of this news, suggesting markets either prepared for labor action ahead of time - building precautionary inventories ahead of the labor-contract negotiations now underway - or that demand growth is slowing. We think a combination of both likely explains the price weakness following the transitory supply disruptions noted above. On the demand side, any optimism about rising copper prices due to an expected $1 trillion fiscal package in the U.S. is misplaced. Indeed, increased U.S. infrastructure spending - a largely unknown demand-side factor in terms of its details and dimensions - does not figure prominently in our assessment of future copper and based metals prices. The U.S contribution to global copper demand, and to base metals consumption in general, remains limited and has been decreasing in the last decades. U.S. copper demand now represents ~ 7.5% of world copper demand. Therefore, the U.S. market has a relatively small influence on copper prices compared to China, which accounts for close to 50% of global demand (Chart 2A and Chart 2B). Chart 2AU.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China Chart 2B U.S. Copper Consumption Pales Relatively To China U.S. Copper Consumption Pales Relatively To China We believe recent run-up in copper prices mainly was due to financial demand rather than physical demand (Chart 3). This elevated demand from financial investors could elevate price volatility, as any new fundamental information that provokes a sudden change in the copper outlook - e.g., faster restart to once-sidelined production, say, at Glencore's Katanga Mining facilities in the DRC, which are scheduled to be back on line later this year and next - could lead to an exodus of investors out of their long positions. Copper ETF holdings and copper open interest have been elevated in past weeks, and can have a significant effect on the evolution of copper prices (Chart 4).1 Prices have started to trend lower, a development that bears watching, given the still-high speculative holdings of the red metal. Chart 3Speculators Are Exiting Copper, ##br##Even As Supply Disruptions Mount Speculators Are Exiting Copper, Even As Supply Disruptions Mount Speculators Are Exiting Copper, Even As Supply Disruptions Mount Chart 4China PMI Vs. Copper Net Speculative Positions: ##br##Spec Positioning Matters For The Red Metal China PMI Vs. Copper Net Speculative Positions: Spec Positioning Matters For The Red Metal China PMI Vs. Copper Net Speculative Positions: Spec Positioning Matters For The Red Metal Global Copper Fundamentals Keep Us Neutral Looking at the next 6 to 12 months, we see no clear evidence to be bullish copper given supply-demand fundamentals. On the supply side, Australia's Department of Industry, Innovation and Science (DIIS) estimates mine output will be up 3.1% this year to 21mm MT - roughly in line with our estimates - and 4.1% next year to 21.8mm MT. Refined output hit a record high of almost 23.6mm MT last year, and is expected to increase 2.5% next year to 24mm MT. By 2018, the DIIS expects refined output to be up 4%, at 25mm MT. Large production gains were reported by the International Copper Study Group (ICSG) for Peru, where mine output was up 38% at 650k MT last year, offsetting lower mine production in Chile, where output was down 3.8% to 220k MT. Global production estimates by the DIIS for 2016 were in line with ICSG estimates for both mine production and world refined production. The ICSG estimates were released earlier this week. Global demand was up 3% last year at 23.4mm MT, and is expected to increase 2% this year to 24mm MT and 3% next year to 24.6mm MT, based on DIIS's estimates. These estimates also are in line with the ICSG's assessment of global sage. The ICSG estimated global demand last year was up ~ 2%. As is apparent, global supply and demand for copper have been, and will remain, relatively balanced this year and next (Chart 5).2 This will be supported by countervailing fundamentals: Global economic activity is picking up, especially in the manufacturing sectors of major economies, which will be supportive for copper prices (Chart 6); and, running counter to that, A strong USD, coupled with inventories at close to 3-year-high levels, will keep copper prices from escalating dramatically.3 Chart 5Global Copper Market Is Balanced Global Copper Market Is Balanced Global Copper Market Is Balanced Chart 6Global Growth Synchronization Is Underway Global Growth Synchronization Is Underway Global Growth Synchronization Is Underway China's Reflationary Policies Will Wind Down While reflationary policies launched over the past couple of years will continue to stimulate the Chinese economy in 2017, the fiscal and monetary impulses from them are waning. China's manufacturing sector, fixed-asset investment and the property sector are expected to stay strong during the first half of the year, which will support copper demand (Chart 7). However, this stimulus is winding down, and, following the 19th National Congress of the Communist Party in the autumn, we expect it to decline at a faster pace: These lagged effects of the wind-down of fiscal and monetary stimulus will be apparent - particularly in the property markets. Policymakers likely will reduce and re-direct policy stimulus to support consumer- and services-led growth, and continue to invest in the country's electricity grid, which accounts for about a third of China's copper demand. Net, demand likely will grow, but at a slower pace. Global copper inventories are now at an elevated level, which suggests there is no alarming scarcity in the market. This is corroborated by the contango observed in the copper futures market (Chart of the Week). An important takeaway from last week's People's Congress is that the main objective of Premier Li's work plan is to maintain economic and social stability. This primary objective is now more important than the Communist's Party's growth objective, and can be seen in the lower GDP growth target approved by policymakers (6.5%) going forward. The Chinese fiscal impulse already has started to roll over - government expenditures are now growing at a rate of close to 7.5% versus a peak of 29% in Nov/15 (Chart 8). This poses a risk to the downside for base metals prices, given that much of China's base-metals demand is dependent on government expenditures. Chart 7Fixed Asset Investments Are Resilient Fixed Asset Investments Are Resilient Fixed Asset Investments Are Resilient Chart 8Expansionary Chinese Fiscal Policy Is Slowing Down Expansionary Chinese Fiscal Policy Is Slowing Down Expansionary Chinese Fiscal Policy Is Slowing Down Chart 9China Might Have Reached A Sustainable Growth Path China Might Have Reached A Sustainable Growth Path China Might Have Reached A Sustainable Growth Path That said, recent data from China showing resilient industrial activity and fixed-asset investments despite the roll-over in government expenditures gives hope the economy reached a sustainable growth path and that it will stay buoyant throughout the year (Chart 9). China's Red-Hot Property Market Will Cool China's housing sector has, since the economy's liberalization in the late 1990s, grown into one of the most important drivers of its GDP. Most of the 2002 - 2010 increase in base metal prices - nearly 85% - can be explained by the spectacular growth in the Chinese housing sector.4 Building construction accounts for close to 45% of total copper consumption in China (Chart 10). Within that, residential construction makes up 70% of China's real estate investment, according to Australia's DIIS.5 Globally, China accounts for a third of the copper used in construction, according to the CME Group.6 This equates to ~ 10% of global copper usage. Chart 10Building Construction Is Crucial For Copper Demand Copper's Price Supports Are Fading Copper's Price Supports Are Fading In 2016, the Chinese real estate sector experienced extremely high growth, which was mainly fueled by easy access to credit, interest-rate cuts, easing of mortgage rules and an income effect from reflationary policies. This tendency reversed in late 2016 - early 2017, as can be seen in Chart 11. Looking forward, the evolution of the housing market will rely heavily on the policy path taken by the Chinese government. In the second half of 2016, the high level of speculative demand apparent in the property market red-flagged Chinese authorities that a price bubble was developing, producing an inflated debt load that posed a risk to future economic growth. President Xi repeatedly affirmed that China's priority going forward will be to keep the economy stable. This implies keeping the property market stable by nudging investment behavior and expectations to control the supply-side of the market. This is reflected in President Xi statement: "houses are for living in, not for speculating" during the recent Peoples Congress.7 Chinese authorities will maintain loan restrictions and stricter selling conditions implemented late last year, for first- and second-tier cities, where prices increased dramatically. First-tier newly constructed residential building prices were up on average by 18% year-on-year in February 2017, and the National Bureau of Statistics of China's sales price index of residential buildings in 70 large and medium-sized cities was up 11.3% in 2016. For other cities - where home inventories are still elevated and prices are relatively stable - the government could keep its facilitating policies in place, to encourage consumption and to draw down inventories of unsold homes. These developments will introduce downside risk to copper prices, given the importance of Chinese residential construction. Still, the Chinese government cannot allow real estate prices to drop suddenly, or even to slow too much, given that housing remains the main savings vehicle - directly or indirectly - for households. According to Xi and Jin (2015), Chinese citizens save around 70-80% of their wealth via the property market. It is true that financial innovation and the opening of Chinese financial markets should help households save using alternative strategies. However, changing households' savings behavior is not an instantaneous process. Moreover, we believe reflationary policies in other sectors of the economy will remain accommodative during the first half of the year, as headline and core inflation are still at relatively low levels (Chart 12). And, as mentioned previously, we expect continued investment in China's power grid, which will support copper prices this year and next. As the consumer economy grows, we would expect demand for electricity to continue to grow. Chart 11China's Property Market Peaked In 2016 China's Property Market Peaked In 2016 China's Property Market Peaked In 2016 Chart 12Inflation Close To Six-Year Lows Inflation Close To Six-Year Lows Inflation Close To Six-Year Lows Bottom Line: Combining these opposing effects, Chinese demand should remain high enough to maintain copper prices at a relatively stable level in 2017. However, following the 19th Communist Party later this year, we expect reflationary stimulus to wind down and for fiscal and monetary policy to be directed to supporting consumer- and services-led growth, which is less commodity intensive than heavy industrial and investment-led growth. We strongly believe the Communist Government will strengthen its focus on stronger enforcement of environmental regulations, which will introduce new supply-demand dynamics to the copper market. We will be exploring the "greening" of China in subsequent research, and its implications for base metals demand. Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We found that year-on-year variations in copper prices and in speculative long open interest exhibit a feedback loop - there is two-way Granger causality between them (i.e., they are endogenously related and each of their lagged values explain variation in the other's current price). The causality is stronger from copper prices to speculative long open interest; however, it also is significant the other way around. This means that in period of high speculative interest in copper - similar to what we experienced following the U.S. presidential election in late 2016 - the open interest variable is actually driving copper prices in the short term. We have also been able to explain copper prices by modeling year-on-year percentage change in the broad U.S trade-weighted index (TWI), Chinese PMI and in speculative long open interest. We find a 1% increase in the yoy speculative long open interest leads to a 0.19% increase in yoy copper prices. The adjusted R2 of the regression is 0.84. 2 The ICSG estimated there was a 50k MT deficit last year, trivial in a 23.4mm MT market. 3 We estimated the long-term relationship between copper prices, china PMI, world copper consumption and the U.S. TWI using a cointegrating regression. Interestingly, we found that, in equilibrium, a 1% increase in the China PMI variable translates to a 1.17% increase in copper prices. This relation can obviously be thrown out of equilibrium following an exogenous shock to the fundamentals of any of the variables in the model. The adjusted R2 of the regression is 0.71. 