Canada

Highlights Duration: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). ECB: The ECB has started to take notice of the latest batch of softening euro area economic data. Yet it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases by year-end. Canada: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and inflation. Stay underweight Canadian government bonds. Feature We're Sticking With Our Country Allocations One of our key investment themes for 2018 has been that economic growth, monetary policies and bond yields would be far less correlated between countries than was seen in 2017. This would create cross-country fixed income trading and investment opportunities that were much harder to come by last year. With the 10-year U.S. Treasury yield finally reaching the 3% level last week, that story looks to be playing out. Yields are going up elsewhere, but nothing like what is happening in the U.S., where growth remains firm compared to the string of negative data surprises seen in other countries (Chart of the Week). This theme of divergence can also be seen in the recent actions and comments from central bankers. Officials at the U.S. Federal Reserve have continued to signal, with increasing conviction, that additional rate hikes will be needed later this year (although not at this week's FOMC meeting). This is to be expected given that not only is U.S. growth holding up well (Q1 real GDP growth "only" slowed to an above-potential pace of 2.3%), but both core PCE inflation and the Wages & Salaries component of the Employment Cost Index are accelerating at a marginal pace not seen since the 2008 crisis (Chart 2). Chart of the WeekU.S. Economy Outperforming,##BR##USTs Underperforming U.S. Economy Outperforming, USTs Underperforming U.S. Economy Outperforming, USTs Underperforming Chart 2No Reason For The Fed##BR##To Turn Less Hawkish No Reason For The Fed To Turn Less Hawkish No Reason For The Fed To Turn Less Hawkish At the same time, policymakers in other major developed countries have turned somewhat more cautious: The Bank of Japan (BoJ) announced that it will no longer provide a specific date when it expects inflation to reach its target The European Central Bank (ECB) took the highly unusual step of holding a monetary policy meeting last week without actually discussing the monetary policy outlook, according to ECB President Mario Draghi Bank of England (BoE) Governor Mark Carney dampened expectations of a rate hike in May that was nearly fully discounted by markets The Bank of Canada (BoC), which had already delivered several rate hikes when inflation was below its 2% target, chose to keep rates on hold despite inflation finally breaching 2% Sweden's Riksbank pushed out the expected timing of its next rate hike (yet again) to the end of 2018, even with inflation now at target With global growth losing some momentum, it is no surprise that policymakers are trying to not sound too hawkish, which could trigger an unwelcome decline in inflation expectations. Here again, divergences between countries have opened up. Rising oil prices are translating into higher market-based inflation expectations in countries like the U.S. and Canada where growth is still above-potential and leading economic indicators are rising (Chart 3). This is not the case in places like the U.K., Australia and Japan where growth is sluggish, leading indicators are slowing, but with markets still pricing in interest rate increases over the next year (Chart 4). This divergence is a critical underpinning of our current recommended country allocation within government bond markets - overweighting the U.K., Australia and Japan where tighter monetary policy will be difficult to achieve; while underweighting the U.S. and Canada, where rate hikes are still in the cards. Chart 3Shifting Oil/Inflation Correlation... Shifting Oil/Inflation Correlation... Shifting Oil/Inflation Correlation... Chart 4...In Countries Where Growth Is Slowing ...In Countries Where Growth Is Slowing ...In Countries Where Growth Is Slowing The European Duration Call Gets A Bit Trickier The evidence on the euro area is a bit less conclusive on this front, however. The OECD's leading economic indicator has only dipped modestly from its recent peak, and the correlation between oil prices and inflation expectations has not broken down. Draghi stated in his press conference following last week's policy meeting that the ECB Governing Council was focused on "very important" current euro area economic data that had clearly lost momentum in the first quarter of this year. He noted that there were many one-off factors that could have caused the softer growth (weather, labor strikes, the timing of holidays), but that the slump was very broad-based and hit almost all euro area countries. This makes the next few months of data critical to determine the ECB's next policy move, which could be an announcement of a tapering of its asset purchases when the current program ends in September. From our perspective, the sluggish Q1 euro area economic performance looks to be driven by a major slowing of export growth. Industrial confidence remains at a high level and growth in retail sales volumes has remained stable since the middle of 2017 (Chart 5). Yet the annual growth rate of total euro area exports has slumped to less than 3%, with exports to Asia now contracting on a year-over-year basis (bottom two panels). If the export slump continues in the coming months, this could begin to impact hiring activity across the euro area. A rise in unemployment would definitely change the ECB's calculus in altering its policy stance. At the moment, the Governing Council can look at a steadily declining overall euro area unemployment rate - which is approaching the OECD's estimate of the full employment NAIRU - combined with moderate increases in core HICP inflation, wage growth and inflation expectations, as confirmation that trends are still broadly following the path laid out in its latest economic projections (Chart 6). Chart 5An Export-Led Cooling##BR##Of Euro Area Growth An Export-Led Cooling Of Euro Area Growth An Export-Led Cooling Of Euro Area Growth Chart 6ECB Will Not Lift Rates Until##BR##Inflation Expectations Move Back To 2% ECB Will Not Lift Rates Until Inflation Expectations Move Back To 2% ECB Will Not Lift Rates Until Inflation Expectations Move Back To 2% The ECB has made it clear that it views a tapering of its asset purchases and any subsequent interest rate hikes as separate policy decisions. The hurdle to end the bond purchases is much lower than it is for raising interest rates. On the former, as long as unemployment and inflation continue to evolve along the lines of the ECB's projections, then a full tapering of bond purchases will occur by year-end (with an announcement occurring at either of the June or July ECB meetings). On the latter, it will take inflation expectations (as measured by the 5-year EUR CPI swap, 5-years forward) rising back above 2% for the ECB to feel confident that rate increases will be necessary, as was the case during the mid-2000s tightening cycle and the 2011 mini-cycle (bottom panel). For now, we are maintaining our moderate underweight stance on euro area government debt. Looking ahead, we will be watching the correlation between oil prices denominated in euros and inflation expectations, as well as the development of leading economic indicators in the euro area. If the Q1 growth slump widens into a broader downturn, then the ECB could be forced to revise its economic projections lower and continue with the asset purchases into 2019. While that is not our base case scenario, such a development would force us to reconsider our stance on euro area debt. Bottom Line: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). In Europe, it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases later this year. Canada: Still On Track For More Hikes This Year The BoC has been sending more cautious signals of late regarding its next policy moves, after delivering 75bps of rate hikes since last summer. Some of this simply reflects a more measured tone taken by other central banks in response to signs of global growth losing some momentum, as discussed earlier. Yet in the case of Canada, it is difficult to make a credible case that the central bank should not continue its rate hiking cycle, particularly with inflation now above the midpoint of the BoC's 1-3% target band. Upside Risks To Canadian Growth Versus BoC Projections Yes, the Canadian economy has lost some of the rapid upward momentum seen in 2016 and 2017, led mostly by weakness in exports which are now contracting on a year-over-year basis (Chart 7). This was focused in aircraft, transportation equipment, and energy products. The latter is due to poor weather conditions and transportation bottlenecks involved in getting oil out of Alberta rather than a sign of weakening demand for Canadian oil. The BoC did take a more cautious view on exports in the latest set of economic projections presented in the April Monetary Policy Report (MPR). The central bank now expects real exports to be stagnant in 2018, downgrading the expected contribution to real GDP growth to zero from the +0.6 percentage points presented in the January MPR. This was, by far, the biggest downgrade to any of the GDP growth components in the BoC's forecast, and was main reason why the BoC downgraded its overall 2018 real GDP growth projection to 2.0% from 2.2%. Yet at the same time, the BoC actually upgraded its global growth projection to 3.8% from the 3.6% figure in the January MPR. We suspect that the downgrade to the export contribution to expected 2018 growth was the BoC trying to inject some room for error in its growth forecasts for any negative outcome in the current round of NAFTA trade negotiations with the U.S. and Mexico. Otherwise, it makes no sense to have such a large downgrade without becoming more pessimistic on global growth. Our Geopolitical strategists are now much more optimistic that a NAFTA deal will be reached, rather than having the U.S. exit the agreement as President Trump has threatened. If that happens, the BoC's growth projections may end up being too low. We can see a similar level of "excessive cautiousness" with regards to the BoC's assessment of the Canadian labor market and the outlook for consumption. Consumer spending has also cooled off a bit from very robust levels, although an unusually long and harsh winter likely played a large role there, as evidenced by the suspiciously large plunge in retail sales growth (Chart 8). The fundamental underpinnings for Canadian consumption still look solid, though. Chart 7Canadian Economy Holding Up Well,##BR##Despite Weak Exports Canadian Economy Holding Up Well, Despite Weak Exports Canadian Economy Holding Up Well, Despite Weak Exports Chart 8Solid Income Fundamentals##BR##For The Canadian Consumer Solid Income Fundamentals For The Canadian Consumer Solid Income Fundamentals For The Canadian Consumer Consumer confidence remains near cyclical highs. Wage growth currently sits at 3.2% in nominal terms and 1.5% in real terms. The BoC noted in its Spring Business Outlook Survey that wage pressures are increasing due to greater competition in the labor market (3rd panel) and, to a lesser extent, recent minimum wage increases. The BoC noted in the April MPR that wages were growing "somewhat below what would be expected were the economy operating with no excess labor." Yet that argument appears overly pessimistic - the unemployment rate is currently 0.7 percentage points below the OECD's NAIRU estimate, at a time when nominal wages are growing in excess of 3%. Again, there is a greater chance that the BoC will end up surprised by how strong Canadian wage growth will turn out over the next 6-12 months. Even the persistent structural problems of very high Canadian household debt levels and overheated house prices appear less of an issue at the moment. The household debt/GDP ratio has stabilized as growth in mortgage debt has decelerated since mid-2017 - an outcome that can be attributed to rising mortgage rates, tighter lending standards on mortgage lending and poor housing affordability in the major cities (Chart 9). Meanwhile, the supply side of the housing market is finally improving with housing starts now back to pre-recession levels. National house price inflation has cooled from the overheated 15% growth rates to a more "normal" pace around 5%, according to data from Terranet. There will be a long-term day of reckoning for the highly-indebted Canadian homeowner during the next recession. In the near term, however, the combination of rising supply, lower demand and softer house prices suggest that the Canadian housing market is trending in a direction of becoming less imbalanced. The BoC took note of these developments in the April MPR, using much less cautious language in describing the risk to the inflation outlook from household debt and overheated housing markets. The outlook for Canadian business investment also has the potential to give an upside surprise to the BoC. The Spring Business Outlook Survey showed that firms' capital spending intentions remain very strong (Chart 10), a fact confirmed by the robust growth in import volumes of machinery & equipment (middle panel). Finally, the overall financial condition for Canadian companies is in good shape, according to our new Canadian Corporate Health Monitor (CHM) that was introduced last week.1 The CHM correlates strongly with the overall Business Outlook Survey Indicator (bottom panel), which suggests that the cyclical improvement in the financial health of Canadian companies will support capital spending in the coming quarters - especially if the uncertainty over the NAFTA negotiations fades away. Chart 9A Better Supply/Demand Balance##BR##In Canadian Housing? A Better Supply/Demand Balance In Canadian Housing? A Better Supply/Demand Balance In Canadian Housing? Chart 10Canadian Capex##BR##Is In Good Shape Canadian Capex Is In Good Shape Canadian Capex Is In Good Shape The BoC Will Be Surprised By Canadian Inflation, Too Chart 11Inflation Now Above The BoC's 2% Target Inflation Now Above The BoC's 2% Target Inflation Now Above The BoC's 2% Target With the economy likely to continue expanding at an above-potential pace in the next 6-12 months, the current uptrend in inflation is should continue. Headline CPI inflation is already above the 2% target and core inflation is right at target (Chart 11). The BoC is forecasting that CPI inflation will only remain modestly above 2% until the end of 2018, and will return back to 2% in 2019. Yet there is essentially no spare capacity left in the Canadian economy, based on output gap estimates of both the BoC and International Monetary Fund (IMF). The BoC has slightly revised its projection for the Q1 2018 output gap, leaving it somewhat wider than the previous forecasts due to positive revisions of potential GDP growth (now 1.8% from 1.6% in the January MPR, based on a faster pace of trend labor productivity). These are small changes, however, and real GDP growth is likely to be faster than the BoC is projecting in 2018. Market-based inflation expectations have been steadily rising along with the increase in global energy prices (bottom panel), and we continue to expect inflation breakevens to widen over the balance of 2018. BoC Will Not Disappoint Market Expectations On Rate Hikes The markets are currently discounting a similar pace of rate hikes in Canada and the U.S. over the next year, according to pricing in the Overnight Index Swap (OIS) markets (Chart 12). The BoC's estimate of the neutral policy rate is between 2.5% and 3.5%, which is well above the current policy rate of 1.25%. The OIS market is discounting 75bps of hikes over the twelve months, which would take the policy rate to 2% - still a below-neutral, accommodative level for an economy that is already at full employment and where inflation has risen back to the BoC's target. We expect the BoC to continue to follow its typical pattern of following moves by the Fed with a lag. This is a sensible strategy given how exposed Canadian growth is to U.S. growth through exports, and also given how responsive the Canadian dollar is to the expected rate differentials between the U.S. and Canada. Given our view that the Fed will deliver at least another 50bps of rate hikes over the course of 2018, with the potential for more if inflation continues to accelerate without any growth slowdown, the BoC will likely deliver on the rate hikes currently discounted by markets. This is the main reason why we are maintaining our underweight stance on Canadian Government bonds (bottom panel). The BoC has a much higher potential to actually hike rates by at least as much as the market is expecting, which is not the case in every other developed market country except the U.S., where we are also underweight. This week, however, we are stopping ourselves out of our recommended Tactical Overlay trade in the Canadian BAX interest rate futures curve (long the Dec/18 contract versus the June/18 contract). We introduced that trade back in January, positioning for more rapid BoC rate hikes in the latter half of 2018 that would flatten the BAX futures curve. The recent dovish turn by the BoC has resulted in a steepening of the BAX futures curve, however, and we are stopping ourselves out at a modest loss of -0.12% (Chart 13). Chart 12Stay Underweight##BR##Canadian Government Debt Stay Underweight Canadian Government Debt Stay Underweight Canadian Government Debt Chart 13We Are Stopped Out Of##BR##Our BAX Futures Curve Trade We Are Stopped Out Of Our BAX Futures Curve Trade We Are Stopped Out Of Our BAX Futures Curve Trade Bottom Line: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: Growth Is Papering Over The Cracks", dated April 24, 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index From Convergence To Divergence From Convergence To Divergence Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global corporate bond markets have seen both ups and downs so far in 2018. Credit spreads in the developed markets and emerging markets, both for investment grade (IG) and lower quality credit tiers, tightened in January. This was followed by a sharp widening of spreads in the two months after the "VIX spike" in early February. Spreads have begun narrowing again in April, but remain above levels that began the year in all major countries with one notable exception - U.S. high-yield. Feature The volatility in corporate credit is a reflection of the growing list of investor worries, coming at a time when yields and spreads still remain near historically low levels in almost all markets. Topping that list is the fear that low unemployment and rising inflation rates will force the major central banks to maintain a more hawkish (or, at least, less dovish) policy bias in the medium term, even with the global economy losing some upside momentum so far this year after a robust 2017. Add in other concerns over U.S. trade policy (i.e. tariffs), U.S. fiscal policy (i.e. wider deficits, more U.S. Treasury issuance) and even signs of potential stresses in global funding markets (i.e. wider LIBOR-OIS spreads), and it is no surprise that more uncertain investors have become less comfortable with the risks stemming from credit exposure. This can be seen in the volatility of mutual fund and ETF flows into riskier bond categories like U.S. high-yield (HY), which saw a whopping -$19.8bn in outflows in Q1/2018, but has already seen +$3.8bn in inflows in April - possibly in response to the surprisingly strong results seen in Q1 U.S. corporate earnings reports.1 Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. In this CHM Chartbook, we introduce new country coverage to our CHM universe, adding a bottom-up measure for Japan and both top-down and bottom-up CHMs for Canada. After these new additions, we now have CHMs covering 92% of the Barclays Bloomberg Global Corporate Bond Index universe, based on country market capitalization weightings. The broad conclusion from the latest readings on our CHMs is that global credit quality has enjoyed a cyclical improvement in response to the coordinated growth seen in 2017, but with important geographical differences (Chart 1): Chart 1Global Corporates: Now Supported##BR##By Growth, Not Central Banks Global Corporates: Now Supported By Growth, Not Central Banks Global Corporates: Now Supported By Growth, Not Central Banks Credit quality in the U.S. has improved on the back of the solid performance of U.S. profits over the past year, but high leverage and low interest coverage suggest corporates are highly vulnerable to any slowing in economic growth Underlying credit quality in euro area corporates remains supported by low interest rates and the easy money policies of the European Central Bank (ECB), but the CHMs are trending in the wrong direction due to poor profitability metrics - most notably, a very depressed return on capital - and rising leverage among core European issuers U.K. corporate health continues to benefit from a very robust short-term liquidity position, although sluggish profitability and weak interest coverage suggest potential medium-term problems beneath the surface Japanese corporates are in good shape, enjoying strong interest coverage and low leverage, although absolute levels of profitability remain much lower than the other countries in our CHM universe Canadian corporate health has enjoyed some modest cyclical improvement, but low absolute levels on profitability and interest coverage, combined with high leverage, point to underlying risks. Looking ahead, the tailwinds that have supported corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds. Inflation expectations are moving higher in most countries, fueled by low unemployment rates and rising oil prices. This is most evident in the U.S., where the additional boost to growth from fiscal stimulus will keep the Fed on its rate hiking path over the next year. A mild inflation upturn is also visible in the euro area and Japan, where the ECB and Bank of Japan (BoJ) are already contributing to a less favorable liquidity backdrop for corporates by reducing the pace of their asset purchases. That trend is projected to continue over the next year, to the detriment of credit market returns that have been boosted by those unusual monetary policies (see the bottom panel of Chart 1). At some point within the 6-12 months, more hawkish central banks will act to slow global economic growth, triggering a more fundamental underperformance of corporates versus government bonds. For now, the backdrop remains supportive, but the clock is ticking as the end of this credit cycle draws closer. U.S. Corporate Health Monitors: A Cyclical Improvement, But Underlying Problems Persist Our top-down CHM for the U.S. has been flashing "deteriorating health" for fourteen consecutive quarters dating back to the middle of 2014 (Chart 2). Yet there has been a modest cyclical improvement seen in many of the individual CHM ratios over the past couple of years - most importantly, return on capital and profit margins - helping push the top-down level to close to the zero line. It is important to note that, due to delays in the reporting of the data used in the top-down U.S. CHM, the latest reading is only from the 4th quarter of 2017.2 A move into "improving health" territory in the 1st quarter of 2018 would require additional increases in cyclical profitability measures. This will be difficult to achieve with U.S. economic growth cooling off a bit in the first three months of 2018 (although the enactment of the Trump corporate tax cuts will likely help support the after-tax measure of margins used in the top-down CHM as 2018 progresses). From a longer-term perspective, the fact that the top-down CHM return on capital metric is well off the post-crisis peak is a disturbing development, given that non-financial corporate profit margins have been stable over the same period. This suggests a more fundamental problem with weak U.S. productivity growth and lower internal rates of return on marginal investments for companies, which is a longer-term concern for U.S. corporate health when the economic growth backdrop becomes less friendly. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also both improved, with the HY indicator sitting right at the zero line. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term problems of high leverage and low returns on capital are not going away. In particular, HY interest and debt coverage remains near multi-decade lows. Chart 2Top-Down U.S. CHM:##BR##A Cyclical Pause Of A Structural Deterioration Top-Down U.S. CHM: A Cyclical Pause Of A Structural Deterioration Top-Down U.S. CHM: A Cyclical Pause Of A Structural Deterioration Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##A Bit Better, But Still Deteriorating Bottom-Up U.S. Investment Grade CHM: A Bit Better, But Still Deteriorating Bottom-Up U.S. Investment Grade CHM: A Bit Better, But Still Deteriorating What is rather worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of debt has now expanded to a point where the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or the U.S. experiences a major economic downturn. Interest costs would rise while earnings deteriorate, which would push interest coverage to historic lows, as was discussed in a recent report from our flagship Bank Credit Analyst service.3 For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after U.S. inflation expectations rise to levels consistent with the Fed's inflation target (i.e. when both the 5-year/5-year forward U.S. TIPS breakeven and the outright 10-year TIPS breakevens reach 2.4-2.5%). This will give the Fed confidence to follow through on its rate hike projections, pushing the funds rate to restrictive levels. In turn, that will dampen future corporate profit expectations and raise risk premiums on U.S. corporate bonds. With those breakevens now sitting at the highest point in four years (2.19%), that tipping point for credit markets is drawing nearer. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##A Strong Cyclical Improvement Bottom-Up U.S. High-Yield CHM: A Strong Cyclical Improvement Bottom-Up U.S. High-Yield CHM: A Strong Cyclical Improvement Chart 5The Beginning Of The End Of##BR##The U.S. Credit Cycle The Beginning Of The End Of The U.S. Credit Cycle The Beginning Of The End Of The U.S. Credit Cycle Euro Corporate Health Monitors: Getting Better Thanks To The Economy & The ECB Our top-down Euro Area CHM remains in "improving health" territory, as it has for the entire period since the 2008 crisis. The trend in the indicator has been steadily worsening since 2015, however, and the top-down CHM now sits just below the zero line (Chart 6). The steady deterioration of the top-down CHM is due to declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity and interest coverage, which are being supported by the easy money policies of the ECB (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Compared to the top-down CHMs we have constructed for other countries, there is an even longer lag on data availability from euro area government statisticians. Our top-down euro area CHM is only available to the 3rd quarter of 2017 and, therefore, does not reflect the strong performance of the euro area economy at the end of last year. Our bottom-up versions of the euro area CHMs for IG (Chart 7) and HY (Chart 8), which are based on individual earnings data that is more timely, both show that corporate health continued to improve at the end of 2017. Return on capital for euro area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, similar to the level in the bottom-up U.S. IG CHM but higher than the equivalent measures in our U.K., Japan and Canada CHMs. Both interest coverage and liquidity ratios for euro area IG are also close to U.S. IG levels. The euro area HY CHM is also showing improvement though declining leverage, although these results should be interpreted with caution as the sample size is relatively small. Chart 6Top-Down Euro Area CHM:##BR##Health Improving At A Diminishing Rate Top-Down Euro Area CHM: Health Improving At A Diminishing Rate Top-Down Euro Area CHM: Health Improving At A Diminishing Rate Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Steady Improvement Bottom-Up Euro Area Investment Grade CHMs: Steady Improvement Bottom-Up Euro Area Investment Grade CHMs: Steady Improvement Within the Euro Area, our bottom-up CHMs show that the gap has closed between issuers from the core countries versus those in the periphery, but all still remain in the "improving health" zone. (Chart 9). Return on capital, interest coverage and debt coverage are higher in the core, while liquidity is better in the periphery despite more highly levered balance sheets. Chart 8Bottom-Up Euro Area High-Yield CHMs:##BR##Steady Improvement As Leverage Declines Bottom-Up Euro Area High-Yield CHMs: Steady Improvement As Leverage Declines Bottom-Up Euro Area High-Yield CHMs: Steady Improvement As Leverage Declines Chart 9Bottom-Up Euro Area IG CHMs:##BR##Core Vs. Periphery Bottom-Up Euro Area IG CHMs: Core Vs. Periphery Bottom-Up Euro Area IG CHMs: Core Vs. Periphery While all of our euro area CHMs are indicating healthier balance sheets, that fact is already discounted in the low yields and tight spreads for both IG and HY issuers (Chart 10). Euro area corporates are also benefitting from the supportive bid of the ECB, which buys credit as part of its asset purchase program. We expect the ECB to fully taper its government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. That would be a scenario that could be keep euro area credit spreads tight, although the momentum in the euro area economy will likely be the more important driver of credit valuations. If the soft patch in growth seen in the first few months of 2018 continues in the coming months, euro area credit spreads would likely widen, although by less than if the ECB was not buying corporates. We have preferred to own U.S. corporates over Euro Area equivalents for much of the past year. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although that has not yet flowed through into any meaningful outperformance of U.S. IG and HY corporates. Chart 10European Credit:##BR##Spreads & Yields Have Bottomed Out European Credit: Spreads & Yields Have Bottomed Out European Credit: Spreads & Yields Have Bottomed Out Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe Relative Top-Down CHMs Still Favor The U.S. Over Europe Relative Top-Down CHMs Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: Still No Major Causes For Concern The top-down U.K. CHM remains firmly in the "improving health" zone, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital remains near 20-year lows around 6%, however, mirroring levels seen in this ratio in the CHMs for other countries. Profit margins remain at 20%, near the middle of the historical range. U.K. credit has benefitted from highly stimulative monetary policy settings by the Bank of England (BoE) - especially after the 2016 Brexit shock when the central bank not only lowered policy rates, but announced bond buying programs for both Gilts and U.K. corporates. The BoE has begun to take back some of that monetary easing by raising rates 50bps since last November. However, we remain skeptical that the central bank will be able to deliver much additional tightening over the rest of 2018 given sluggish growth, falling realized inflation and lingering Brexit uncertainties weighing on business confidence. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet both yields and spreads have been drifting higher in recent months, mirroring the trends seen in other global corporate bond markets (Chart 13). It is difficult to paint a scenario of renewed outperformance of U.K. credit versus Gilts without a fresh catalyst like accelerating growth or monetary easing. Yet the combination of accommodative monetary policy with a solid credit backdrop leads us to maintain a neutral recommendation on U.K. corporate debt. Chart 12U.K. Top-Down CHM:##BR##Steady Improvement U.K. Top-Down CHM: Steady Improvement U.K. Top-Down CHM: Steady Improvement Chart 13U.K. Credit: Yields & Spreads##BR##Are Drifting Higher U.K. Credit: Yields & Spreads Are Drifting Higher U.K. Credit: Yields & Spreads Are Drifting Higher Japan Corporate Health Monitor: A Small, But Very Healthy, Market We introduced our Japan CHM in a recent Weekly Report.4 We only have a bottom-up version of the indicator at the moment, as there is not the same consistency of top-down data sources as are available in other countries. Furthermore, the Japanese corporate bond market is small, as companies have historically chosen to borrow money (when needed) through bank loans and not bond issuance. This means that we have a much more limited amount of data available with which to build a Japan CHM, which covers only 43 companies and only goes back to 2006. The Japan CHM has been in "improving health" territory for the past decade, driven by very healthy liquidity levels and rising return on capital and interest coverage (Chart 14). While the trend in the latter two ratios differs from what is shown in all CHMs for other countries, it is noteworthy that Japan's return on capital has risen to a "high" level (6%) that is similar to the current historically low levels in the U.S. and Europe. The comparison is even less flattering when looking at profit margins, which have been steadily improving over the past five years but are only around 6% - less than half the levels seen in the bottom-up IG CHMs for the U.S. and Europe. Turning to the corporate spread, it has slightly widened in 2018, but by a far smaller amount than seen in other corporate bond markets (Chart 15). We have shown that Japanese corporate spreads are highly correlated to the level of the yen. The direct effect is obvious, as a stronger yen will hurt the competitiveness and profitability of the exporter-heavy Japanese non-financial corporate sector. Yet a strong yen is also a reflection of the market's belief in the next move by the BoJ with regards to Japanese monetary policy. On the front, we continue to expect the BoJ to maintain a very dovish policy stance, with no change in the central bank's interest rate targets (both for short-term interest rates and the 10yr JGB yield). The bigger issue will be if the current softness in the Japanese economic data turns into a broader trend, which would damage corporate profits and likely result in some widening of Japanese credit spreads.  Chart 14Japan Bottom-Up CHM:##BR##Very Healthy Japan Bottom-Up CHM: Very Healthy Japan Bottom-Up CHM: Very Healthy Chart 15Japanese Corporates##BR##Will Continue To Outperform JGBs Japanese Corporates Will Continue To Outperform JGBs Japanese Corporates Will Continue To Outperform JGBs Canada Corporate Health Monitor: In Good Shape On A Cyclical Basis In this CHM Chartbook, we are introducing new CHMs for Canada. Like Japan, this is another relatively small market. Canadian corporates represent a slightly larger share of the Bloomberg Barclays Global Investment Grade Corporate Bond Index (5%) than Japan (3%). The average credit rating of the Canadian corporate bond index is A2/A3, which is higher quality than that of the U.S. IG index with but with similar credit spreads over their respective government bonds. However, due to the lack of liquidity and market accessibility, Canadian corporates are considered a niche market that has not gained much attention from global investors. We created both a top-down and bottom-up version of the Canada CHM. For the bottom-up CHM, we gathered data on 85 companies from both the Bloomberg Canadian dollar-denominated IG and HY indices. We combined IG and HY bonds into one set of data given the small sample sizes of each category, which also allows us to compare it to the top-down Canadian CHM that does not distinguish by credit quality. Both Canadian CHMs are firmly in the "improving health" territory (Chart 16). Unsurprisingly, these CHMs have shown a reasonably strong correlation to oil prices, which are a key driver of the Canadian economy through the energy sector. This can be seen in the deterioration in the CHMs after global oil prices collapsed in 2014/15, and the subsequent improvement as oil prices have recovered over the past couple of years. Going through the individual CHM components, leverage has been steadily rising and currently sits around 100%. While Canada's problems with high household debt levels are well known, the Bank for International Settlements (BIS) noted in its March 2018 Quarterly Review that high Canadian corporate leverage could also pose a future problem for the Canadian economy.5 Among the other CHM ratios, return on capital and profit margin have fallen for nearly a decade, although there has been some moderate improvement of late thanks to higher oil prices. Debt coverage and interest coverage are also showing some very moderate recovery due to low interest rates - a trend also observed in other countries where central banks have maintained easy monetary policy. Canadian corporate bond valuations are not cheap at the moment, with the index spread around decade-lows of 100bps (Chart 17). BCA's commodity strategists expect global oil prices to continue climbing over the next year, which should support Canadian corporate valuations versus government bonds given past correlations. We also expect the Bank of Canada to continue to slowly raise interest rates over the next year, as well, mimicking moves we also anticipate from the U.S. Federal Reserve. Given the cyclical signs of improving corporate health from our Canadian CHMs, and our bearish views on Canadian government bonds, we are upgrading our recommended allocation on Canadian corporates to overweight while downgrading governments. This is strictly a carry trade, however, as we do not anticipate spreads narrowing much from current levels. Chart 16Canada CHMs:##BR##Cyclical Improvements, Structural Problems Canada CHMs: Cyclical Improvements, Structural Problems Canada CHMs: Cyclical Improvements, Structural Problems Chart 17Canadian Corporates:##BR##No Cyclical Case For Spread Widening Yet Canadian Corporates: No Cyclical Case For Spread Widening Yet Canadian Corporates: No Cyclical Case For Spread Widening Yet Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.6 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Table 1Definitions Of Ratios##BR##That Go Into The CHMs BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks Appendix Chart 1We Now Have CHM Coverage For 92% Of##BR##The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks 1 http://lipperalpha.financial.thomsonreuters.com/2018/04/high-yield-bond-funds-attract-investor-attention/ 2 The majority of data used in the top-down U.S. CHM comes from the Federal Reserve's quarterly Financial Accounts Of The United States Z1 release (formerly known as the Flow of Funds), which is typically published in the third month following the end of a quarter. Thus, those data inputs for Q1/2018 will not be available until June. 3 Please see Section II of the March 2018 edition of The Bank Credit Analyst, available at bca.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 5 https://www.bis.org/publ/qtrpdf/r_qt1803.htm 6 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. When the chartbook was last published in September 2017, the main message was that less accommodative monetary policy was required in the developed economies. This was largely driven by solid global growth and diminishing economic slack visible in measures like falling unemployment rates and rising capacity utilization. Since then, there have been multiple rate hikes in the U.S., single rate increases in Canada and the U.K., and a slowing of the pace of central bank asset purchases in the euro area and Japan. No other central banks have made any moves, however, with inflation still struggling to return to policymaker targets in most countries. A new element that central banks are dealing with is the increased financial market volatility seen in 2018. Yet the BCA Central Bank Monitors continue to point to a need for tighter monetary policy in all countries (Chart of the Week). This means policymakers are unlikely to "come to the rescue" of less stable financial markets through more dovish (and bond bullish) policy without evidence that slower global growth was leading to an easing of cyclical inflation pressures. Chart of the WeekGreater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Greater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Greater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Feature An Overview Of The BCA Central Bank Monitors Chart 2The Cyclical Backdrop Remains Bond Bearish The Cyclical Backdrop Remains Bond Bearish The Cyclical Backdrop Remains Bond Bearish The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are above the zero line for all countries for which we have built the indicator. This implies that the conditions are not yet present to expect a period of declining global bond yields driven by more dovish central banks. Yet differences in the trajectories of the Monitors have opened up. The BoE, RBA and RBNZ Monitors have fallen well off their peaks, while the Fed, ECB, BoC and even the BoJ Monitors are all still at or close to recent highs. In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against our 12-Month Discounters, which measure the expected change in interest rates over the following year taken from OIS curves. Fed Monitor: Market Turbulence Not Yet Enough To Change Fed Plans Our Fed Monitor remains in the "tight money required" zone, signalling that cyclical pressures are still pointing toward additional Fed rate hikes (Chart 3A). FOMC officials are now expressing strong conviction that the Fed's growth and inflation forecasts for 2018 will be realized, and even upgraded those projections last month. That increased confidence comes amid signs that core inflation is finally moving higher after last year's surprising slump (Chart 3B). Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. No Spare Capacity In The U.S. No Spare Capacity In The U.S. The growth and inflation subcomponents of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published last September. In particular, the inflation subcomponent is on the cusp of breaching the zero line for the first time since 2011 (Chart 3C). The Fed Monitor (unlike the other Central Bank Monitors) includes a Financial Conditions component that is rolling over from very elevated (i.e. supportive) levels. Chart 3CSteady Pressure On The Fed To Tighten, But More From Growth Than Inflation Steady Pressure On The Fed To Tighten Steady Pressure On The Fed To Tighten The sharp sell-off in U.S. equity markets seen since early February is a development that would typically give the Fed pause on the need to tighten monetary policy further. Yet there are no real signs - yet - that any slowing of U.S. growth is in the cards for the next few quarters. Leading indicators are still climbing, employment growth has been accelerating in recent months, and both consumer and business confidence remain around multi-year highs. The Fed is likely to deliver on its projection of an additional 50bps of rate hikes in 2018, which is already discounted in money markets (Chart 3D). Additional increases beyond that in 2019 are still likely to occur, barring any signs that the current financial market volatility is altering the current rising trends in growth and inflation. Chart 3DThe Fed Will Continue To Hike In 2018 & 2019 The Fed Will Continue To Hike In 2018 The Fed Will Continue To Hike In 2018 BoE Monitor: Diminishing Pressures To Hike The Bank of England (BoE) Monitor is drifting lower, but remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has raised the base rate only once over that period - in November of last year. On the surface, inflation pressures remain strong. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, largely because the British pound is now up 9% off the post-Brexit 2016 lows. Rapid declines in pipeline price pressures (PPI, imported goods price inflation) point to additional slowing of CPI inflation in the next several months. Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Tight Capacity In The U.K. Tight Capacity In The U.K. Meanwhile, the economic picture looks mixed. Leading economic indicators have rolled over, as have cyclical measures like the manufacturing PMI and industrial production. Yet at the same time, recent readings on both consumer and business confidence have shown modest improvement. Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator are now falling (Chart 4C). Given the decelerating path of leading economic indicators, and with the currency-fueled rise in U.K. inflation now starting to reverse, we think the BoE will be hard pressed to deliver more than the 41bps of rate hikes over the next year currently discounted in U.K. money markets (Chart 4D). Chart 4CGrowth & Inflation Components Of The BoE Monitor Are Slowing Growth & Inflation Components Of The BoE Monitor Are Slowing Growth & Inflation Components Of The BoE Monitor Are Slowing Chart 4DThe BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted The BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted The BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted We continue to recommend an overweight stance on Gilts, which continue to trade as a "defensive" lower-beta alternative to U.S. Treasuries and core European debt, within dedicated global government bond portfolios. ECB Monitor: Tapering? Yes. Rate Hikes? No. Our European Central Bank (ECB) Monitor has been grinding higher over the past couple of years and broke sustainably above zero in July 2017 (Chart 5A). The broad-based cyclical economic upturn in the euro area has continued to absorb spare capacity, with the unemployment rate for the entire region now down to 8.6%, right at the OECD's NAIRU estimate (Chart 5B). Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area Economy Now At Full Capacity Euro Area Economy Now At Full Capacity Euro Area Economy Now At Full Capacity Despite strong growth, headline (1.1%) and core (1.0%) inflation remain well below the ECB's target of "just below" 2%. This lack of upward momentum flies in the face of the inflation subcomponent of our ECB Monitor, which has been steadily moving higher for the past three years (Chart 5C). Chart 5CRising Pressure On ECB To Tighten Monetary Conditions Rising Pressure On ECB To Tighten Monetary Conditions Rising Pressure On ECB To Tighten Monetary Conditions The ECB remains on track to deliver some of the monetary tightening that our ECB Monitor is calling for later this year, but it will not be through interest rate hikes (Chart 5D). ECB officials have made it clear that a tapering of asset purchases will take place when the current program ends this September. However, it will take more evidence that inflation will sustainably return to the ECB's target before rate hikes will commence. Chart 5DECB Will Deal With Tightening Pressures First By Tapering Asset Purchases ECB Will Deal With Tightening Pressures First By Tapering Asset Purchases ECB Will Deal With Tightening Pressures First By Tapering Asset Purchases The recent softening of cyclical euro area economic data like manufacturing PMIs, combined with underwhelming inflation prints, justifies the ECB's cautiousness on rates. Although leading economic indicators are still pointing to another year of above-trend growth in 2018. The likelihood of a taper later this year leads us to recommend a moderate underweight stance on core European government bonds, but with a neutral stance on Peripheral European debt which benefits from an expanding economy. BoJ Monitor: Still Far Too Soon To Expect Any Policy Changes The Bank of Japan (BoJ) Monitor has inched into the "tighter money required" zone for the first time since 2007 (Chart 6A), thanks largely to a robust economy. Yet while growth has been enjoying strong momentum, inflation remains stuck below the BoJ's 2% target - even with record low unemployment and a positive output gap (Chart 6B). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BJapanese Inflation Still Too Low Japanese Inflation Still Too Low Japanese Inflation Still Too Low Japanese businesses remain reluctant to boost wages despite robust profitability and a tight labor market. This makes it difficult for the BoJ to hit the 2% inflation target even using extreme policy tools like negative interest rates and asset purchases. Yet even these policies are approaching limits. Liquidity in the Japanese government bond (JGB) market is severely impaired with the BoJ now owning nearly one-half of all outstanding JGBs. This is the main reason why the BoJ shifted from targeting a 0% yield on the 10-year JGB back in September 2016, aiming to target the price of bonds purchased instead of the quantity. With both the inflation and growth components of our BoJ Monitor are now above the zero line (Chart 6C), a case could be made for the BoJ to consider raising its yield target on the 10-year JGB. In our view, any shift in the BoJ yield curve target will only happen if the yen is much weaker (the 115-120 range), core inflation and wage growth both hit at least 1.5%, and global bond yields hit new cyclical highs (i.e. the 10-year U.S. Treasury yield approaching 3.5%). Chart 6CGrowth & Inflation Pressures Have Picked Up In Japan Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation We continue to recommend an overweight stance on Japan, as the BoJ remains a long way from signaling to the markets that interest rate expectations must begin to rise (Chart 6D). Chart 6DThe BoJ Will Not Signal Any Change In Policy In 2018 The BoJ Will Not Signal Any Change In Policy In 2018 The BoJ Will Not Signal Any Change In Policy In 2018 BoC Monitor: Still Following The Fed The Bank of Canada (BoC) Monitor has stayed above the zero line since the beginning of 2017 (Chart 7A). The BoC has hiked rates three times since last summer, with Canada's robust growth justifying the tightening of monetary policy. Real GDP expanded by 3% in 2017, enough to push Canada's output gap into positive territory and drive the unemployment rate (5.8%) to below NAIRU (6.5%). As a result, both headline and core inflation are now back to the midpoint of the BoC's 1-3% target range (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BNo Spare Capacity In The Canadian Economy No Spare Capacity In The Canadian Economy No Spare Capacity In The Canadian Economy Growth has cooled a bit recently, though, most notably in consumer spending and housing data. In addition, the inflation component of the BoC Monitor has slowed and is diverging from the rising growth component (Chart 7C). These developments may be a sign that previous BoC hikes are starting to have an impact, although overall GDP growth remains well above trend and leading economic indicators are not slowing. Chart 7CA Divergence In The Growth & Inflation Components Of The BoC Monitor A Divergence In The Growth & Inflation Components Of The BoC Monitor A Divergence In The Growth & Inflation Components Of The BoC Monitor Looking ahead, the Trump administration's rising protectionist rhetoric is a potential threat to both Canada's economy and the value of the Canadian dollar. However, Canada was exempted from the recent tariffs imposed on U.S. steel and aluminum imports, suggesting that Trump may only seek a renegotiation, rather than a tearing up, of NAFTA. We continue to recommend an underweight stance on Canadian government bonds. Only 51bps of rate hikes are discounted over the rest of 2018 (Chart 7D), a pace that can be surpassed if the BoC follows its typical behavior of following the policy lead of the U.S. Fed, which is still expected to deliver 2-3 more rate hikes this year. Chart 7DThe BoC Will Continue Its Hiking Cycle This Year The BoC Will Continue Its Hiking Cycle This Year The BoC Will Continue Its Hiking Cycle This Year RBA Monitor: Lagging Behind While our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory, it has pulled back considerably over the past four months and is now near the zero line (Chart 8A). This move suggests that there is no imminent need to adjust monetary policy, given tepid inflation pressures. Despite the recent surge in employment growth, labor markets still have plenty of slack. Part time employment as a percentage of total employment and the underemployment rate are both near all-time highs. Wage growth is weak and a substantial recovery is unlikely given that real GDP growth slowed in Q4 and the output gap is still wide (Chart 8B). Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BAustralian Inflation Remains Subdued Australian Inflation Remains Subdued Australian Inflation Remains Subdued Looking ahead, consumption is at risk. Real wage growth has been nonexistent, so households have supported their spending by reducing savings. However, the rate of increase for house prices has slowed and prices in Sydney actually declined in Q4. If overall house prices were to decline going forward, then the lack of a wealth effect boost would force already massively-indebted consumers to reverse the savings downtrend and cut spending. Both headline and underlying inflation remain below the RBA's target range of 2-3%, with policymakers expecting underlying inflation to reach 2% only in June of 2019 with just a gradual improvement in labor markets. The inflation component of our RBA Monitor has already declined significantly on the back of collapsing iron ore prices, softening survey-based inflation measures and cooling house prices (Chart 8C). Chart 8CThe Inflation Component Of The RBA Monitor Has Plunged The Inflation Component Of The RBA Monitor Has Plunged The Inflation Component Of The RBA Monitor Has Plunged As such, we maintain our overweight position on Australian government debt, as the RBA will not even deliver the one 25bp rate hike in 2018 currently discounted by markets (Chart 8D). Chart 8DThe RBA Will Not Deliver The Discounted Rate Hikes In 2018 The RBA Will Not Deliver The Discounted Rate Hikes In 2018 The RBA Will Not Deliver The Discounted Rate Hikes In 2018 RBNZ Monitor: No Inflation, No Rate Hikes Our Reserve Bank of New Zealand (RBNZ) Monitor, which was the most elevated of all our Central Bank Monitors in last September's update, has plunged sharply since then (Chart 9A). Inflation remains stubbornly below the midpoint of the RBNZ's 1-3% target range, even with a tight labor market and no spare capacity in the New Zealand economy (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ At Full Employment, But Inflation Peaking NZ At Full Employment, But Inflation Peaking NZ At Full Employment, But Inflation Peaking Both the growth and inflation sub-components have fallen sharply, with the inflation measure now down below the zero line (Chart 9C). A firmer New Zealand dollar, the flipside of the weaker U.S. dollar, has played a large role in dampening traded goods price inflation. Chart 9CStrong NZ Inflation Pressures, But Growth May Be Peaking Strong NZ Inflation Pressures, But Growth May Be Peaking Strong NZ Inflation Pressures, But Growth May Be Peaking The February RBNZ Monetary Policy Report expressed an optimistic view on growth supported by elevated terms of trade, population growth, fiscal stimulus and low interest rates. Headline CPI inflation, however, is not projected to rise back to 2% level until 2020. Unsurprisingly, the RBNZ is signaling no change in policy rates until then, even with the central bank projecting the New Zealand dollar to weaken in the next couple of years. We have been recommending long positions in New Zealand government debt versus other developed market debt since last May. New Zealand bonds have outperformed strongly over that period, as markets have priced in no change in rates from RBNZ (Chart 9D) unlike other countries where rate hikes were repriced and, in some cases, delivered. With the RBNZ on hold for at least this year and likely much of 2019, we our staying long New Zealand government bonds. Chart 9DRBNZ Will Stay On Hold In 2018 RBNZ Will Stay On Hold In 2018 RBNZ Will Stay On Hold In 2018 Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Policymakers Are In A Tough Spot BCA Central Bank Monitor Chartbook: Policymakers Are In A Tough Spot Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way U.S. Growth Leading The Way U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Sticking With The Plan Sticking With The Plan 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations Tracking Our Recommendations Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Sticking With The Plan Sticking With The Plan Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor The Japan Corporate Health Monitor The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Sticking With The Plan Sticking With The Plan Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Data based on Bloomberg/Barclays global treasury/aggregate indexes from December 1990 to January 2018 supports the argument that foreign government bonds are not worthy of investing in when unhedged, due to extremely high volatility. On a hedged basis, however, foreign bonds are a good source of risk reduction for bond portfolios. Hedging not only reduces volatility of a foreign government bond portfolio, it reduces it so much that on a risk adjusted-return basis, foreign government bonds outperform both domestic government bonds and domestic credit for investors in Australia, New Zealand, the U.K., the U.S. and Canada. Aussie and kiwi fixed income investors stand out as the biggest beneficiaries of investing overseas, because hedged foreign government bonds not only provide lower volatility compared to domestic bonds, but also higher returns. This empirical evidence does not support the strong home bias of Aussie and kiwi investors. Investors in the euro area also benefit from the risk reduction of hedged foreign exposure. However, they also suffer significant return reduction - such that the improvement in risk-adjusted returns is not significant. Investors in Japan do enjoy higher returns from foreign government bonds, hedged and unhedged, yet at the cost of much higher volatility, with risk-adjusted returns also not justifying investing overseas. This empirical finding does not lend support to the "search for yield" strategy that has been very popular among Japanese investors. Feature Practitioners and academics do not often agree with one another on investment management issues, but when it comes to whether to hedge foreign government bonds, both accept that foreign government bonds should be fully hedged because currency volatility overwhelms bond volatility. Yet hedged total returns from foreign government bonds are very similar to those from domestic bonds for investors in the U.S., U.K. and Canada, while worse in the euro area. Only in Japan, Australia and New Zealand do investors enjoy higher hedged returns from investing in foreign bonds, as shown in Chart 1 based on Bloomberg/Barclays Global Treasury Indexes hedged to their respective home currencies. So why do investors in the U.S., U.K. and euro area, whose own government bond markets currently account for about 60% of the global treasury index universe (Chart 2), even bother to invest in foreign government bonds? Even for those who may achieve higher returns overseas, would they not be better off just buying domestic corporate bonds (for the potentially higher returns from taking domestic credit risk) rather than venturing into foreign countries and taking the trouble to hedge currency risk? Indeed, home bias among bond investors globally is a lot higher than among equity investors. Chart 1Domestic Vs. Foreign Bonds Domestic Vs. Foreign Bonds Domestic Vs. Foreign Bonds Chart 2Country Weights In Global Treasury Index Country Weights In Global Treasury Index Country Weights In Global Treasury Index In this report, we present empirical evidence based on Bloomberg/Barclays domestic treasury indexes and aggregate bond indexes, hedged and unhedged global treasury indexes in seven different currencies (USD, EUR, JPY, GBP, CAD, AUD and NZD), in the context of strategic asset allocation. In a future report, we will attempt to identify the driving forces underpinning the decisions between investing in domestic bonds versus foreign bonds in the context of tactical asset allocation. Hedged Foreign Government Bonds Are a Good Source Of Diversification When a foreign bond is hedged back to the domestic currency, its total return correlation with domestic bonds is quite high. As shown in Chart 3, domestic bonds and their respective hedged foreign bonds have an average correlation of around 70% for all currencies, with the exception of the JPY. For Japanese investors, hedged foreign bonds have a much lower correlation with JGBs, averaging around 30%. Intuitively, there should not be a high incentive for USD, GBP, CAD, EUR, AUD and NZD based investors to invest in foreign bonds, while JPY based investors should benefit from the diversification of hedged foreign bonds. In reality, the very high home bias among fixed income investors in general and the popularity of search-for-yield carry trades among Japanese individual investors seems to support this. Is there empirical evidence that shows the same thing? Table 1 presents statistics from Bloomberg/Barclays domestic treasury indexes and their respective market