4 Please see "The Evolution of The Chinese Housing Market and Its Impact on Base Metal Prices," published by the Bank of Canada, March, 2016. It is available at http://www.bankofcanada.ca/wp-content/uploads/2016/03/sdp2016-7.pdf. Using an approach that accounts for the uncertainty around the official data, the lack of consistency in the data and the high level of seasonality and volatility in the data, the authors concluded that the Chinese GDP would have been around 9% lower at the end of 2010 in a scenario in which the housing market did not grow after 2002. Following this, they estimated two vector-error-correction models (VECM), one with the actual level of global activity, and one where the Chinese activity is 9% lower. 5 Please see "China Resources Quarterly" published by Australia's DIIA. It is available at https://industry.gov.au/Office-of-the-Chief Economist/Publications/Documents/crq/China-Resources-Quarterly-Southern-autumn-Northern-spring-2016.pdf 6 Please see "Copper: Supply and Demand Dynamics," published by the CME Group January 27, 2016. 7 Please see "Xi says China must 'unswervingly' crackdown on financial irregularities" published by Reuters. It is available at http://ca.reuters.com/article/businessNews/idCAKBN1671A0 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights U.S. Treasuries: The surprisingly positive response from financial markets to last week's Fed rate hike should force the Fed to quickly shift back to a hawkish bias. Maintain an underweight exposure to U.S. Treasuries, and an overall below-benchmark portfolio duration stance. Bearish Fed Trade: As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade low-beta Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Feature Chart of the WeekAre Central Banks OK With This? Are Central Banks OK With This? Are Central Banks OK With This? The major central banks all had a chance to send a more hawkish message to the markets in the past couple of weeks, and every one took a pass. Even the Fed, who actually hiked rates, signaled that U.S. monetary policy would not be tightened more aggressively than previously planned, which financial markets took very bullishly. With the global economy finally enjoying a synchronized upturn after several years of sluggishness, policymakers are showing no interest in hitting the brakes too hard, too soon and risking a sudden downturn in growth The current backdrop of improving economic momentum, with central banks remaining accommodative, is sustaining the strong performance of growth-sensitive assets like equities and corporate debt over government bonds. This should continue over the next 6-12 months. Inflation rates, both realized and expected, continue to rise across the developed economies alongside faster economic growth, putting upward pressure on government bond yields (Chart of the Week). Central bank dovishness is looking increasingly non-credible as long as this dynamic persists, but policymakers will likely be slow to respond without a more rapid rise in inflation. Bond yields will continue to climb higher against this backdrop, first from continued increases in inflation expectations and, later, from a shift to less restrictive monetary settings. We continue to recommend a below-benchmark duration stance, while underweighting government bonds versus corporate debt, particularly in the U.S. This week, we are making a significant portfolio shift to get even more defensive within our government bond allocation, upgrading low-beta Japan to above-benchmark while downgrading core Europe (Germany, France & the Netherlands) to neutral. The Fed Declares Victory Over "Low-flation" The market response to last week's Fed tightening was consistent with the idea of a "dovish hike", with U.S. equity and bond markets rallying while the U.S. dollar sold off and overall U.S. financial conditions actually easing. There was heightened nervousness heading into the meeting that the Fed could signal a faster or steeper trajectory for interest rates. That turned out to be a false alarm, as not much was changed from the Fed's prior guidance to markets. The range for the funds rate was raised to 0.75-1.00%, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50bps of increases are expected this year, with 75bps in both 2018 and 2019 (Chart 2). This would bring the funds rate to 3% in 2019, which is the median FOMC member's assessment of where the terminal rate lies. The pricing from the U.S. Overnight Index Swap (OIS) curve shows that market expectations for the funds rate are in line with the Fed's projections for this year, but lower for the next two years. Our proxy measure for the market's assessment of the terminal rate - the 5-year OIS rate, 5-years forward - sits at 2.25%, 75bps below the Fed's number. Our bias is closer to the market on this point, as we do not see a need for the funds rate, in real terms, to end this tightening cycle much above 0% against a backdrop of still very high U.S. debt levels and low U.S. productivity growth. A 0% real funds rate would be the result of the Fed successfully getting U.S. inflation expectations back to its 2% target level, with a nominal funds rate of 2%. That inflation goal has not yet been reached, however, as inflation expectations are still below levels consistent with the Fed's inflation target (Chart 3, bottom panel). Chart 2FOMC & Market Disagree Beyond This Year FOMC & Market Disagree Beyond This Year FOMC & Market Disagree Beyond This Year Chart 3Few Signs Of An Overheating U.S. Economy Few Signs Of An Overheating U.S. Economy Few Signs Of An Overheating U.S. Economy The FOMC has made it clear that they believe the U.S. economy is running very close to full employment. Yet the recent modest deceleration in the various measures of wage inflation (middle panel) suggests that there could still be some excess slack in the U.S. labor market - even with the recent Payrolls reports showing job growth of over 200k per month. If that pace is sustained for several months, however, the unemployment rate will likely fall further and wage pressures will intensify. In the near-term, the Fed will continue to focus on financial markets to get a sense of whether current policy settings are too restrictive or too accommodative. One recent development on this front is that the correlation between the U.S. dollar (USD) and risk assets has flipped, with a stronger USD now positively correlated to global equities and credit (Chart 4). This shift was already starting to happen before the election of Donald Trump and his pro-growth agenda last November, likely because the global economy was improving as evidenced by the accelerating trend in our global purchasing managers' index (PMI, bottom panel). We have written extensively about the Fed being stuck in a "policy loop" in the past couple of years, where a shift to a more hawkish bias would sharply drive up the USD and cause a risk-off move in global financial markets. This unwanted tightening of financial conditions would cause the Fed to back off from its hawkishness, causing the USD to soften and markets to rally. We have argued that the way to break out of this loop would likely be a rise in non-U.S. economic growth that would allow the Fed to continue slowly normalizing U.S. monetary policy without disrupting global markets. We seem to be in that period now. One implication of this is that the longer risk assets can withstand rising U.S. interest rates and a stronger USD, the more the fed funds rate and U.S. Treasury yields must rise in response to U.S. economic strength. For this reason, we continue to recommend a below-benchmark duration stance on U.S. Treasuries on a 6-12 month horizon. We also maintain our bias towards a bear-steepening of the Treasury curve through our butterfly trade, long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The curve will remain positively correlated to inflation expectations until those reach the Fed's target level, after which any additional Fed rate hikes will likely flatten the yield curve in a more typical pattern during the latter stages of a tightening cycle. It is possible, though, that because markets shrugged off the latest rate increase, the Fed could return to sending hawkish signals in the near term. To play for this possibility, our colleagues at BCA U.S. Bond Strategy recommend that investors add a tactical trade: going short the January 2018 fed funds futures contract (Chart 5). We are today adding this trade to our list of Tactical Overlay Trades (see page 12). Chart 4The Strong USD Is Not A Problem The Strong USD Is Not A Problem The Strong USD Is Not A Problem Chart 5Go Short January 2018 Fed Funds Futures Go Short January 2018 Fed Funds Futures Go Short January 2018 Fed Funds Futures We calculate that this trade will return 11bps in a scenario where the Fed lifts rates twice more before the end of the year and 37bps in a scenario where the funds rate is raised a more aggressive-than-expected three times. However, we do not expect to hold this trade until the end of the year. Rather, we expect the Fed will nudge rate expectations higher in the next month or two in response to the latest easing of financial conditions, and that these gains will be realized over a much shorter horizon. We also add a caveat that, in the present environment, it is safer to implement any "hawkish Fed trades" in either fed funds futures or the OIS market. The Eurodollar market does not provide the same potential for gains because the LIBOR / OIS spread is currently elevated and could tighten to offset the profits from rising rate expectations. Bottom Line: The surprisingly positive response from financial markets to last week's Fed rate hike could force the Fed to quickly shift back to a hawkish bias. Maintain below-benchmark exposure to U.S. Treasuries. As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: A Weaker Yen Is Still The Only Way Out The Bank of Japan (BoJ) stayed on hold last week, as expected. There had been some increased speculation of late that the BoJ could start to signal a potential increase in its 0% target for the 10-year Japanese Government Bond (JGB) yield, given the rising trend in global yields and signs of better growth in Japan. At the press conference following the BoJ meeting, however, Governor Kuroda shot down that notion, saying that the current accommodative policy stance must be maintained given how far Japanese inflation is below the central bank's 2% target. It remains far too soon for the central bank to signal any shift to a less accommodative stance, as both the pace of economic growth and inflation are not only modest but lagging the current global upturn. In Chart 6, we show some Japanese growth variables relative to an aggregate of the same data for the major developed economies.1 What is clear from the chart is that Japan is benefitting from faster global growth on the industrial side, with the manufacturing PMI above 50. However, the domestic demand story is not as positive, with consumer confidence and real retail sales growth languishing. The lack of real income growth remains the biggest drag on Japanese consumers, as we show in another set of international comparisons in Chart 7. Japan's unemployment rate, currently at 3%, is below the OECD's estimate of the full employment level (consistent with stable domestic inflation pressures). This is in contrast to the other major economies, which are either at, or close to, full employment. Yet Japanese wages continue to struggle, both in nominal terms (a year-over-over growth rate of 1%) and real terms (a year-over-year growth rate of 0.4%). The current annual spring round of Japanese wage negotiations is showing that downward pressure remains powerful, with many manufacturing companies offering pay raises only half as large as those of last year.2 Chart 6Japan Is Lagging The Global Upturn Japan Is Lagging The Global Upturn Japan Is Lagging The Global Upturn Chart 7Still No Wage Growth In Japan Still No Wage Growth In Japan Still No Wage Growth In Japan Japan is still struggling to generate positive rates of inflation, even as price growth is accelerating in the other major economies (Chart 8). This is keeping Japanese inflation expectations, which the BoJ believes are mostly a function of the recent performance of actual inflation, subdued. As always, the only reliable source of Japanese inflation seems to be yen weakness. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus weakening the yen through increasingly unattractive interest rate differentials. The BoJ's 0% yield curve targeting framework has been successful in keeping rate differentials wide enough to soften up the yen, especially against the USD (Chart 9). Given our expectations of additional Fed rate hikes, and higher U.S. Treasury yields, over the rest of the year, the yen will likely depreciate further as long as the BoJ sticks with its current interest rate targets. A similar argument holds for the yen versus the Euro, given the increasing likelihood that the European Central Bank (ECB) will be forced to signal a less accommodative monetary policy stance later this year. Against this backdrop, JGBs are likely to outperform the major global government bond markets over the rest of 2017. We upgraded our recommended stance on JGBs from underweight to neutral last October after the BoJ introduced its yield curve targeting framework. In Chart 10, we show the relative performance of JGBs versus some other bond benchmarks, on a duration-matched and common-currency (hedged into USD) basis. We broke up the returns into two periods, from our October 11, 2016 Japan upgrade to January 31 of this year when we upgraded our U.S. corporate bond exposure and cut our overall portfolio duration stance to below-benchmark. The chart shows that JGBs were a good defensive hedge during the latter part of 2016 when global yields were rising, led by U.S. Treasuries. The more recent period, however, shows a much more negligible relative performance, both against other government bonds and corporate debt, during a period where global bond yields have generally traded sideways. Chart 8Japan Inflation Still A No-Show Japan Inflation Still A No-Show Japan Inflation Still A No-Show Chart 9A Weaker Yen Is Still Necessary A Weaker Yen Is Still Necessary A Weaker Yen Is Still Necessary Chart 10Relative Performance Of JGBs Staying Behind The Curve, For Now Staying Behind The Curve, For Now Given our views that U.S. Treasury yields will continue to move higher in the next 6-9 months, and that the performance of core European government bonds will suffer over the same period as the ECB signals a slower pace of asset purchases for next year, a return to the late 2016 relative performance of JGBs is very likely. Thus, we are upgrading Japan to an above-benchmark stance in our model portfolio this week, while downgrading core Europe (Germany, France, the Netherlands) to neutral. This is purely a move to get even more defensive in our overall country exposures, by allocating into JGBs which are low-beta to both U.S. Treasuries (where we are already below-benchmark) and core European government debt. Bottom Line: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The U.S., Euro Area, U.K., Canada & Australia 2 https://www.ft.com/content/0895c4ee-eb3b-11e5-888e-2eadd5fbc4a4 The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Staying Behind The Curve, For Now Staying Behind The Curve, For Now Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Contrary to popular perception, non-cyclical sectors have led the market so far this year, while deep cyclical sectors are breaking down, in relative performance terms. Our models point to more of the same ahead. The oversold rebound in the pharmaceutical group may soon run into resistance so we recommend trimming positions to neutral. Put the proceeds into restaurants, a quasi-defensive group that enjoys a brightening sales outlook without pharma's political and regulatory risk. Recent Changes S&P Pharmaceuticals - Downgrade to neutral. S&P Restaurants - Upgrade to overweight. Table 1 Reading The Market's Messages Reading The Market's Messages Feature Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (Chart 1). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves. Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, Chart 1). Crude oil price corrections have accurately timed equity retreats (Chart 1), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run. Contrary to popular perception, cyclical sectors have not led the broad market so far in 2017. In fact, energy, materials and industrials have all broken down in relative performance terms (Chart 2), after peaking in mid-December. Only the technology sector has stayed resilient. Chart 1Short-Term Fatigue Short-Term Fatigue Short-Term Fatigue Chart 2Cyclicals Have Broken Down Cyclicals Have Broken Down Cyclicals Have Broken Down Chart 3Overshoot Renormalization Overshoot Renormalization Overshoot Renormalization Insipid cyclical sector performance has occurred within the context of a synchronized lift in global economic growth and recovering corporate sector pricing power. So why are cyclical sectors lagging? It may simply be a digestion phase. However, a different interpretation is that a number of key macro factors fail to confirm the durability of last year's outperformance, suggesting that defensive outperformance could last. Concerns that the current global inventory cycle may not morph into a broad-based upturn in global final demand continue to linger: the global credit impulse remains anemic, the Fed and China are tightening monetary policy and commodity markets are cracking (Chart 3). The lack of any meaningful improvement in Chinese loan demand signals that the economy may be quick to cool as the authorities tap the breaks on credit growth. It would take a decisive depreciation in the U.S. dollar to boost the relative profit fortunes of capital spending-dependent cyclical sectors on a sustainable basis. On a more positive note, the Fed's benign forward guidance last week bears close attention. If the U.S. dollar loses upside support, particularly with the ECB contemplating a retreat from full throttle easing, it could change the investment landscape. By reminding markets that their inflation target is symmetric, the Fed signaled it will be willing to tolerate a modest inflation overshoot, which is positive for risk assets in the short run. A softer U.S. dollar would take the pressure off of developing countries, support commodity prices, and bolster our cyclical sector sales models and Cyclical Macro Indicators. However, Chart 4 shows that the objective message from our models remains consistent with continued defensive sector outperformance. With a more protectionist U.S. Administration, we remain reluctant to position exclusively for a much weaker dollar. The ongoing underperformance of emerging market equities relative to U.S. and global benchmarks reinforces that foreign-sourced profit growth continues to lag (Chart 5). Positioning for cyclical sector earnings outperformance requires healthier profits abroad, to spur a new capital investment cycle. Chart 4Heeding The Message From Our Models... Heeding The Message From Our Models... Heeding The Message From Our Models... Chart 5... And The Markets ... And The Markets ... And The Markets We will look to selectively add cyclical exposure when the objective message from our Indicators provides confirmation that earnings-driven outperformance lies ahead. At the moment, there is no such confirmation. In fact, the elevated reading in the SKEW index continues to signal that a defensive posture will optimize portfolio performance (Chart 5). In sum, we continue to characterize the broad market's current momentum as an overshoot phase, with additional technical upside potential, but the rally is starting to fray around the edges. In this environment, holding a mostly defensive basket with selective beta exposure is still recommended. Importantly, within the defensive universe, there are tweaks to be made, especially if the U.S. dollar stops rising. Fade The Pharmaceuticals Rebound Health care has been the second strongest of the eleven broad sectors year-to-date, contrary to popular perception. That is in line with the flattening yield curve, cresting in inflation expectations and a modest correction in oil prices (Chart 6), all of which have revived the allure of non-cyclical sectors. Moreover, our Cyclical Macro Indicator (CMI) for the health care sector remains firm, supported by the ongoing large pricing power advantage. Relative value is the most attractive it has been in five years. While the latter provides little timing help, it indicates low risk, especially with technical conditions still deeply oversold (Chart 7). Chart 6Health Care Is Storming Back Health Care Is Storming Back Health Care Is Storming Back Chart 7Still Cheap And Oversold Still Cheap And Oversold Still Cheap And Oversold The heavyweight pharmaceutical group has led the sector's tactical charge, recouping the ground lost, in relative performance terms, leading up to the U.S. election. While we were caught off guard by the severity of the pullback last September/October, we refrained from selling into an oversold market and noted our intention to lighten positions whenever the inevitable relief rally occurred. The time has come to execute on this thesis. Pharmaceutical stocks are very cheap and have discounted a hostile regulatory environment. The relative forward P/E is well below its historic mean, even though both 12-month and 5-year relative forward earnings growth expectations are depressed (Chart 8). Typically, the latter would serve to artificially inflate valuations. These conditions exist even though free cash flow growth remains strong; merger activity has been solid, albeit ebbing in recent months; and companies have used excess capital to reduce total shares outstanding (Chart 8). In other words, relative forward earnings would have to decline substantially to validate these expectations. Is this plausible? Much depends on the regulatory environment. While details of the U.S. Administration's proposal to replace the Affordable Care Act have started to leak out, final details are still elusive and legislative action is not imminent. So far, it appears as if a worst case scenario would see an increase in the number of uninsured Americans, with a rising cost of insurance (to the benefit of managed care companies). According to the Department of Health & Human Services, the uninsured rate of the U.S. population nearly halved from 16% in 2010 to 9% in 2015. That led to a lift in the number of procedures performed and bolstered hospital bottom lines. Hospitals are a major pharmaceutical buying group. Higher utilization rates fed increased pharmaceutical demand for a number of years. However, drug spending growth has dropped off, and if the legion of uninsured patients rises anew in the coming years, then hospital utilization rates will decline, taking drug consumption growth down with it. Moreover, Trump wants to streamline the FDA's approval process, which would ultimately boost the number of high margin new drugs coming to market. Drug stocks boomed back in the mid-1990s, the last time FDA approval rates accelerated meaningfully (Chart 9). Chart 8Full Capitulation Full Capitulation Full Capitulation Chart 9Full Capitulation Full Capitulation Full Capitulation But at the same time, if government is given leeway to negotiate drug prices directly with drug companies, then pricing power will continue to converge down toward overall corporate sector pricing power, especially if drug consumption rates ease (Chart 9). At the moment, drug consumption growth remains above the rate of overall consumption growth, but that is much slower than during the boom following the introduction of the Affordable Care Act. Retail sales at pharmacies are growing robustly, and hospitals are still adding staff, signaling that they continue to position for expansion, i.e. rising procedure volumes (Chart 10). On the downside, the strong U.S. dollar is a big drag on top-line growth. Drug imports exceed exports by a wide margin, resulting in a negative trade balance and a drag on U.S. drug company profits, all else equal. The combination of a sales growth deceleration and adequate channel inventories has capped drug output growth (Chart 10). That is a productivity and profit margin headwind. Against this background, the industry will need an external assist to deliver profit outperformance. Relative profit estimates rise when disinflationary forces reign supreme, as measured by the NFIB planned price hikes series (shown inverted, Chart 11). This measure of future corporate pricing power intentions has rolled over, but broader measures of inflation are creeping higher. Ergo, drug earnings forecasts may be challenged to keep pace with the overall corporate sector. Chart 10... But Growth Rates Are Slowing ... But Growth Rates Are Slowing ... But Growth Rates Are Slowing Chart 11Mixed Signals Mixed Signals Mixed Signals The good news is that even though U.S. dollar strength is an export drag, the negative drug trade balance suggests that it will hurt other industries more. Indeed, a rising currency often coincides with profit outperformance (Chart 11). There is not enough evidence that exogenous factors will offset slowing domestic drug consumption growth. In all, the case for a further and sustained relative performance recovery has weakened, and we are taking advantage of this year's oversold bounce to move to the sidelines. Bottom Line: Trim the S&P pharmaceuticals index to neutral. This position was deep in the money initially, but last year's downdraft pushed it into a loss position of 10%. BLBG: S5PHARX-JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, PRGO, MNK. Restaurants: Increasing Appetite The broad consumer discretionary sector has been treading water, largely owing to fears that a border adjustment tax (BAT) will undermine the retailing sub-component. This consolidation has restored value and created an attractive technical entry point (Chart 12, bottom panel). Importantly, industry earnings fundamentals are on the upswing. Our consumer discretionary sector Cyclical Macro Indicator has perked up (Chart 12), supported by an increase in wages, and more recently, the decline in oil prices. The latter is freeing up disposable income, which