cap-weighted foreign treasury indexes, hedged and unhedged, in USD, JPY, GBP, EUR, CAD, AUD and NZD. Please see Appendix 1 for the hedged return calculation. Chart 3High Correlations High Correlations High Correlations Table 1Domestic And Foreign Government Bond Profile (Dec 1999 - Jan 2018) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? On an unhedged basis, foreign bonds have much higher volatility compared to domestic bonds for all investors. In terms of return, only Japanese investors enjoy higher yields overseas. On a risk-adjusted return basis, all investors are worse off in investing in unhedged foreign bonds. This is in line with the "conventional wisdom" acknowledged by both academics and practitioners. Hedging not only reduces the corresponding foreign bond portfolio's volatility, it reduces it so much, for all currencies other than the JPY, that the foreign bond portfolio has lower volatility than domestic bonds. As such, in terms of risk-adjusted return, hedged foreign bonds outperform domestic government bonds in all countries except Japan. This implies that on a risk-adjusted return basis, Japanese investors should not invest in hedged foreign bonds at all, while other investors should. Even more shockingly, Table 1 shows that AUD and NZD investors would have achieved both higher returns and lower volatility by investing in hedged foreign bonds. These implications appear to fly in the face of common sense for AUD and NZD investors, because their domestic bonds have much higher returns than others, while in reality Japanese retail investors are keen on "carry trades" as a way to enhance yields. What has caused such significant discrepancies? Could it be simply due to the time period chosen? Chart 4 and Chart 5 present the results of the same analysis performed over different periods: the whole period from 1990, when the majority of the Bloomberg/Barclays indexes first became available; pre-euro (1990-2000); after the euro and before the global financial crisis (GFC); and after the GFC (the extremely low-yield period). Surprisingly, the relative performance of hedged foreign bonds versus domestic bonds for each currency has been quite consistent across all the time periods in terms of risk-adjusted returns, even though absolute performance varied in different periods. Chart 4Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time (1) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Chart 5Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time (2) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? So when it comes to investing in hedged foreign government bonds, investors with different home currencies should bear the following observations in mind: For Japanese investors, the slightly higher yield enhancement from hedged foreign bonds comes with sharply higher volatility compared to JGBs. The risk-adjusted return does not justify investing in foreign bonds.1 This is mostly because Japanese bonds have below-average volatility, while hedged foreign bonds have above-average volatility. For euro area investors, the lower volatility from foreign bonds is at the expense of lower returns. The improvement in risk-adjusted returns is not significant enough to justify the extra work in hedging. U.K. gilts have the highest volatility. As such, U.K. investors have benefited the most in risk reduction from buying hedged foreign bonds, to the slight detriment of returns. Consequently, they are better off investing in hedged foreign government bonds if improving risk-adjusted return is the objective. The Aussie and kiwi government bond markets are very small in terms of market cap (Chart 2). Fortunately, hedged foreign bonds not only have lower volatility than domestic bonds, they also provide much higher returns. Indeed, Aussie and kiwi investors are the most suitable candidates for going global. For U.S. and Canadian investors, hedged foreign portfolios and domestic indexes share similar returns, but foreign portfolios have much lower volatility, hence better risk-adjusted returns. Hedging currencies is not an easy task. Would investors not be better off taking domestic credit risks than investing in hedged foreign government bonds? Domestic Credit Or Hedged Foreign Government Bonds? The Bloomberg/Barclays domestic aggregate bond indexes are comprised of treasuries, government-related, corporate, and securitized bonds. Chart 6 shows the total returns of the aggregate bond indexes and the corresponding treasury weights in each country index. It is clear that Japan's credit portion is very small, while the U.S. and Canadian credit markets dominate their corresponding treasury markets. In the euro area and Australia, credit accounts for about half of the aggregate index, while it is only about 30% in the U.K. Since some aggregate indexes have a short history (Chart 6), we use the corresponding treasury index to fill in the missing links. In the case of New Zealand, an aggregate index does not exist at all, local treasury bonds are used instead in our analysis below. Table 2 presents the risk/return profiles of the Bloomberg/Barclays domestic aggregate bond indexes, and the same market cap-weighted global treasury index hedged and unhedged in USD JPY, GBP, EUR, CAD, AUD and NZD. Chart 6Aggregate Bond Index Composition Aggregate Bond Index Composition Aggregate Bond Index Composition Table 2Domestic Aggregate Bond Index Vs. Hedged Global Treasury Index (Dec 1999 - Jan 2018) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Domestic credits also improve the risk-adjusted returns for all the investors, and for investors in the U.S., Canada and Australia, credits also add returns while reducing volatility compared to their respective treasury indexes. However, the hedged global treasury index has much lower volatility than the domestic aggregate index such that on a risk-adjusted-return basis, the hedged global treasury index still outperforms the local aggregate index for all investors except those in Japan and the euro area. Similar to the findings in the previous section, this observation also holds true across all the time periods as shown in Charts 7 and 8. Aussie and kiwi investors stand out again as the best beneficiaries of going global because the hedged global treasury indexes not only have lower volatility than the domestic aggregate bond indexes, they also provide higher returns. Chart 7Domestic Aggregate Vs. Global Treasury: Consistent Performance Across Time (3) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Chart 8Domestic Aggregate Vs. Global Treasury: Consistent Performance Across Time (4) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? This raises an interesting question for asset allocators: which bond index should one use to measure the performances of global bond managers? It is common for some pension funds and mutual funds to use a domestic aggregate bond index as a benchmark to measure their bond managers' performance. In such a case, what are you really paying for if your managers have the discretion to buy hedged foreign government bonds? Another interesting observation is that the hedged global treasury index has almost the same volatility around 2.85% in different currencies. This essentially levels out the playing-field for bond managers globally in terms of volatility, a very important criteria for bond investors. Is High Home Bias Justifiable? There are many well-known reasons that explain why home bias in bond portfolios is typically high. But are investors giving up too much for the comfort of "staying home"? Chart 9 shows the effects of adding hedged foreign government bonds into a portfolio of domestic aggregate bonds for each investor based on two timeframes - from 1990 and from 1999 to the present. The messages are clear: If investors are comfortable with the volatility in their domestic aggregate bond index, which is already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with currency hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. Chart 9Is High Home Bias Justifiable? Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K., the euro area and Canada are better off investing a large portion overseas. In short, while there may be some justification for most fixed-income investors to maintain a home bias, empirical evidence does not lend strong support to Aussie and kiwi investors having a home bias at all. Chart 9 shows that Australian and New Zealand investors should consider investing 70-90% of their fixed income portfolio in hedged foreign government bonds for higher returns and lower volatility. Implications For Asset Allocators Chart 10What Drives The Dynamics Between ##br## Foreign And Domestic Bonds? What Drives The Dynamics Between Foreign And Domestic Bonds? What Drives The Dynamics Between Foreign And Domestic Bonds? The analysis presented in this report is by nature based on historical data. The findings may not apply to the future, especially because the periods for which we have data cover only the great bull market in government bonds. However, this exercise does provide some interesting aspects for consideration: Should hedged foreign government bonds have a presence in strategic asset allocation? If your fixed income managers have the discretion to invest in foreign government bonds, then is it appropriate for you to use a domestic aggregate bond index to measure their performance? In the context of strategic asset allocation, the answer to the first question is yes and to the second is no, as implied by the analysis in this report. In the context of tactical asset allocation, however, the answer may well be different. In a later report, we will attempt to identify the factors that drive the dynamics between domestic and hedged foreign bonds because the most obvious factor, interest rate differentials, cannot fully explain it as shown in Chart 10. Stay tuned. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com 1 Granted, Japanese retail investors do not pay attention to risk adjusted returns as much as institutional investors do. Therefore their buying unhedged foreign bonds is consistent with their yield enhancement objective, albeit at much higher volatility. Appendix 1: Bond Hedged Return Calculation We use the same methodology as Bloomberg/Barclays1 to calculate hedged return using one-month forward contracts and re-balancing on a monthly basis. This is unlike equity hedging, where the gain or loss of the underlying index during the month is not hedged.2 A bond index can be reasonably assumed to grow at the nominal yield (yield to worst is used). Only the gain/loss that is different from the stated yield during the month is not hedged, but converted back to the home currency at the month-end spot rate. Hedged return using forward contract: 1+Rd,t+1= (Pt+1 * St+1 ) / (Pt * St ) + Ht*(Ft - St+1)/ St..............................................(1) Where: Pt and Pt+1 are the foreign bond total return index levels at time t and t+1 in corresponding foreign currencies; St and St+1 are the foreign currency exchange rates versus the domestic currency at time t and t+1, quoted as one unit of foreign currency equal to how many units of domestic currency; Ht = (1 + Yt/2)(1/6) is the hedged notional; Yt is the yield to worst; Ft is the foreign currency's one-month forward rate at time t for delivery at time t+1; Rd,t+1 is the hedged total return in domestic currency of the foreign hedge index between time t and t+1. 1 https://www.bbhub.io/indices/sites/2/2017/03/Index-Methodology-2017-03-17-FINAL-FINAL.pdf 2 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com

Highlights Federal Reserve: Is the U.S. neutral rate now higher? ECB: How much has the euro rally damaged European growth? Bank of Japan: Will a stronger yen tip Japan back into deflation? Bank of England: Will higher real wages offset Brexit uncertainties? Bank of Canada & Reserve Bank Of Australia: How much spare capacity truly exists? Feature We have not published a regular Weekly Report in Global Fixed Income Strategy since February 6th. We instead published necessary Special Reports on two countries of immediate relevance: Japan, because of the recent surprising strength in the yen, and Italy, because of the upcoming election. The pause in our regular commentary on the state of the markets, however, was useful. It has given us more time to reflect on the potential for a continuation of the global bond bear market after the volatility spike earlier in the month. What we find interesting is that, despite the common narrative that the back-up in global bond yields seen in 2018 has been about rising inflation fears, market pricing suggests the big shift has instead been in real bond yields and central bank policy expectations. In Table 1, we present the year-to-date change in the 10-year government bond yield for the major developed markets. We also show the changes in various other interest rate measures, including: Table 12018 Year-To-Date Changes In Government Bond Yield Components The Biggest Question Facing Each Central Bank The Biggest Question Facing Each Central Bank Our 12-month Policy Rate Discounters, which show the change in short-term interest rates priced into money market curves Our proxy measure of the market pricing of the real neutral ("terminal") interest rate - the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward Our estimate of the term premium on the 10-year government bond yield. What stands out in the table is that markets have moved to price in both a higher amount of expected rate hikes over the next year (Chart 1) and a higher neutral real interest rate, even with very little change in expected inflation. This can also been seen by looking at recent declines in the correlations between inflation expectations and nominal bond yields in the major economies, which are off from the peaks seen late in 2017 (Chart 2). Chart 1Rising Rate Expectations Have##BR##Been Pushing Yields Higher Of Late... Rising Rate Expectations Have Been Pushing Yields Higher Of Late... Rising Rate Expectations Have Been Pushing Yields Higher Of Late... Chart 2...Rather Than Higher##BR##Inflation Expectations ...Rather Than Higher Inflation Expectations ...Rather Than Higher Inflation Expectations The obvious conclusion is that the bulk of the rise in global bond yields seen year-to-date has been driven by increases in the real yield component, which itself has been heavily influenced by expected changes to central bank policy rates. Keeping that in mind, in this Weekly Report, we take a look at the most important question faced by each major central bank, and what that means for future decisions on policy interest rates - and by extension, for government bond yields. The Federal Reserve: "Is The U.S. Neutral Rate Now Higher?" With the 10-year U.S. Treasury yield having taken several runs at the critical 3% level in recent weeks, the debate has raged among investors as to whether that should be considered a breakout point or a buying opportunity. Comparing the U.S. economy now to what it looked like the last time the 10-year yield was at 3% at the end of 2013 suggests that yields could have more upside: Real GDP growth: 1.7% then, 2.3% now1 The unemployment rate: 6.7% then, 4.1% now Headline CPI inflation: 1.4% then, 2.1% now Core CPI inflation: 1.7% then, 1.8% now Average Hourly Earnings growth: 1.9% then, 2.9% now Growth is faster, there is less spare capacity, and inflation