consumers have an incentive to spend given that household net worth (HNW) has climbed to all-time highs as a percent of disposable income (Chart 13). Chart 12A Good Place To Shop A Good Place To Shop A Good Place To Shop Chart 13Piggyback The Wealth Effect Piggyback The Wealth Effect Piggyback The Wealth Effect While we remain overweight housing related equities (homebuilders and home improvement retailers) in addition to our upbeat view on the media and advertising complex, a buying opportunity has surfaced in the neglected S&P restaurants index. We booked gains on an underweight position and lifted exposure to neutral back in late-October. Since then, value has improved further, while leading sales indicators continue to firm. Stronger consumer finances should flow into the casual dining industry. Sales have already started to reaccelerate, and should climb further based on the leading message from HNW (Chart 14). The lower income, $15K-$35K, cohort is also feeling increasingly confident, according to the latest Conference Board survey data (Chart 14). Meanwhile, the National Association of Restaurants Performance Index has regained momentum (Chart 15), signaling increased activity and rising confidence among restaurateurs. While the gap between the cost of dining out and dining in remains wide, it has begun to narrow, which is a plus for store traffic, all else equal. Chart 14Buy Into Weakness Buy Into Weakness Buy Into Weakness Chart 15At A Turning Point Domestically... At A Turning Point Domestically... At A Turning Point Domestically... Chart 16... And Globally? ... And Globally? ... And Globally? Our restaurants profit margin proxy (comprising restaurants CPI versus a blend of the industry's wage bill and food commodity costs) is trending higher. That is notable because it has a good track record in leading relative earnings growth estimates (Chart 15). Nevertheless, it is not all good news. International exposure remains a headache. Typically, soft EM currencies warn of translation drags on foreign sourced revenue (Chart 16). This cycle, there is an offset, as EM interest rates have come down, which is a plus for domestic demand (Chart 16). Thus, the headwind from outside the U.S. should abate as the year progresses. Adding it all up, factors are falling into place for a playable rally in the under-owned and unloved S&P restaurants index. This group offers attractive quasi-cyclical defensive exposure to replace the S&P pharmaceuticals index, without the political and regulatory risks. Bottom Line: Redeploy funds from the pharma downgrade and boost the S&P restaurants index to overweight. BLBG: S5REST-MCD, YUM, CMG, SBUX, DRI. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Dear Client, This week, we are sending you a piece written by my colleague Robert Ryan, Senior Vice-President for our Commodity & Energy sister service. This piece analyses dynamics in the oil markets and concludes that even if the U.S. dollar is indeed experiencing a cyclical bull market, oil prices could buck this trend. This gives us comfort on our more positive stance on the petro currencies within the commodity currency complex. Also, this week the Fed increased rates as was expected by the market. However, the tone of this hike was perceived as dovish, especially by the dollar: Four participants forecasted four hikes in 2017; one Fed president voted to keep rates unchanged, and the natural rate of unemployment estimate was downgraded to 4.7%, suggesting that the Fed perceives that the labor market is not as tight as it thought in December. Do these dynamics signal the end of the U.S. dollar cyclical bull market? No. The U.S. economy remains fundamentally strong. Various new orders surveys continue to hit record highs and capex should recover further. As a corollary, so will employment. Most crucially, the U-6 unemployment rate is now at 9.2%, a level at which wage growth significantly accelerated in 1997 and 2005. Thus, even if the U.S. economy tracks the now much-poorer Q1 GDP growth forecast of the Atlanta Fed, this soft patch will ultimately prove temporary. However, the U.S. dollar may continue to experience some short-term weakness against European currencies and the yen while forming a bottom against EM and commodity currencies. As we have argued in recent weeks, the global economy is very strong right now and it may prove difficult to sustain such a pace of growth in the industrial sector. As such, plays highly levered to the global industrial sector may experience a correction, a process that will boost the USD against EM and commodity currencies, but that will support the euro and the yen. Mathieu Savary, Vice President Mathieu@bcaresearch.com Highlights Global fundamentals - supply, demand and inventories - will support oil prices generally, and will remain bullish for the evolution toward backwardated forward curves, even as the Fed's interest-rate normalization policy supports the USD's broad trade-weighted index (TWI). This will cause the oil-USD divergence noted in earlier research to persist.1 Energy: Overweight. We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. Our oil-balances modeling indicates storage will draw throughout the rest of this year and next. Base Metals: Neutral. Spot copper prices remain subdued despite strikes at Peru's Cerro Verde and Chile's Escondida mines. Meanwhile, export-license talks continue in Indonesia at the Grasberg mine. When a market fails to rally on supportive news, it normally is a bearish indicator. An unexpected surge in LME copper stocks partly offset supply-side concerns. Precious Metals: Neutral. Gold will remain weak, as markets discount the timing and size of further rate hikes. We remain long volatility, with our long-put/long-call spread combination in June, recommended on February 23/17, up 29.5%. Ags/Softs: Underweight. Indications of higher output of corn and beans in South America from the USDA, and a well-supported USD keep us bearish. Lower planting intentions - to be reported at month-end - could support corn. Feature Markets got a rare "two-fer" yesterday. The first, a long-anticipated bullish oil inventory report from the U.S. Energy Information Administration (EIA). The second, a fully priced follow-through on the Fed's recent forward guidance in the form of a 25bp hike in overnight rates, which, while important to oil markets, will continue to be secondary to the fundamental adjustments that will be reflected in subsequent EIA reports. Not unexpectedly, U.S. commercial oil inventories drew hard last week - more than 8mm bbl (including SPR), with crude stocks accounting for 1.1 mm bbl - following weeks of builds, which forced many a long from the market. The balance of the draws will shift to crude within the next month, as U.S. refiners come back off performing routine maintenance. With the year-end surge from OPEC's Gulf producers now fully absorbed, we expect to see a sustained draw in OECD storage this year. This will force inventories toward the five-year average levels sought by OPEC and non-OPEC producers in their production-cutting agreement last year (Chart of the Week). Chart of the WeekOil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Chart 2OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply In our balances model, we have global supply up 0.5 mm b/d in 2017 yoy and demand up 1.5 mm b/d on average. For 2018, we have supply up 1.5 mm b/d on average vs. 2017, and demand up 1.6 mm b/d. This will produce the draws in OECD inventories anticipated by the Kingdom of Saudi Arabia (KSA) and Russia when they led the negotiations between OPEC and non-OPEC oil-producing states that will produce these supply deficits (Chart 2). The Fed - And The USD - Still Matter, But Not As Much The 25bp hike in overnight rates was perhaps the most strongly telegraphed messaging from FOMC members in post-GFC history. If nothing else, the Fed is unambiguously signaling its intent to normalize interest-rate policy, which, all else equal, will be supportive of the USD's TWI. We do not believe the Fed is intent on raising real rates, which will somewhat temper the rates normalization policy of the Fed. This will allow the synchronized global growth we now see - along with a synchronized increase in global inflation rates - to continue, and will prevent an overly strong USD from crimping demand ex-U.S. - particularly in the EM markets. Indeed, we continue to expect strong growth in EM oil demand, which we proxy by non-OECD oil consumption (Chart 3). Chart 3EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand Chart 4USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution Therefore, while the evolution of the USD will remain important to the evolution of oil prices, we do not expect it to dominate that evolution as it has post-GFC to the end of 1Q16. As can be seen in Chart 4, which shows Brent prices as a function of the USD TWI, this relationship has weakened some, after fundamentals - chiefly supply destruction and demand growth - reacted to the lower prices brought on by the market-share war declared by OPEC in November 2014. However, we do not expect this relationship to break down entirely: Indeed, it has been remarkably durable since 2000, when oil prices - like the USD - became random-walking economic variables (Chart 5).2 We do think the market is in a transition phase - chiefly from being over-supplied to tighter, given the physical deficits we expect - with price levels capable of following a more stable path with less volatility. This will translate into even greater volatility in the forward curves for oil prices, which we believe will become more backwardated as markets finally get evidence storage is drawing (Chart 6). We continue to expect WTI prices to trade between $45 and $65/bbl, with a central tendency of $55/bbl this year and next. Chart 5Expect The USD To Be Less##br## Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Chart 6We Continue to Expect Backwardation##br## in Oil Forwards We Continue To Expect Backwardation In Oil Forwards We Continue To Expect Backwardation In Oil Forwards Back In The Backwardation Trade We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. We are including a stop-loss on this recommendation of -$0.36/bbl (i.e., the Dec/17 vs. Dec/18 spread goes into a -$0.48/bbl contango), given this is a strategic recommendation and we are willing to incur larger losses given our high-conviction view of the evolution of the WTI forward curve. As the above analysis indicates, we strongly expect storage to draw throughout the rest of this year and next. This will produce backwardated markets - prompt-delivery prices exceed deferred-delivery prices - and tighten markets globally. We recently exited the exact same trade on February 23/17, when we entered it at -$0.11/bbl (in contango), and exited at +$0.96/bbl, for a gain of +$1.07/bbl (972.7%). This is evidence of the volatility we continue to expect as the forward curve transitions to a backwardated structure. Bottom Line: The oil market is performing as we expect, with supply cuts in the face of strong demand growth producing a physical deficit. This will lead to a backwardation in the forward curves for WTI and Brent, which we are capitalizing on by re-establishing our long Dec/17 WTI vs. short Dec/18 WTI position. While the USD will continue to exert an influence on oil prices, we continue to believe this will be secondary to the evolution of prices. Fundamentals will drive price discovery going forward. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Days Of Oil Future's Past: Mean-Reversion," dated March 2, 2017, and "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil," dated March 9, 2017, available at ces.bcaresearch.com. 2 Please see "Days Of Oil Future's Past: Mean-Reversion," published March 2, 2017, referenced above. In that article we examine the evolution of oil prices from a mean-reverting series to a difference-stationary series. We considered the possibility the KSA - Russia production agreement could deepen, allowing these states to exert more control over the evolution of prices. This is not foregone, by any means, but it is useful to consider the implications of supply contracting as a result of their detente, and the return of a more inelastic supply curve. In such a market, small adjustments to the supply side can have profound effects on prices - assuming demand remains inelastic - and allow these states to regain a measure of control over oil market fundamentals. Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 The greenback had an interesting reaction to the Fed rate hike. The FOMC's statement and forecasts disappointed markets and the DXY pared back most of its February gains, depreciating more than 1% following the hike. The Summary of Economic Projections confirmed two more hikes this year, for which the dates are uncertain, decreasing the perceived risk of four hikes in 2017. Moreover, the downgrade of the estimate for the structural unemployment rate suggests the Fed sees more labor market pressures than in December. Furthermore, FOMC board member, Neel Kashkari, voted against the hike, preferring instead to maintain the target rate at 0.5%-0.75%. February CPI numbers slowed slightly with core CPI falling to 2.2% from 2.3%, however, this was expected by the market. Additionally, headline CPI picked up to 2.7% from 2.5%, also as expected. The timing of the next up-leg in the dollar may now rest on the next clarifications of Trump's recent budget proposals. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 The euro minimally reacted to the Dutch elections, as its appreciation reflected the weak dollar. Regardless, the outcome for the elections was mainly market-positive as Euroskeptic Geert Wilders was defeated by Europhile party VVD. Also, Comments by ECB board member Nowotny gave the euro a further filip. Economic data, however, was not too strong: German CPI and HICP remained steady at 2.2%; ZEW Survey measures for the German Current Situation and the Economic Sentiment both underperformed expectations; Euro area industrial production declined annually; Euro area headline inflation held at 2%, and core also remained at 0.9%. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 In its monetary policy statement yesterday the BoJ reiterated its commitment to maintain its policy rate at -0.1% and to keep its yield curve control program, which leaves the rate of 10-year JGBs around 0%. Furthermore, the BoJ also recognized one theme that we have highlighted before: Japanese economic activity is improving and inflation, although still very weak, is improving. Evidence can be found in recent data: Industrial production yearly growth increased by 3.7% in January relative to a 3.2% growth in December Labor cash earnings grew by 0.5% from a year ago, outperforming expectations. Given that rates are anchored and inflation continues to improve, real rates Japanese rates should fall vis-à-vis the rest of the world, putting downward pressure on the yen on a cyclical basis. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 The pound rallied following the monetary policy statement of the BoE justifying why policy rate was left unchanged. In fact, the hawkish tone was enhanced by the dissent of one member who favored hiking. Furthermore the BoE also stated that "if aggregate demand stays resilient, monetary policy may need to be tightened sooner and to a greater degree". How likely is it that aggregate demand will stay resilient (and consequently that the pound gains)? Recent data paints a mixed picture in the short term: Industrial production growth and manufacturing production growth came in at 3.2% and 2.7%, underperforming expectations. However unemployment decreased to 4.7% and the goods trade balance continued to improve, beating expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 AUD/USD gained more than 1.5% this week on the back of a weak greenback and strong Chinese data. Industrial production in China increased by 6.3% in January, more than expected. We think this strength is temporary and will pass shortly: Inflation expectations released by the Melbourne Institute decreased to 4%; Unemployment rate increased by 0.2% to 5.9%, underperforming expectations; Employment decreased by 6,400. Part-time employment decreased by 33,500, while full-time employment increased by 27,100. Although this is an overall net decrease in employment, this may imply a tightening labor market as the full-time market strengthens relative to the part-time one. However, it is still too soon to tell. Monitoring labor market developments is important as they provide an important outlook for wage, and thus inflation, developments. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 The NZD has been the worst performer amongst the commodity currencies so far in 2017. This has been in part due to disappointing economic data such as the recent GDP numbers which came below expectations at 2.7% yearly growth. However the central bank has also been responsible for the poor performance of the NZD as it has been much less hawkish than anticipated. The RBNZ blamed low tradable-goods inflation and a worsening current account caused by a strong NZD as the main reasons behind its neutral bias. However the central bank may be falling behind the curve. Food inflation now stands at 2.2%, while the current account continues to close faster than expectations. This means that inflation might reach its target much before the RBNZ late 2018 projection, which could lift kiwi rates and the NZD as markets begin doubting the RBNZ's resolve. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 After a period of weakness due to a dovish rhetoric by the BoC and the recent surprise surge in oil inventories, CAD has rebounded against the greenback on the back of the USD's broad weakness. Within Canada, upbeat data has also contributed to this strength as the labor market has shown some improvements recently: The net change in employment was recorded at 15,300, beating expectations of 2,500; Unemployment came in at 6.6%. These developments took place despite a mild decrease in participation rate, suggesting the decrease in the unemployment rate was mostly driven by a stronger employment sector. The improvement in employment has manifested across the board, with employment among prime-age women increasing by 1.7% and among men aged 55 and above also increasing. Importantly, part-time employment actually fell by 90,000 while full-time employment rose by 105,000, potentially indicating a tightening in the labor market. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Yesterday, the SNB left its policy rate unchanged at -0.75%. Furthermore, as we expected, it stood by its commitment to intervene in the franc as the central bank still consider that the franc is "significantly overvalued". At the moment, EUR/CHF has risen from the implied floor of 1.065 set by the SNB, thanks to the overwhelming victory by the Europhile green party in the Dutch elections. This will take some pressure off the SNB, which last week was accumulating reserves at the fastest pace since December 2014. On the inflation front, the SNB upgraded its short term forecast and downgraded their long term forecast. We will continue to monitor how inflation develops in comparison to the SNB's forecast, as here lies the key to judging whether a break from the peg is possible or not. 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-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 After skyrocketing following the surprising increase in oil inventories last week, USD/NOK has come down to earth, thanks to this week's draw in oil stocks. Additionally, the fall in the U.S. dollar following the "dovish Fed hike" has also put downward pressure on USD/NOK. Overall, oil prices should provide a tailwind, for the NOK, particularly against other commodity currencies, as oil is set to outperform base metals given that supply cuts by OPEC will ultimately results in draws in inventory. The domestic situation paints a more bearish picture. Core inflation plummeted from 2.1% to 1.6% from last month. Moreover, Norway continues to have an output gap of -2.5% and a negative credit impulse. All of these factors should support the Norges Bank dovish bias in an environment of rising U.S. rates, lifting USD/NOK in the process. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017’s Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 The Krona strengthened across the board as inflation numbers came in stronger than previously: monthly CPI came in at 0.7%, up from -0.7%; and yearly CPI was recorded at 1.8%, close to the Riksbank's 2% target. With capacity utilization above its historical average and the Riksbank's Resource Utilization indicator being at pre-crisis levels, this indicates that the economy could soon hit its inflation target. The labor market's tightness is apparent due to the low supply of workers relative to demand. Mismatch in terms of the supply and demand of labor are likely to put upward pressure on a substantial share of wage earners as firms find it difficult to fulfill vacancies. While both short-term and long-term dynamics paint an inflationary picture, the Riksbank is likely to lean to the dovish side for the remainder of the year: The Swedish central bank wants to prevent any build-up of a deflationary mindset and wants to mitigate any external risks to the economy. 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 Global fundamentals - supply, demand and inventories - will support oil prices generally, and will remain bullish for the evolution toward backwardated forward curves, even as the Fed's interest-rate normalization policy supports the USD's broad trade-weighted index (TWI). This will cause the oil-USD divergence noted in earlier research to persist.1 Energy: Overweight. We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. Our oil-balances modeling indicates storage will draw throughout the rest of this year and next. Base Metals: Neutral. Spot copper prices remain subdued despite strikes at Peru's Cerro Verde and Chile's Escondida mines. Meanwhile, export-license talks continue in Indonesia at the Grasberg mine. When a market fails to rally on supportive news, it normally is a bearish indicator. An unexpected surge in LME copper stocks partly offset supply-side concerns. Precious Metals: Neutral. Gold will remain weak, as markets discount the timing and size of further rate hikes. We remain long volatility, with our long-put/long-call spread combination in June, recommended on February 23/17, up 29.5%. Ags/Softs: Underweight. Indications of higher output of corn and beans in South America from the USDA, and a well-supported USD keep us bearish. Lower planting intentions - to be reported at month-end - could support corn. Feature Markets got a rare "two-fer" yesterday. The first, a long-anticipated bullish oil inventory report from the U.S. Energy Information Administration (EIA). The second, a fully priced follow-through on the Fed's recent forward guidance in the form of a 25bp hike in overnight rates, which, while important to oil markets, will continue to be secondary to the fundamental adjustments that will be reflected in subsequent EIA reports. Not unexpectedly, U.S. commercial oil inventories drew hard last week - more than 8mm bbl (including SPR), with crude stocks accounting for 1.1 mm bbl - following weeks of builds, which forced many a long from the market. The balance of the draws will shift to crude within the next month, as U.S. refiners come back off performing routine maintenance. With the year-end surge from OPEC's Gulf producers now fully absorbed, we expect to see a sustained draw in OECD storage this year. This will force inventories toward the five-year average levels sought by OPEC and non-OPEC producers in their production-cutting agreement last year (Chart of the Week). In our balances model, we have global supply up 0.5 mm b/d in 2017 yoy and demand up 1.5 mm b/d on average. For 2018, we have supply up 1.5 mm b/d on average vs. 2017, and demand up 1.6 mm b/d. This will produce the draws in OECD inventories anticipated by the Kingdom of Saudi Arabia (KSA) and Russia when they led the negotiations between OPEC and non-OPEC oil-producing states that will produce these supply deficits (Chart 2). Chart of the WeekOil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Oil Markets Will Tighten This Year And Next Chart 2OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply OECD Inventories Will Draw Sharply The Fed - And The USD - Still Matter, But Not As Much The 25bp hike in overnight rates was perhaps the most strongly telegraphed messaging from FOMC members in post-GFC history. If nothing else, the Fed is unambiguously signaling its intent to normalize interest-rate policy, which, all else equal, will be supportive of the USD's TWI. We do not believe the Fed is intent on raising real rates, which will somewhat temper the rates normalization policy of the Fed. This will allow the synchronized global growth we now see - along with a synchronized increase in global inflation rates - to continue, and will prevent an overly strong USD from crimping demand ex-U.S. - particularly in the EM markets. Indeed, we continue to expect strong growth in EM oil demand, which we proxy by non-OECD oil consumption (Chart 3). Therefore, while the evolution of the USD will remain important to the evolution of oil prices, we do not expect it to dominate that evolution as it has post-GFC to the end of 1Q16. As can be seen in Chart 4, which shows Brent prices as a function of the USD TWI, this relationship has weakened some, after fundamentals - chiefly supply destruction and demand growth - reacted to the lower prices brought on by the market-share war declared by OPEC in November 2014. Chart 3EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand EM Growth Will Drive Oil Demand Chart 4USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution USD Will Not Dominate Oil-Price Evolution However, we do not expect this relationship to break down entirely: Indeed, it has been remarkably durable since 2000, when oil prices - like the USD - became random-walking economic variables (Chart 5).2 We do think the market is in a transition phase - chiefly from being over-supplied to tighter, given the physical deficits we expect - with price levels capable of following a