is higher now than it was just over four years ago. Yet when looking at the decomposition of the 10-year U.S. Treasury yield into its real and inflation expectations component (Chart 3, 2nd panel), we find that the mix is only slightly more skewed to real yields today: Chart 3Treasury Yields Still Have More Upside,##BR##Based On 2013 Comparisons Treasury Yields Still Have More Upside, Based On 2013 Comparisons Treasury Yields Still Have More Upside, Based On 2013 Comparisons Nominal 10-year Treasury yield: 3.03% then (December 31st, 2013), 2.87% now (February 26th, 2018) Inflation expectations (10-year CPI swap): 2.54% then, 2.30% now Real yields (nominal 10-year yield minus 10-year CPI swap): 0.49% then, 0.57% now In other words, the real yield today is 20% of the total nominal 10-year yield compared to 16% back at the end of 2013. Not a major difference. Yet there are much bigger discrepancies between the elements that go into our real neutral rate proxy for the U.S. (bottom two panels): 5-year OIS rate, 5-years forward: 4.1% then, 2.6% now 5-year CPI swap rate, 5-years forward: 2.9% then, 2.3% now Real neutral rate proxy: 1.2% then, 0.3% now The market is now pricing in a real neutral funds rate that is nearly one full percentage point below the level that prevailed the last time the 10-year Treasury yield reached 3% prior to 2018. Even though the U.S. economy is now growing faster, with far less spare capacity and higher inflation, than it did at the end of 2013. This does suggest that the level of the neutral real fed funds rate has likely gone up, which the 43bps increase in our market-implied real neutral rate proxy so far in 2018 is likely reflecting. But does the Fed actually believe that the neutral funds rate should be higher? The minutes from the January FOMC meeting, released last week, noted that there was discussion on the neutral funds rate, but one that was different than during previous FOMC meetings in 2017 - the actual appropriate level of the neutral funds rate was a topic of debate: "Some participants also commented on the likely evolution of the neutral federal funds rate. [...] the outlook for the neutral rate was uncertain and would depend on the interplay of a number of forces. For example, the neutral rate, which appeared to have fallen sharply during the Global Financial Crisis when financial headwinds had restrained demand, might move up more than anticipated as the global economy strengthened. Alternatively, the longer-run level of the neutral rate might remain low in the absence of fundamental shifts in trends in productivity, demographics, or the demand for safe assets."2 Any change in the Fed's estimation of the long-run neutral funds rate is critical for the future path of Treasury yields, given where market pricing is at the moment. The U.S. OIS curve has now fully converged to the FOMC interest rate projections (the "dots") for this year and next year. More importantly, the market-implied terminal rate (the nominal 5-year OIS rate, 5-years forward) has now caught up to the FOMC terminal rate dot (Chart 4). The implication is that any further meaningful increase in Treasury yields can only come from higher inflation expectations - unless the Fed signals that a higher neutral rate is required. Our colleagues at our sister publication, U.S. Bond Strategy, recently noted that the Fed has historically been much more reluctant to raise its terminal rate projection in response to rising inflation than it was in cutting the projection when inflation falls.3 The conclusion is that inflation expectations will likely need to return to levels consistent with the Fed's inflation target - 2.3-2.5% on both the 10-year TIPS breakeven rate and the 5-year breakeven rate, 5-years forward - before the Fed would make any significant upward revisions to its terminal rate projection. In the meantime, Treasury yields are more likely to see a near-term consolidation, as U.S. data surprises have rolled over, market positioning has become very short, momentum is oversold and market pricing has fully converged with Fed expectations (Chart 5). In terms of data, the release of the next U.S. Employment report on March 9th is critical for the Treasury market in the near term, given that the January uptick in wage growth was the trigger for the spike in bond yields, and subsequent equity market correction, at the beginning of February (bottom panel). Chart 4Could The Fed Move##BR##The Interest Rate 'Goalposts'? Could The Fed Move The Interest Rate 'Goalposts'? Could The Fed Move The Interest Rate 'Goalposts'? Chart 5Treasury Selloff May Be##BR##Due For A Pause Treasury Selloff May Be Due For A Pause Treasury Selloff May Be Due For A Pause The ECB: "How Much Has The Euro Rally Damaged European Growth?" The European Central Bank (ECB) has been slowly preparing markets for an eventual withdrawal of its extraordinary monetary policy stimulus since last summer. Specifically, the ECB has begun a discussion of what it would take to end its bond buying program. Already, the central bank cut the monthly pace of its asset purchases in half at the beginning of 2018, and the topic of "tapering" has come up in many speeches from ECB officials. The ECB has been trying to not present an overly hawkish message when discussing an eventual end to its hyper-easy monetary stance. The overall level of government bond yields - both in the core and Periphery of the Euro Area - has been drifting higher, but by less than the increases seen in the U.S. Inflation expectations have been rising since the middle of 2017, although most of the 23bps increase in the benchmark 10-year German Bund yield seen so far in 2018 can be attributed to rising real yields (Chart 6). The market-implied real neutral rate has also been increasing, but still remains below zero (-0.2%). Yet despite only the modest increase in European interest rate expectations, there has been a substantially larger move in the euro. The trade-weighted euro has bond up by 8% over the past year, bringing the currency back to levels last seen in 2014 (Chart 7, top panel). The appreciating euro has become a subject of focus by the ECB, although it is not yet a cause for worry according to the minutes of the January ECB meeting released last week: Chart 6Only A Modest Rise In European Yields, So Far Only A Modest Rise In European Yields, So Far Only A Modest Rise In European Yields, So Far Chart 7A Potential ECB Dilemma A Potential ECB Dilemma A Potential ECB Dilemma "[...] although the past appreciation of the euro had so far had no significant impact on euro area external demand, volatility in foreign exchange markets represented a further increase that need monitoring."4 Chart 8No Damage Yet To European##BR##Exports From The Euro Rally No Damage Yet To European Exports From The Euro Rally No Damage Yet To European Exports From The Euro Rally The ECB is correct that the rising euro has not yet impacted Euro Area exports, the growth rate of which remains solid at 8% (bottom panel). This contrasts sharply with the performance the last time the trade-weighted euro was at current levels in 2014, when exports were barely growing at all. The difference is a much stronger global economy that is demanding far more European goods and services now compared to four years ago. For now, the ECB can look to the stability of export demand as a sign that the euro has not become a drag on the economy, but some warning signals may be flashing. Euro Area economic data surprises have plunged sharply, and the manufacturing PMI data has been softer in the past couple of months (Chart 8). While the absolute levels of the PMIs suggest an economy that is still growing at an above-trend pace, a continuation of the recent drops could pose a problem for the ECB as it tries to communicate its next policy move to the markets. The surging euro has done very little to drag down overall Euro Area headline inflation, given the strength in global oil prices over the past year (3rd panel). Core inflation has struggled to stay much above 1% over the past year or so, but our core inflation diffusion index - which measures the number of core Euro Area HICP sectors with rising inflation rates versus those with falling inflation rates - has surged in the past couple of months, which typically leads to a faster rate of core inflation (bottom panel). As long as the Euro Area export growth data holds up, the ECB is likely to focus more on rising core inflation than a stronger euro and should begin signaling an end to the asset purchase program by year-end. The Bank Of England: "Will Faster Wage Growth Offset Brexit Uncertainty?" The Bank of England (BoE) has surprised markets with its more hawkish commentary of late, particularly given the reason for the change - faster wage growth. The BoE had previously been cautious on its outlook for the U.K. economy, which was suffering from two powerful drags. First, the uncertainty over the Brexit negotiations was dampening business confidence and restraining capital spending. Second, the surge in realized inflation following the post-Brexit collapse of the British Pound triggered a period of contracting real wages that would be a drag on consumer spending. Until these were resolved, the BoE would be cautious with its future policy moves. Next month's European Union (EU) summit can provide some news on Brexit, as the U.K. government will be seeking a transition agreement that would give U.K. businesses a firm timeline for the separation of the U.K. from the EU. The U.K. government is reported to be seeking a two-year period for the agreement, but it may take longer than that to hammer out all the deals involved with the contentious issues of trade, immigration, etc. The longer the Brexit transition period, the more likely that U.K. firms will hold back on long-term investment spending because of uncertainty. As for the wage side of the story, the annual growth rate of Average Weekly Earnings has increased from 1.7% to 2.6% since the April 2017 low, but this is still below the headline CPI inflation rate of 3% (Chart 9, bottom panel). With the U.K. unemployment rate at a cyclical low of 4.4% - far below the OECD's estimate of the full employment NAIRU rate of 5.1% - additional increases in wage growth are possible if hiring demand does not begin to slow. Yet with U.K. data surprises rolling over (top panel), and with the OECD's U.K. leading economic indicator decelerating (middle panel), there is a growing risk that economic growth will slow in the coming quarters, to the detriment of hiring activity and wages. The current market pricing shows that there remains a wide gap between U.K. inflation expectations and nominal Gilt yields (Chart 10). The real 10-year Gilt yield is -1.84% (deflated by CPI swaps), while the market-implied neutral real interest rate is -1.94%. While such a deeply negative interest rate is unlikely to be a permanent state of affairs in the U.K., such an accommodative policy setting is required to prevent the economy from falling into a deep slump. Chart 9Is The BoE More Worried About##BR##Wage Pressures Than Growth? Is The BoE More Worried About Wage Pressures Than Growth? Is The BoE More Worried About Wage Pressures Than Growth? Chart 10Real Gilt Yields Rising,##BR##But Still Very Low Real Gilt Yields Rising, But Still Very Low Real Gilt Yields Rising, But Still Very Low As we noted back in January, we do not see the BoE being able to raise rates much at all this year given the likelihood of prolonged sluggishness of the U.K. economy and some reversal of the currency-fueled surge in inflation seen in 2017.5 The BoE choosing to tackle rising wage inflation while growth was decelerating would be a huge policy error that would eventually benefit the performance of U.K. Gilts. The Bank Of Japan: "Will A Stronger Yen Tip Japan Back Into Deflation?" The extraordinary monetary policy accommodation provided by the Bank of Japan (BoJ) makes an analysis of Japanese Government Bond (JGB) yields far less interesting. After all, when the central bank is actively intervening in large quantities to hold the level of the 10-year JGB around 0%, do the signals sent from money market and bond yield curves have any meaning vis-à-vis the actual Japanese economy? Right now, the pricing of the real 10-year JGB yield (deflated by CPI swaps) is just below 0%, as is the real terminal rate proxy from the Japanese OIS curve (Chart 11). Keeping JGB yields at such low levels is part of the BoJ's attempt to raise Japanese inflation back towards the central bank's 2% yield target. The mechanism by which that should happen is through a weaker Japanese yen. Yet the yen has been showing surprising strength in recent weeks, most notably the USD/JPY exchange rate that has been falling in the face of rising U.S.-Japan interest rate differentials (Chart 12, top panel). Chart 11Negative Real Rates Still Necessary In Japan Negative Real Rates Still Necessary In Japan Negative Real Rates Still Necessary In Japan Chart 12An Unwelcome Rise In The Yen An Unwelcome Rise In The Yen An Unwelcome Rise In The Yen The risk going forward is that the strengthening yen will create a drag on headline Japanese inflation that has recently accelerated back to 1% (middle panel). Given that both core CPI and nominal wages barely growing at all (bottom panel), the odds are increasing that Japanese inflation could begin to move lower without getting anywhere close to the BoJ's 2% target. As we discussed in our recent Special Report, a much weaker yen (i.e. USD/JPY between 115 and 120) is the first necessary precondition before the BoJ would consider raising its yield target on the 10-year JGB.6 We had placed odds of no more than 20% that the BoJ would raise its yield target in 2018, but if the yen continues to hold firm or even strengthen further from current levels, those odds fall to zero. Bank Of Canada & Reserve Bank Of Australia: "How Much Spare Capacity Truly Exists?" We are lumping the Bank of Canada (BoC) and Reserve Bank of Australia (RBA) together in this report, as both are facing the same critical question. The BoC has already raised its policy rate three times since last summer, in response to accelerating growth and diminished spare capacity in Canada. Canadian bond yields have risen in response through higher inflation expectations, rising real yields and greater expected rate increases from the BoC (Chart 13). The real 10-year Canadian yield has risen back to the highs last seen in late 2013, while inflation expectations are not quite back to those levels - a similar story to that seen in the U.S. The BoC's own estimate of the Canadian output gap flipped into positive territory at the end of 2017, signifying that there was no longer any spare capacity in the Canadian economy (Chart 14, top panel). The signal from the Canadian labor market is similar, with the unemployment rate now at 5.9% - well below the OECD NAIRU estimate of 6.5% (middle panel). Yet Canadian inflation rates, both for headline and core CPI, are only at 1.7% and 1.5%, respectively - both not even at the midpoint of the BoC's 1-3% target band (bottom panel). At the same time, wages have been accelerating, with the annual growth rate of Average Hourly Earnings now up to a two-year high of 3.3%. Chart 13All Bond Yield Components Rising In Canada All Bond Yield Components Rising In Canada All Bond Yield Components Rising In Canada Chart 