more stable path with less volatility. This will translate into even greater volatility in the forward curves for oil prices, which we believe will become more backwardated as markets finally get evidence storage is drawing (Charts 6). We continue to expect WTI prices to trade between $45 and $65/bbl, with a central tendency of $55/bbl this year and next. Chart 5Expect The USD To Be Less Determinant ##br##For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Expect The USD To Be Less Determinant For Oil Prices Chart 6We Continue To Expect Backwardation ##br##In Oil Forwards We Continue To Expect Backwardation In Oil Forwards We Continue To Expect Backwardation In Oil Forwards Back In The Backwardation Trade We are once again long Dec/17 WTI vs. short Dec/18 WTI, after the resting order placed on March 9/17 was elected on March 13/17 at -$0.12/bbl. We are including a stop-loss on this recommendation of -$0.36/bbl (i.e., the Dec/17 vs. Dec/18 spread goes into a -$0.48/bbl contango), given this is a strategic recommendation and we are willing to incur larger losses given our high-conviction view of the evolution of the WTI forward curve. As the above analysis indicates, we strongly expect storage to draw throughout the rest of this year and next. This will produce backwardated markets - prompt-delivery prices exceed deferred-delivery prices - and tighten markets globally. We recently exited the exact same trade on February 23/17, when we entered it at -$0.11/bbl (in contango), and exited at +$0.96/bbl, for a gain of +$1.07/bbl (972.7%). This is evidence of the volatility we continue to expect as the forward curve transitions to a backwardated structure. Bottom Line: The oil market is performing as we expect, with supply cuts in the face of strong demand growth producing a physical deficit. This will lead to a backwardation in the forward curves for WTI and Brent, which we are capitalizing on by re-establishing our long Dec/17 WTI vs. short Dec/18 WTI position. While the USD will continue to exert an influence on oil prices, we continue to believe this will be secondary to the evolution of prices. Fundamentals will drive price discovery going forward. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Days Of Oil Future's Past: Mean-Reversion," dated March 2, 2017, and "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil," dated March 9, 2017, available at ces.bcaresearch.com. 2 Please see "Days Of Oil Future's Past: Mean-Reversion," published March 2, 2017, referenced above. In that article we examine the evolution of oil prices from a mean-reverting series to a difference-stationary series. We considered the possibility the KSA - Russia production agreement could deepen, allowing these states to exert more control over the evolution of prices. This is not foregone, by any means, but it is useful to consider the implications of supply contracting as a result of their detente, and the return of a more inelastic supply curve. In such a market, small adjustments to the supply side can have profound effects on prices - assuming demand remains inelastic - and allow these states to regain a measure of control over oil market fundamentals. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights Fed: The Fed will deliver another rate hike tomorrow, but we do not expect a signal that a higher trajectory for the funds rate is necessary. The Fed wants to see higher inflation expectations and will remain as accommodative as possible until that happens. Maintain a below-benchmark allocation to U.S. Treasuries within global fixed income portfolios. ECB: The ECB opened the door slightly to a less-accommodative policy stance last week, although the talk of a rate hike is premature. A 2018 taper is the more probable scenario, likely to be introduced at the September 2017 policy meeting. This will raise longer-dated European bond yields and widen spreads for both Peripheral European government debt and Euro Area corporate bonds. Reduce Euro Area IG to below-benchmark. U.S. High-Yield: U.S. junk bond spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade U.S. High-Yield from neutral to overweight. Feature Chart of the WeekStill A Positive Backdrop ##br##For U.S. Corporates Still A Positive Backdrop For U.S. Corporates Still A Positive Backdrop For U.S. Corporates After a run of smooth sailing for the markets so far in 2017, investors will have a lot of event risk to chew over this week. A slew of central bank meetings - the Fed on Wednesday followed by the Bank of England, Bank of Japan and Swiss National Bank all on Thursday - provide opportunities for policymakers to respond to the rising trends in global growth and inflation. Only the Fed is expected to make a change, though, delivering a now fully priced rate hike. Throw in the Dutch elections on Wednesday and the G20 finance ministers meeting in Germany at the end of the week and there are plenty of potentially market-moving headlines that can hit the tape. While there has been selling pressure on all global bonds during the bear phase since last July, U.S. Treasuries still remain most exposed to additional losses in the near term given the combination of improving growth, booming asset markets, a whiff of Trumpian "animal spirits" and a Fed that still appears to be playing catch-up to the overall positive U.S. macro backdrop. A bigger potential move in yields could occur if and when the European Central Bank (ECB) shifts to a less accommodative monetary stance - a taper of asset purchases first, not a rate hike, in our view - although that will likely require more evidence that medium-term Euro Area inflation expectations are sustainably moving back to the ECB's 2% target (Chart of the Week). For now, we continue to see a more negative near-term environment for U.S. Treasuries over core European debt, and a more positive environment for U.S. corporate bonds than European equivalents. As we have discussed in recent Weekly Reports, the time is coming for a shift out of core European government debt into U.S. Treasuries, although we prefer to wait for that switch until after the French elections. After the recent back-up in U.S. High-Yield spreads that has restored some value to junk bonds, however, we are upgrading our allocation to U.S. High-Yield this week to above-benchmark, while downgrading Euro Area Investment Grade corporate bonds to neutral from above-benchmark. Simply put, we prefer to take our growth-sensitive spread risk in U.S. corporates over European equivalents. Fed Vs. ECB: Dawn Of Hawkish? Some investors and financial media pundits have been asking if the Fed has fallen "behind the curve" with regards to U.S. monetary policy, especially after another solid Payrolls report and with U.S. inflation expectations holding firm despite a pullback in oil prices. In our view, being a little bit behind the curve is exactly where the Fed wants to be, allowing the economic upturn to blossom and inflation expectations to continue drifting towards the Fed's 2% target. We do not anticipate that the Fed will shift to a more aggressively hawkish stance this week, with no signal that rates will rise in 2017 more than is currently projected (three times by year-end). However, we do expect some acknowledgement of the positive macro backdrop both in the U.S. and abroad, justifying the need to move sooner by hiking now. This is especially true with the U.S. dollar still well off the 2017 peak and not providing much of a tightening in monetary conditions that could postpone a Fed rate hike. Any surprise shift higher in the Fed's interest rate projections (the "dots") would not be taken well by the Treasury market, particularly after last week's European Central Bank (ECB) meeting where a message that was merely less dovish than expected sent European bond yields sharply higher. A more hawkish shift by either central bank would be premature right now, as bond markets are not yet signaling that significantly higher real interest rates are necessary. It is important to note that most of the rise in Treasury yields since last July, and virtually all of the rise in German Bund yields, has come from rising inflation expectations rather than higher real yields (Chart 2 & Chart 3). Also, the market expectation for the real terminal policy rate - where interest rates should end up at the end of the tightening cycle - remains around 0% in the U.S. and -1% in Europe, using our proxy measure of the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the equivalent forward inflation rate from the TIPS and CPI swap markets (bottom panel of both charts). In other words, markets are only expecting a cyclical rise in interest rates in response to faster inflation, not a structural rise in interest rates because of faster potential economic growth. Chart 2Rising Inflation Explains ##br##Most Of The Rise In U.S. Yields... Rising Inflation Explains Most Of The Rise In U.S. Yields... Rising Inflation Explains Most Of The Rise In U.S. Yields... Chart 3...And All Of The Rise##br## In European Yields ...And All Of The Rise In European Yields ...And All Of The Rise In European Yields On that front, the winds are shifting in a fashion that is more bearish for Treasuries, at least in the near term. In Chart 4, we show the relationship between inflation expectations and oil prices for the U.S. and Euro Area. As can be seen in the bottom panel, the correlation between oil and expectations remains high in the Euro Area, but has fallen to zero in the U.S., where inflation expectations are increasingly influenced by domestic price pressures (i.e. rising wage growth and faster core inflation). Chart 4U.S. Inflation Now Not Just About Oil, ##br##Unlike Europe U.S. Inflation Now Not Just About Oil, Unlike Europe U.S. Inflation Now Not Just About Oil, Unlike Europe This remains a key element underpinning of our current below-benchmark call on U.S. Treasuries, particularly versus core European bonds. U.S. yields are likely to have more upside from higher inflation expectations with the Fed likely to stay as accommodative as possible by hiking rates at a slower pace than inflation is rising. At some point, monetary policy will become restrictive, particularly if the U.S. dollar bull market resumes with gusto as the Fed is delivering additional rate hikes and expectations for U.S. growth and inflation moderate, capping the current cyclical rise in Treasury yields. We are still some time away from that point, however. Bottom Line: The Fed will deliver another rate hike tomorrow, but we do not expect a signal that a higher trajectory for the funds rate is necessary. The Fed wants to see higher inflation expectations, and will remain as accommodative as possible until that happens. Maintain a below-benchmark allocation to U.S. Treasuries within global fixed income portfolios. ECB Begins The Path To Tapering The ECB last week put a relatively positive spin on the Euro Area economy, while declaring that the worst of the deflationary pressures have passed. President Draghi sounded less downbeat on the Euro Area economy than he has for some time, citing the broadening Euro Area economic upturn that was pushing down unemployment and absorbing economic slack. The ECB only slightly raised its growth forecast for 2017 and 2018, though, raising both figures by 0.1 percentage points to 1.8% and 1.7%, respectively. This would still be sufficient to remove additional slack from the economy, with the ECB currently estimating trend growth of around 1% in the Euro Area. A look at the details of those projections showed that real consumer spending is only expected to grow by 1.4% this year and next, even as the Euro Area unemployment rate is projected to fall below 9% in 2018 on the back of steady job gains. Capital spending is also expected to pick up in the next couple of years, but the projections were downgraded slightly from previous forecasts. These numbers seem a bit too cautious compared to the recent improvements seen in consumer and business confidence in the Euro Area (Chart 5), and to the more positive tone on the economy expressed in the ECB policy statement and in Draghi's press conference following the meeting. Perhaps this is simply central bank prudence at work, particularly in an environment where there is still considerable uncertainty about politics within the Euro Area and global trade in the Trumpian era. Whatever the reason, it now seems likely that growth will at least match, if not exceed, the relatively low bar set by the ECB. This is important, as the central bank is already projecting that the Euro Area will reach full employment by 2019, when the unemployment rate is projected to fall to 8.4%. The ECB expects wage pressures to rise as a result, helping boost core inflation up to 1.8% within two years (Chart 6). This would be consistent with the rising path of interest rates currently discounted in the Euro Overnight Index Swap (OIS) curve where rates are now expected to start going up in the middle of next year, with the negative rate era ending in 2019 (bottom panel). Chart 5ECB Too Pessimistic On ##br##Euro Area Growth? ECB Too Pessimistic On Euro Area Growth? ECB Too Pessimistic On Euro Area Growth? Chart 6ECB Will Not Hike Rates Before ##br##Full Employment Is Reached ECB Will Not Hike Rates Before Full Employment Is Reached ECB Will Not Hike Rates Before Full Employment Is Reached The ECB knows that interest rates will have to rise if its core inflation forecast pans out, as this would almost certainly mean that headline inflation and inflation expectations would be at the ECB target of "at or just below" 2%. Yet it is still too soon to discuss that scenario, with core inflation struggling to surpass 1% and the 5-year CPI swap rate, 5-years forward at similar levels. The ECB did slightly alter its forward guidance in its policy statement to suggest that it was now much less likely that additional monetary easing would be needed to boost growth, and that it would no longer be necessary to use "all instruments" to fight deflation in Europe. This was taken as a hawkish surprise by the markets, particularly after media reports indicated that some members of the ECB discussed raising interest rates before the tapering of the ECB's asset purchases. As we discussed in our previous Weekly Report, the current backdrop in Europe looks similar in many respects to the U.S. prior to the "Taper Tantrum" episode in 2013.1 We see the ECB following a similar path to what the Fed did during the Tantrum, by signaling a tapering of asset purchases several months in advance, then raising interest rates after the taper is complete. Many clients have asked us if it is possible for the ECB to raise short-term interest rates before starting a tapering of asset purchases. This question also came up at last week's ECB meeting, and President Draghi reiterated the view that rates would be expected to "remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases." This fits with the ECB's unemployment and inflation scenarios, which do not project a return to full employment - which would justify a rate hike - until 2019. A rate hike too soon would result in an unwanted tightening in financial conditions in Europe that could threaten the current economic upturn. We do not believe that investors could neatly separate the impact of a rate hike from that of a taper. A tightening is a tightening, as can be seen in the strong correlation of our Euro Area months-to-hike measure and the term premium on 10yr German Bund yields in recent years (Chart 7).2 If the ECB were to deliver a rate hike, even a modest one of less than the typical 25bp increment, while maintaining the current pace of bond buying, it would send a contradictory message given the ECB's benign inflation outlook for the next couple of years. Clearly, the market is already a bit confused, as the months-to-hike has been rapidly declining, even as shorter-dated bond yields in core Europe stay low and the term premium on longer-dated government debt has stopped rising. We still see a taper next year as a more likely scenario, to be announced at the September 2017 ECB meeting, with a rate hike to occur within 6-12 months of the completion of the taper. This would allow the ECB to reduce the pace of monetary expansion in line with a less deflationary backdrop in Europe, while leaving the rate hike for a more traditional move when full employment is reached in 2019. In Chart 8, we present some potential tapering scenarios and what it would mean for the growth rate of the ECB's monetary base. We show the base case for this year of €60bn/month in asset purchases that ends in December (a "full-stop" with no tapering), along with alternative scenarios of a pace of tapering that reduces the bond buying to zero within six months (i.e. a €10bn/month reduction until June 2018) and with a full taper over 12 months (i.e. a €5bn/month reduction until December 2018). We also show an additional scenario where the ECB decides to extend the asset purchases into 2018 at the same current pace of €60bn/month. Chart 7A Rate Hike Before Tapering ##br##Is A Confusing Message A Rate Hike Before Tapering Is A Confusing Message A Rate Hike Before Tapering Is A Confusing Message Chart 8Taper Or Not, ECB Effect ##br##On Bund Yields Fading... Taper Or Not, ECB Effect On Bund Yields Fading... Taper Or Not, ECB Effect On Bund Yields Fading... The bottom panels of Chart 8 show the annual growth rate of the monetary base under the different scenarios, and how that maps into longer-term German bond yields through a widening term premium. Importantly, the growth rate of the ECB's monetary base would decelerate even if there was no taper next year, which would put upward pressure on European bond yields. Unless the ECB is willing to raise the pace of bond buying next year, which would only occur if there was an unexpected downturn in the Euro Area economy before full employment is reached, then the writing is on the wall for Euro Area government bond yields. They are moving higher. The same goes for Peripheral European debt and even Euro Area Investment Grade corporate debt, which the ECB has also been buying. A slowing pace of ECB buying will put upward pressure on both yields and spreads next year (Chart 9), although a better Euro Area economy that improves corporate profits and tax revenues will help mitigate the rise in yields. It is possible that the ECB could alter the composition of its purchases while tapering, choosing to continue to buy more shorter-dated bonds to limit the potential of an unwanted rise in the Euro. As can be seen in Chart 10, the typical indicators that correlate to the EUR/USD currency pair - the relative balance sheets of the Fed and ECB, and the 2-year interest rate differential between European and U.S. interest rates - are still pointing to an extended period of Euro weakness. It would take a combination of rate hikes in Europe and rate cuts in the U.S. to turn EUR/USD around on a sustainable basis. While the tapering announcement will likely push the Euro immediately higher, such a move will not last without a more fundamental change in relative interest rates. Chart 9...And For European ##br##Spread Product, Too ...And For European Spread Product, Too ...And For European Spread Product, Too Chart 10Tapering Will Not Sustainably ##br##Boost The Euro Tapering Will Not Sustainably Boost The Euro Tapering Will Not Sustainably Boost The Euro Bottom Line: The ECB opened to door slightly to a less-accommodative policy stance last week, although the talk of a rate hike is premature. A 2018 taper is the more probable scenario, likely to be introduced at the September 2017 policy meeting. This will raise longer-dated European bond yields and widen spreads for both Peripheral European government debt and Euro Area corporate bonds. Reduce Euro Area Investment Grade to below-benchmark. The Value Is Back In U.S. High-Yield One of our key themes for 2017 is that the uptrend in the U.S. High-Yield default rate is due for a pause.3 With the first quarter of the year nearly complete, all the indicators that make up our U.S. Default Rate Model are showing noticeable improvement (Chart 11). Interest coverage remains elevated A strong U.S. Manufacturing PMI points to a rebound in after-tax cash flow Lending standards have rolled over and are now just barely in "net tightening" territory An improving sales/inventory ratio portends a return to positive industrial production growth Job cut announcements have fallen back to 2011 levels on a trailing 12-month basis Chart 11Default Rate Indicators Are Showing Improvement Default Rate Indicators Are Showing Improvement Default Rate Indicators Are Showing Improvement Meantime, even though the default outlook continues to improve, junk spreads have actually widened during the past couple of weeks. The average option-adjusted spread on the Bloomberg Barclays U.S. High-Yield index has widened from a low of 344bps up to 378bps (Chart 12). Some of that spread increase is likely attributable to declining oil prices, as energy sector credits have indeed underperformed the overall index. However, the underperformance of the energy sector did start before the sharp drop in oil prices (Chart 12, bottom panel). In any event, our commodity strategists are not expecting the current decline in oil prices to persist and their estimates show that the oil market has recently shifted from an environment of excess supply to one of excess demand. U.S. crude oil inventories are poised to decline later this month and the OPEC / non-OPEC production deal negotiated by the Kingdom of Saudi Arabia and Russia at the end of last year should be met with high compliance.4 If this view is correct, then the energy sector will not drag overall junk spreads wider in the months ahead. The combination of wider junk spreads and an improving default outlook has led to an increase in our preferred gauge of value for high-yield bonds - the default-adjusted spread (Chart 13). The default-adjusted spread is calculated by subtracting an ex-ante estimate of default losses from the average spread on the Bloomberg Barclays U.S. High-Yield index. Chart 12Energy Contributed To Junk Sell-Off Energy Contributed To Junk Sell-Off Energy Contributed To Junk Sell-Off Chart 13Some Value Returns To High-Yield Some Value Returns To High-Yield Some Value Returns To High-Yield To arrive at an estimate of default losses we use the Moody's baseline forecast for the default rate and our own forecast for the recovery rate based on the historical relationship between recoveries and defaults. With the release of February's default report, the Moody's baseline default rate forecast fell to 3.14% for the next 12 months. Based on this forecast, we estimate that the recovery rate will be 44%. Combining the default and recovery rate forecasts gives an estimate for default losses of 3.14% x (1- 0.44) = 176bps for the next 12 months. Since the average option-adjusted spread of the Bloomberg Barclays U.S. High-Yield index is currently 378bps, we calculate the default-adjusted spread to be: 378 bps - 176bps = 202bps. A default-adjusted spread of 202bps is 60bps higher than the reading of 142bps that prevailed just last week. This 60bps spread advantage makes a considerable difference in terms of projected excess returns. Chart 14 shows the relationship between 12-month excess returns and the starting default-adjusted spread. We observe a reasonably strong correlation and note that, using a linear regression, an extra 60bps of spread translates to an extra +251bps of excess return on average over a 12-month period. Chart 1412-Month Excess High-Yield Returns Vs. Ex-Ante Default-Adjusted Spread (2002 - Present) March Madness March Madness Table 1 provides more detail in terms of what excess returns have historically been associated with different levels of the default-adjusted spread. We see that when the default-adjusted is between 100 bps and 150bps, high-yield bonds earn positive excess returns 64% of the time over the following 12 months. When the default-adjusted spread is between 200bps and 250bps, high-yield earns a positive 12-month excess return 71% of the time. Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread March Madness March Madness Given our upbeat assessment of the trend in defaults and a wider junk spread than we have seen in a while, we think it is a good time to upgrade high-yield from neutral to overweight. The key near-term risk to this view is that the Fed will be more hawkish than we anticipate at this week's meeting. If the Fed's median forecast is revised up to four hikes in 2017, then it is possible that the recent bout of junk spread widening will have a bit further to run. However, given still-low inflation readings, the Fed would eventually be forced to back away from its hawkish rhetoric and support renewed spread tightening. In our view, the main risk to upgrading junk this week is that we are a bit too early. Bottom Line: U.S. junk bond spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade U.S. High-Yield from neutral to overweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?", dated March 7, 2017, available at gfis.bcaresearch.com 2 Last week, we presented the Euro Area months-to-hike measure. We discovered that our measure was not calibrated for the current era of negative interest rates in Europe, and the months-to-hike indicated was actually signaling the "months until interest rates turned positive." We have since corrected our methodology to show the months until one full 25bp rate hike was priced in from the current negative levels, which is what is shown in Chart 7 of this report. This does not change the direction of the months-to-hike indicator, but it does bring forward to date of the first rate hike versus what was presented last week. 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil", dated March 9, 2017, available at ces.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index March Madness March Madness Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Monetary Policy: The Fed will lift rates this week, but will likely leave its median forecast for three hikes this year unchanged. With inflation still below target the Fed has an incentive to take it easy. Curve steepeners, TIPS breakeven wideners and overweight spread product positions will benefit. Duration: The growth outlook is improving and the 10-year Treasury yield could soon move higher, breaking out of its recent trading range. An already elevated economic surprise index should not be a deterrent. High-Yield: Junk spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade high-yield from neutral to overweight. Feature Chart 1How Much Hawkishness ##br##Can Markets Take? How Much Hawkishness Can Markets Take? How Much Hawkishness Can Markets Take? In early November, just prior to the U.S. election, money markets were still only discounting one rate hike before the end of 2017. The Fed has already raised rates once since then and the market is now almost priced for another three hikes before year-end (Chart 1). Encouragingly, financial markets digested the shift up to two 2017 rate hikes without much of a hiccup - the yield curve steepened, TIPS breakevens widened and junk spreads tightened - but the journey from two to three hikes has not gone down quite as easily (Chart 1, bottom panel). The yield curve has now started to flatten, breakevens have leveled off and junk spreads have edged wider. The worry is that a further shift in expectations - from three to four hikes in 2017 - might cause markets to choke. Fed Will Take It Slow Markets are already priced for a rate hike at this week's FOMC meeting along with no change to the Fed's median forecast for three hikes in 2017. As such, we would not expect much of a market reaction if that outcome is delivered. If the Fed were to increase its median forecast from three to four hikes in 2017, then we would anticipate at least some tightening of financial conditions. In other words, we would expect the yield curve to flatten, TIPS breakevens to narrow, the dollar to strengthen and credit spreads to widen. As we have written several times,1 with core inflation and TIPS breakevens still below target, the Fed must ensure that the economic recovery continues. It will therefore be quick to back away from any nascent hawkishness if financial conditions start to tighten. With markets already showing some signs of stress, we expect the Fed to err on the side of caution this week. This means the Fed will lift rates, but also leave the median forecast of three 2017 rate hikes unchanged. This notion that the Fed should be lifting rates, but only very slowly, is confirmed by our Fed Monitor (Chart 2). The Fed Monitor is a composite of 32 indicators that track the evolution of U.S. economic growth, inflation pressures and financial market conditions. Historically, a positive reading from the monitor has coincided with rate hikes, and vice versa. Chart 2BCA Fed Monitor Suggests A Slow Pace Of Rate Hikes BCA Fed Monitor Suggests A Slow Pace Of Rate Hikes BCA Fed Monitor Suggests A Slow Pace Of Rate Hikes The Fed Monitor just recently moved above zero, suggesting that only modestly tighter monetary policy is required. As an aside, we view the strongly positive readings from the Fed Monitor in 2011 and 2012 as anomalous and an artifact of the zero-lower-bound on interest rates. Since interest rates could not be lowered as much as would have been necessary (according to the Fed Monitor) in 2009, they also could not be raised as quickly as the monitor suggested in 2011. With the base effects from the financial crisis now out of the data, the Fed Monitor should go back to providing a useful signal about the future course of monetary policy. Chart 3BCA Fed Monitor Components BCA Fed Monitor Components BCA Fed Monitor Components We gain further insight from splitting the Fed Monitor into its three key components: growth, inflation and financial conditions (Chart 3). The growth component has accelerated strongly into positive territory but the inflation component still suggests that an easy policy stance is required. Financial conditions are also consistent with modest Fed tightening but have ticked down in recent weeks as the market has discounted a more rapid pace of hikes. Judging from the prior two cycles, an acceleration of the inflation component will be necessary for the Fed to deliver on its current expected path of rate hikes. While the Fed has sometimes started to lift rates with the inflation component below zero, that component has always surged into positive territory soon after hikes began (Chart 3, panel 2). While economic growth is accelerating, below-target inflation means that the Fed must continue to nurture the economic recovery. Investors should position for a steeper curve, wider TIPS breakevens and tighter credit spreads until inflationary pressures are more pronounced. This means at least until long-maturity TIPS breakevens reach the 2.4% to 2.5% range and core PCE inflation is firmly anchored around 2%. Bottom Line: The Fed will lift rates this week, but will likely leave its median forecast for three hikes this year unchanged. With inflation still below target the Fed has an incentive to take it easy. Curve steepeners, TIPS breakeven wideners and overweight spread product positions will benefit. Consolidation Complete? The 10-year Treasury yield has been stuck in a tight range below 2.6% since mid-December (Chart 4), but recent trends in the economic data suggest that it could be on the verge of breaking through this key resistance level. Economic surprises are positively correlated with changes in the 10-year Treasury yield and currently appear extended (Chart 4, bottom panel). While not a mean-reverting series by construction, economic surprises tend to follow a mean reverting pattern because investors revise their expectations higher as the economic data outperform. Eventually, expectations are bound to become excessive and the series will mean revert. However, we have found that economic surprises are usually first reflected in Treasury yields. In fact, changes in the 10-year Treasury yield tend to lead the economic surprise index by several weeks. This means that stagnant yields during the past few months have already foreshadowed a reversal in the surprise index. In other words, some mean reversion in economic surprises is already in the price and should not prevent yields from rising in the coming weeks. More important is that economic growth should be sustainably above trend on a 6-12 month horizon. This will continue to put upward pressure on inflation and ensure that the Fed remains in a rate hike cycle. Judging from recent data, not only is growth sustainably above trend, but it is probably even accelerating. Last week's February employment report showed that nonfarm payrolls rose by 235k, the second consecutive month of gains above 200k. The rate of change of employment growth is now threatening to reverse the downtrend that started in early 2015, and aggregate hours worked have accelerated suggesting that GDP growth will be strong in Q1 (Chart 5). Chart 410-Year Yield Facing Resistance 10-Year Yield Facing Resistance 10-Year Yield Facing Resistance Chart 5Labor Market Points To Stronger Growth... Labor Market Points To Stronger Growth... Labor Market Points To Stronger Growth... Financial conditions are also supportive of a further acceleration in growth. We found that the financial conditions component of our Fed Monitor provides a strong indication of near-term trends in GDP growth (Chart 6). This highlights that growth should be strong during the next few months but also that the Fed must respond to any tightening in financial conditions if it wants growth to remain robust. Chart 6...So Do Financial Conditions ...So Do Financial Conditions ...So Do Financial Conditions Bottom Line: The growth outlook is improving and the 10-year Treasury yield could soon move higher, breaking out of its recent trading range. An already elevated economic surprise index should not be a deterrent. The Value Is Back In High-Yield One of our key themes for 2017 is that the uptrend in the high-yield default rate is due for a pause.2 With the first quarter of the year nearly complete, all the indicators that make up our Default Rate Model are showing noticeable improvement (Chart 7). Chart 7Default Rate Indicators Are Showing Improvement Default Rate Indicators Are Showing Improvement Default Rate Indicators Are Showing Improvement Interest coverage remains elevated A strong Manufacturing PMI points to a rebound in after-tax cash flow Lending standards have rolled over and are now just barely in "net tightening" territory An improving sales/inventory ratio portends a return to positive industrial production growth Job cut announcements have fallen back to 2011 levels on a trailing 12-month basis Meantime, even though the default outlook continues to improve, junk spreads have actually widened during the past couple of weeks. The average option-adjusted spread on the Bloomberg Barclays High-Yield index has widened from a low of 344 basis points up to 378 bps (Chart 8). Some of that spread increase is likely attributable to declining oil prices, as energy sector credits have indeed underperformed the overall index. However, the underperformance of the energy sector also started before the sharp drop in oil prices (Chart 8, bottom panel). In any event, our commodity strategists are not expecting the current decline in oil prices to persist and their estimates show that the oil market has recently shifted from an environment of excess supply to one of excess demand. U.S. crude oil inventories are poised to decline later this month and the OPEC / non-OPEC production deal negotiated by the Kingdom of Saudi Arabia and Russia at the end of last year should be met with high compliance.3 If this view is correct, then the energy sector will not drag overall junk spreads wider in the months ahead. The combination of wider junk spreads and an improving default outlook has led to an increase in our preferred gauge of value for high-yield bonds - the default-adjusted spread (Chart 9). The default-adjusted spread is calculated by subtracting an ex-ante estimate of default losses from the average spread on the Bloomberg Barclays High-Yield index. Chart 8Energy Contributed To Junk Sell-Off Energy Contributed To Junk Sell-Off Energy Contributed To Junk Sell-Off Chart 9Some Value Returns To High-Yield Some Value Returns To High-Yield Some Value Returns To High-Yield To arrive at an estimate of default losses we use the Moody's baseline forecast for the default rate and our own forecast for the recovery rate based on the historical relationship between recoveries and defaults. With the release of February's default report, the Moody's baseline default rate forecast fell to 3.14% for the next 12 months. Based on this forecast we estimate that the recovery rate will be 44%. Combining the default and recovery rate forecasts gives an estimate for default losses of 3.14% x (1- 0.44) = 176 bps for the next 12 months. Since the average option-adjusted spread of the Bloomberg Barclays High-Yield index is currently 378 bps, we calculate the default-adjusted spread to be: 378 bps - 176 bps = 202 bps. A default-adjusted spread of 202 bps is 60 bps higher than the reading of 142 bps that prevailed just last week. This 60 bps spread advantage makes a considerable difference in terms of projected excess returns. Chart 10 shows the relationship between 12-month excess returns and the starting default-adjusted spread. We observe a reasonably strong correlation and note that, using a linear regression, an extra 60 bps of spread translates to an extra +251 bps of excess return on average over a 12-month period. Chart 1012-Month Excess High-Yield Returns Vs. ##br##Ex-Ante Default-Adjusted Spread (2002 - Present) Buy The Back-Up In Junk Spreads Buy The Back-Up In Junk Spreads Table 1 provides more detail in terms of what excess returns have historically been associated with different levels of the default-adjusted spread. We see that when the default-adjusted is between 100 bps and 150 bps, high-yield bonds earn positive excess returns 64% of the time over the following 12 months. When the default-adjusted spread is between 200 bps and 250 bps, high-yield earns a positive 12-month excess return 71% of the time. Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Buy The Back-Up In Junk Spreads Buy The Back-Up In Junk Spreads Given our upbeat assessment of the trend in defaults and a wider junk spread than we have seen in a while, we think it is a good time to upgrade high-yield from neutral to overweight. The key near-term risk to this view is that the Fed will be more hawkish than we anticipate at this week's meeting. If the Fed's median forecast is revised up to four hikes in 2017, then it is possible that the recent bout of junk spread widening will have a bit further to run. However, given still-low inflation readings, the Fed would eventually be forced to back away from its hawkish rhetoric and support renewed spread tightening. In our view, the main risk to upgrading junk this week is that we are a bit too early. Bottom Line: Junk spreads have widened even though default rate indicators continue to show improvement. With valuations now looking more attractive, we upgrade high-yield from neutral to overweight. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "Fed's Pre-Emptive Hike Will Hit Gold, Not Oil", dated March 9, 2017, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

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