14Where's The Inflation? Where's The Inflation? Where's The Inflation? Such a wide gap between price inflation and wage growth does throw into the question if the BoC's own output gap estimate is correct. We expect Canadian price inflation to eventually begin to close the gap with wage inflation, which will keep the BoC on its current expected rate hiking path in 2018 as long as the economy does not begin to slow meaningfully. The CPI inflation reports will be the most important data to watch in Canada over the next few months to determine if our view will pan out. In Australia, the market pricing is nowhere near as hawkish as in Canada, with inflation expectations (10-year CPI swaps) having been stuck in a range between 2.2-2.4% for the past two years (Chart 15, 2nd panel). The market-implied neutral real interest rate is stuck at 0% and has not been sustainably above that level since 2014 (bottom panel). Yet, like Canada, there are questions about the true degree of slack in the economy. The Australian unemployment rate is currently at 5.5%, well below NAIRU (Chart 16, top panel). The last time that the Australian economy ran for so long beyond full employment was in 2010-11, when headline inflation breached the upper limit of the RBA's 1-3% target band (bottom panel). Yet the so-called "underemployment rate" - essentially, those working part-time that would like to work full-time - has been much higher in recent years and now sits at 8.3%. This also fits with the IMF's estimate of the Australian output gap, which is still a very large -1.8%. Chart 15Australian Yields Are Stuck In A Range Australian Yields Are Stuck In A Range Australian Yields Are Stuck In A Range Chart 16Very Different Than 2011-12 Very Different Than 2011-12 Very Different Than 2011-12 Given these signs of excess capacity in both the labor market and the overall economy, it is no surprise that Australian inflation has struggled to surpass even the 2% midpoint of the RBA target band. The implication is that the Australian NAIRU is much lower than the official OECD estimate, and that the RBA is under no pressure to contemplate any interest rate increases for at least the rest of 2018. Net-net, while both the BoC and RBA are facing questions over the true amount of spare capacity in their economies, the situation is much more bullish for Australian government bonds than Canadian equivalents given the greater slack Down Under. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 These are average quarterly growth rates of U.S. real GDP for the full calendar year of 2013 and 2017, respectively. 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180131.pdf 3 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20th, 2018, available at usbs.bcaresearch.com. 4 https://www.ecb.europa.eu/press/accounts/2018/html/ecb.mg180222.en.html 5 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt Up In Equities AND Bond Yields?", dated January 23rd, 2018, available at gfis.bcaresearch.com. 6 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Biggest Question Facing Each Central Bank The Biggest Question Facing Each Central Bank Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, Wednesday, we sent you a Special Report by our Global Investment Strategist, Peter Berezin titled: The Return of Vol, which fleshed out BCA's view on the recent volatility spike and the associated market selloff. BCA believes that markets are realizing that U.S. inflation is not forever dead. As such, market volatility is set to rise, even if global equities can make new highs. From an FX perspective, a rise in U.S. inflation, especially when accompanied by the kind of spending programs announced this week in Washington DC, could result in a period of strength for the U.S. dollar. Additionally, since financial markets tend to experience clusters of volatility, the recent bout of volatility can stay in place for a while. High volatility tends to be negative for carry trades, hence EM currencies could suffer this quarter. The Australian dollar and the euro could also decline under this scenario. However, the yen and CHF may experience upside, but mostly against other currencies than the greenback. In this present report, we are updating our views on the G10 central banks. Best regards, Mathieu Savary Feature In our Special Report published last summer titled "Who Hikes Next?" we examined which of the G10 central banks would be next to join the Federal Reserve on its tightening path.1 Seven months later, we now know that the Bank of Canada and, to a lesser extent, the Bank of England, were respective second and third to begin raising their own policy rates. It is now time to revisit the topic and see which central banks are most likely to adjust their policy further. As Chart 1 shows, global goods prices have picked up steam, which has been translated in an ebbing of global deflationary forces. A few factors lie behind this improvement. First, China is not exporting deflation around the world anymore because the trade-weighted yuan has been stable and producer price inflation, which currently stands at 5%, has been in positive territory for 15 straight months. Second, thanks to ebullient global growth, global capacity utilization has grown significantly. Third, oil prices have climbed further. This development has been particularly meaningful as it has contributed to a significant pick-up in market-based inflation expectations. But as in every economic cycle, some risks are worth monitoring. As we have highlighted before, global money growth has slowed, Chinese monetary conditions have tightened meaningfully and Asian manufacturing activity has decelerated in a wide swath of countries. Even BCA's Global Capex Indicator (Chart 1, bottom panel), which flashed an unabashed green light last June, has begun to roll over. The recent market shakeup has also reminded investors that higher bond yields do have an impact on asset prices and economic growth. Despite these worries, we expect more central banks to join the fray this year and begin removing accommodation one way or another. Others will shy away, but they will guide markets toward expecting less monetary accommodation next year. Finally, some central banks will likely stand pat, and will leave their policy settings unchanged. Chart 2 illustrates where we think G10 central banks stand in their respective hiking cycles. Chart 1The Reasons Why Central Banks Are Tightening The Reasons Why Central Banks Are Tightening The Reasons Why Central Banks Are Tightening Chart 2G10 Central Banks Map Who Hikes Again? Who Hikes Again? The Hikers 1) The U.S. Chart 3U.S. U.S. U.S. The Federal Reserve will continue to tighten policy this year. To begin with, its communications on the topic have been extremely clear: the Federal Open Market Committee wants to increase interest rates three times in 2018. The Fed has good reasons for this hawkish stance. The gap between the real policy rate and the recent average of real GDP growth remains in stimulative territory (Chart 3). Meanwhile, U.S. financial conditions have rarely been easier, yet the economy is receiving a boost thanks to tax cuts and spending increases. There is, therefore, little mystery as to why survey data point to healthy GDP growth for the first half of 2018. In fact, the Atlanta Fed GDPnow model currently forecasts a growth rate of 4.0% for the first quarter of this year. This is an inflationary combination. It is not just growth conditions that are creating tailwinds for the Fed. Resource utilization is also elevated. According to the CBO, the U.S. output gap closed last year, and the unemployment rate not only stands at its lowest level in 17 years, but it is also well below equilibrium. We are already seeing the symptoms of this state of affairs: the employment cost index is growing at 2.6%/annum, its highest rate in three years; the growth of average hourly earnings just hit 2.9%/annum, and even core inflation is bottoming. These developments will give comfort to the Fed that hiking rates three times this year is the right strategy. The Hikers 2) Canada Chart 4Canada Canada Canada The Bank of Canada has already increased rates three times since we first explored this topic last summer. Like the Fed, the BoC has strong justification behind its hawkish stance. While the policy rate is not as stimulative as it was last year, capacity utilization has become much tighter (Chart 4). The unemployment rate is now back in line with its underlying equilibrium, and the BoC's Business Outlook Survey shows that the quantity and intensity of labor shortages have become elevated, which has historically led to higher wages. Additionally, the OECD's approximation of the output gap has closed, something also acknowledged by the BoC's models. Core inflation has begun to respond, rising to 1.5% in December. The current backdrop suggests this trend has further to go. Moreover, as exports to the U.S. represent 20% of Canada's GDP, the economic vigor south of the border will only translate into further inflationary pressures up north. Based on these factors, we expect the BoC to increase rates as much as the Fed in 2018. This view is not without risks. NAFTA negotiations remain rocky, and the uncertainty emanating from trade policy could hurt Canadian capex. Additionally, Canadian house prices remain 31% above fair value, Canadians sport a debt load of 170% of disposable income, and a growing array of macro-prudential measures are being implemented to slow the housing market. If this combination bites deeply - which remains to be seen - the BoC may be forced to, at least, pause its tightening policy faster than anticipated. Still Hiking? 3) The U.K. Chart 5U.K. U.K. U.K. On many metrics, the Bank of England looks set to hike again in 2018. There is no denying that British monetary policy remains extremely easy, as the gap between the real policy rate and real GDP growth is still in massively stimulative territory (Chart 5). Moreover, according to the OECD, the output gap stands at 0.4% of potential GDP. This observation seems to be corroborated by the fact that the unemployment rate remains nearly 1% below its equilibrium value. Adding credence to these assertions, U.K. core inflation spiked as high as 2.9% one month ago. However, make no mistake: the spike in inflation, while facilitated by tight supply conditions, is still mostly a consequence of the pass-through created by the pound's collapse in 2016. Because the rate of change of the pound has stabilized, the U.K.'s inflation rate will fall back to earth. Moreover, the outlook for British consumption is murky as the household savings rate has plunged to a mere 5.2% of disposable income, and debt growth is peaking. Corporations too have curtailed their borrowings, pointing to a weak capex outlook. While the MPC would like to hike once or twice this year, since a policy tightening is contingent on elevated inflation, the central bank may once again disappoint. For now, rate hikes look likely, but this may change if inflation decelerates sharply. In The Starting Blocs For 2018 4) Sweden Chart 6Sweden Sweden Sweden The December policy statement by the Riksbank highlighted that while the world's oldest central bank will reinvest the proceeds from redemptions and coupon payments from its large bond portfolio, it still expects to begin lifting its benchmark rate in the middle of 2018. This is not a minute too soon. Swedish monetary conditions are incredibly easy: Real interest rates are 6% below the average real GDP growth of the past three years (Chart 6). Moreover, Sweden is facing growing capacity constraints. The unemployment rate is nearly 1% below equilibrium, and according to the OECD, the output gap stands at 1.5% of GDP, the most positive number among the G10. The Riksbank's own capacity utilization measure - an excellent leading indicator of inflation - is at a 10-year high, pointing to further acceleration in a core inflation that is already very close to 2%. Additionally, Sweden is in the thralls of a massive real estate bubble, a byproduct of extremely loose monetary policy. The external environment will remain the main source of risk to this hawkish outlook. On the plus side, the European Central Bank has begun tapering its QE program and should end new purchases in September 2018. This limits how high the SEK can spike against the euro - the currency of Sweden's main trading partner - if the Riksbank tightens policy. However, Asian industrial production has slowed sharply, and Swedish PMIs are already buckling. Any deepening of the recent selloff in risk assets, especially if it spreads further into commodities, could cause Riksbank Governor Stefan Ingves to retreat to his dovish safe place. In The Starting Blocs For 2019... Or 2018 5) New Zealand Chart 7New Zealand New Zealand New Zealand The Reserve Banks of New Zealand is slated to hike rates by mid-2019. However, risks are growing that the RBNZ could be forced into an earlier first hike. Policy is currently massively accommodating as the real official cash rate stands nearly 4% below the average real GDP growth of the past three years (Chart 7). At 1.4%, core inflation remains below the RBNZ's target, but it is on a rising trend, especially as the Kiwi economy is beyond full employment and the OECD's measure for New Zealand's output gap is at 0.8% of potential GDP. Moreover, GDP growth remains robust, and terms of trade have been improving as dairy prices are still firm, thus a further overheating in this economy is likely. The political front could also give impetus for the RBNZ to hike earlier than it recently suggested. The Ardern government has proposed increasing the minimum wage to NZ$20/hour by 2021, starting in April 2018. This could fuel already improving wages, and thus fan inflation. This government also plans to increase fiscal spending, which tends to exacerbate inflationary pressures when an economy is at full capacity. Thus, inflationary risks in New Zealand are skewed to the upside. In The Starting Blocs For 2019... Or 2018 6) Norway Chart 8Norway Norway Norway The Norges Bank anticipates it will begin to increase rates toward the middle of 2018. The Norwegian central bank is facing an interesting cross current. On the one hand, when compared with other nations on the list, the Norwegian economy seems less ripe to withstand higher rates. To begin with, because Norwegian core inflation has fallen precipitously in recent years, the gap between real interest rates and the average real GDP growth of the past three years has narrowed considerably (Chart 8). Moreover, the unemployment rate remains 0.9% above equilibrium, while a more broad-based measure of slack, the output gap, stands at -1.6% of potential GDP, at least according to the OECD. Moreover, core inflation only hovers near a 1.2% annual pace and is expected to stay below 2.5% in the coming years. Despite these negatives for Norway, some important positives also exist, which explains the Norges Bank's optimism. The Norwegian economy did not go through much of a financial crisis this cycle; as a result, Norwegian banks are healthy, and the Norwegian money multiplier never imploded as it did in other G10 countries. Also, the Norwegian krone is very cheap, adding a further reflationary impulse beyond low rates. Moreover, Norwegian GDP growth has experienced a rebound on the back of rallying oil prices. However, oil prices are nearing the top end of our energy strategists' forecasts, suggesting this tailwind is receding. Altogether, this confluence of factors suggests that similar to the RBNZ, the Norges Bank is likely to hike rates in early 2019 or late 2018. 2019 Take Off 7) Australia Chart 9Australia Australia Australia The Reserve Bank of Australia may well begin increasing interest rates in early 2019. Many factors would argue that the RBA could in fact increase interest rates earlier. Even though it is less accommodative than Sweden's or New Zealand's, Australian monetary policy is quite easy as the gap between the real policy rate and the average real GDP growth rate of the past three years is well into negative territory (Chart 9). Additionally, core inflation has rebounded hitting 1.9% recently, while trimmed-mean CPI stands at 1.8%. Among additional positives, Australia's national income is growing at a robust 4.3% annual pace and job creation is brisk, with payrolls expanding at an impressive 3.6% rate on a yearly basis. These positives mask some stiff headwinds. Rapid national income growth will likely peter out. It was the result of the very large rebound in the RBA's commodity price index, however, this benchmark, which was growing at a 53% annual rate in February 2017, is now contracting at a 1% annual rate. Additionally, the OECD's measure for the Australian output gap stands at -1.5%. While it is true that the unemployment rate is below its equilibrium rate, the RBA's labor underutilization measure remains near 25-year highs. This explains why robust job creation is not being translated into wage gains, and suggests that the RBA is right to expect trimmed-mean inflation to durably be at 2-2.25% only by the end of 2019. Moreover, the recent strength in the AUD will also weigh on inflation going forward. Netting out pros and cons suggests that the most likely first hike by the RBA will be in early 2019. 2019 Take Off 8) Euro Area Chart 10Euro Area Euro Area Euro Area The European Central Bank has begun tapering its QE program, and if the global economy does not experience any meaningful relapse, the ECB will end new purchases this September. However, a rate hike is not in the offing this year. To begin with, the ECB's communications on the topic have been rather clear: At its latest press conference, President Mario Draghi once again rejected any possibility of a move this year, and even Jens Weidmann, the Bundesbank's head, acknowledged that the current market pricing - a hike in the summer of 2019 - is about right. While it is true that the ECB's monetary policy setting is still very accommodative, the unemployment rate remains 0.8% above equilibrium, and outside of Germany, labor underutilization is still high. Moreover, the OECD's estimate of the euro area's output gap still stands at -0.5% of potential GDP (Chart 10). Another hurdle is core CPI which remains well below the ECB's objective; in fact, after hitting 1.2% in May, inflation excluding food and energy has now relapsed to 0.9%. Peripheral nations are experiencing even weaker inflation readings. With the ECB's inflation forecast still well below target until 2020, a rate hike will have to wait until next year. The Laggards 9) Switzerland Chart 11Switzerland Switzerland Switzerland The Swiss National Bank remains firmly among the lagging central banks within the G10. Because inflation is still at only 0.7%, the gap between real interest rates and average real GDP growth of the past three years is among the least stimulative in the G10 (Chart 11). Corroborating this observation, loan growth has averaged a paltry 4% over the course of the past three years. Moreover, the Swiss economy is still replete with excess capacity. The unemployment rate may be a low 3%, but it still stands 1.3% above equilibrium, and Swiss wage growth remains very depressed. Moreover, the OECD pegs the Swiss output gap at -1.2% of potential GDP. On a PPP basis, the Swiss franc remains 5% overvalued against the euro, Swiss core inflation was only 0.7% in December, but better than the -1% posted in early 2016. The SNB is likely to officially abandon its foreign asset purchases this year. The Swiss economy has recovered from its doldrums of the past several years, and most importantly, the euro crisis is now fully in the rearview mirror. This means that safe-haven flows out of the euro area, which were pushing the CHF to nosebleed valuation levels, have dried up. In fact, this year's weakness in the franc versus the euro was not accompanied by much increases in SNB sight deposits, suggesting this depreciation has been organic and not manufactured in Bern and Zurich. However, until core CPI moves closer to 2% and Swiss wages pick up, the SNB will likely lag the ECB when it comes to actual interest rate increases amid fears that the Swiss franc will rebound and tighten policy again. A late 2019 or early 2020 hike remains the most likely scenario. The Laggards 10) Japan Chart 12Japan Japan Japan The Bank of Japan is also faraway from increasing policy rates. This is not because the Japanese economy is replete with excess slack. It is not. The active job openings-to-applicants ratio stands at a whopping 44-year high, the unemployment rate is 0.8% below equilibrium and the OECD's estimate of the output gap is in positive territory (Chart 12). However, despite this very inflationary backdrop, inflation excluding food and energy remains a paltry 0.3%/annum. The BoJ has rightfully identified moribund inflation expectations as the key to unlocking this mystery. Decades of deflation have created a deflationary mindset among Japanese economic agents. As a result, wages and inflation itself are not experiencing much of a lift. The BoJ is tackling this issue head on, and has made it clear that it will not abandon its yield curve control strategy until inflation is well above its 2% target. In the BoJ's view, an inflationary overshoot is now necessary to shock deflationary mentalities, which will be the keystone to let inflation take off in durable fashion. For now, the tight negative relationship between Japanese financial conditions and inflation suggests the BoJ will do its utmost to contain the yen, which would undermine the progress made in recent quarters. As such, we do not foresee any rate hikes until well into 2019. QQE is likely to be abandoned first, as in practice the BoJ has not hit its JGB purchases target since the first half of 2016. Investment Implications The dollar could experience a further lift in the first half of 2018. Investors plunked the greenback last year and in the opening weeks of 2018 because they had been focusing on the far future - a future in which the ECB hikes rates faster than the Fed. But the reality remains that this year and next, the Fed will lift interest rates much more than the ECB. This means the euro is vulnerable to a pullback as it is very expensive relative to differentials at the front end of the curve. The outlook for EUR/USD will improve again once we get closer to 2019. The CAD has niether much upside nor downside. Interest rate markets are pricing in as many interest rate increases as we are. The key for the CAD will once again be oil prices, but keep in mind that Brent prices are not far off from our energy strategists' target of US$67/bbl. The SEK and the NOK will likely experience upside versus the euro. Their central banks are also set to pull the trigger before the ECB. Moreover, these two currencies are very cheap. However, the ride is unlikely to be a smooth one. The budding slowdown in Asian manufacturing could generate temporary hiccups before yearend that will cause these extremely pro-cyclical currencies to swoon. The picture for the pound remains as murky as ever. On one hand, the BoE has begun to increase rates. However, this progress could run astray very easily if, as we expect, British inflation weakens anew. Moreover, Brexit negotiations with the rest of the EU are far from fully settled. Further, the trade-weighted pound is moving toward the top end of its post-Brexit range, making it highly vulnerable to even a modest disappointment. The Australian dollar is likely to experience a poor 2018, as the RBA is a long way from increasing interest rates, and on all the long-term metrics we track, the AUD is one of the most expensive currencies. A continuation of the recent spat of asset market volatility could prove to be unkind to the Aussie. The kiwi will likely outperform its antipodean brethren as we see upside risk for interest rates in New Zealand. Finally, Swiss and Japanese interest rates will remain near current levels for a few more years. This suggests that the Swiss franc and the yen have little durable upside this year. The same holds true for the first half of 2019. However, since Switzerland and Japan still sport hefty current account surpluses and supersized positive net international investment positions, the CHF and JPY will continue to behave as safe-haven currencies, rallying when global asset prices weaken. This means that since markets tend to experience volatility clusters, the recent bout of market volatility could continue, which will help both the Swiss franc and the yen over the coming weeks. This will be especially true if the CHF and JPY are bought against the EUR, AUD, CAD, and NZD. But beware: the yen is especially cheap, so any signs that inflation expectations of Japanese agents pick up could be associated with a sharp rally in the yen, as it will spell imminent doom for the BoJ's YCC strategy. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades

The GAA DM Equity Country Allocation model is updated as of January 31, 2018. The model has made large shifts in country allocations. The U.S. is upgraded to neutral from previously the largest underweight, driven largely by technical conditions. It seems dramatic, but as shown in Chart 2, the model did have similar large shifts in the past as well. Canada also has received a large increase to overweight driven by extremely attractive valuation. To fund these upgrades, the previously largest overweight in Italy is cut in half (mainly driven by liquidity and valuation) and Australia is back to underweight (trading places with Canada). As a result, the model now is overweight the Netherlands, Italy, Germany, Canada and Spain, neutral on the U.S. and underweight Japan, the U.K., France, Australia and Sweden as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 99 bps in January, largely driven by the Level 2 model which outperformed by 207 bps, thanks to the underweights in the U.K., Japan and Canada vs. the overweights in Italy, the Netherlands and Germany. Since going live in January 2016, the overall model has outperformed the benchmark by 190 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 570 bps. The Level 1 model has performed in line with the MSCI world benchmark. Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates Table 2Performance (Total Returns In USD) GAA Quant Model Updates GAA Quant Model Updates Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 31, 2018. The model continues to be bullish on global growth as seen by a 10% aggregate overweight in the cyclical sectors. The model continues to hold equal underweights in consumer staples, health care, telecom and utilities stocks. Looking forward, we believe improving global growth dynamics, and rising equity markets will help us maintain an aggregate cyclical pro-growth bias. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights The Japanese economy is booming. This is allowing the BoJ to move away from its QQE (Quantitive and Qualitative Easing) program. However, the YCC (Yield Curve Control) program will stay in place for the foreseeable future as inflation remains a direct function of financial conditions. Because yen positioning and valuations are so skewed, this could result in a yen rally, especially against the Euro. Short EUR/JPY. Like the Fed, the BoC will hike rates three times this year. However, the market already discounts more hikes in Canada than the U.S. We remain neutral USD/CAD. However, CAD will experience downside against the NOK. Short CAD/NOK. Feature Chart I-1JPY Vs. Bonds: The Divorce JPY Vs. Bonds: The Divorce JPY Vs. Bonds: The Divorce Something fascinating happened to USD/JPY in recent months: it began to decouple from U.S. bond yields (Chart I-1). To a large degree, this break in relationship reflected the dollar's own weakness, as the dollar index fell by 10% in 2017. But as weak as the dollar may have been last year, it has actually been flat since September 7. Another culprit behind the yen's decoupling from bond yields has been that as the European Central Bank announced the end of its own asset purchases program, the Bank of Japan has been seen as the next in line to diminish its purchases. On January 8th, the BoJ began moving in that direction, as it started to curtail its buying of long-dated JGBs. Since that day, not only have global bonds sold off, but the yen has regained vigor as well. We believe the yen bear market is not over, but a playable rally against the euro is likely to emerge. The Sun Is Rising The BoJ is justified in wanting to remove some policy stimulus. The Japanese economy is firing on all cylinders, and the improvement seems broad-based. Consumer confidence, buoyed by rising asset prices and an unemployment rate at 23-year lows, is hitting record highs (Chart I-2). This will continue to support real household spending, which is now growing at a nearly 2% pace after contracting steadily from 2015 to early 2017. Another support for household spending comes from the wage front. Contractual wages are already growing at their fastest pace since 2006, and wages excluding overtime pay are expanding at rates not seen since 1998 (Chart I-3). Moreover, the openings-to-applicant ratio is at its highest level since 1974. This increases the likelihood that Prime Minister Shinzo Abe's arm-wrestling with corporate Japan to increase wages will bear fruit, and that the upcoming spring wage negotiation will generate accelerating gains. Chart I-2Japanese Households Feel Ebullient CONSUMER CONFIDENCE SURVEY Japanese Households Feel Ebullient CONSUMER CONFIDENCE SURVEY Japanese Households Feel Ebullient Chart I-3Wage Growth Has Picked Up Wage Growth Has Picked Up Wage Growth Has Picked Up Business confidence is also surging. The Japanese manufacturing PMI number is elevated by Japanese standards, currently at 54, and small business confidence points toward an acceleration in industrial production (Chart I-4). Financial markets validate this picture as well. The surge in the Nikkei has grabbed the imagination of investors, but even more impressive has been the strength in small-cap equities, which have outperformed their large-cap counterparts by 17% since 2015 (Chart I-5). This development has coincided with a pick-up in credit growth, and is also normally associated with a robust growth outlook. The GDP model developed by our sister publication, The Bank Credit Analyst, encapsulates these various phenomena, and forecasts that Japanese real GDP growth could hit an annual rate of 3% in the first half of 2018 (Chart I-6). Thus, it would seem that the Japanese economy will continue to gain momentum. Chart I-4Japanese Companies Are Also##br## Feeling The Good Vibes Japanese Companies Are Also Feeling The Good Vibes Japanese Companies Are Also Feeling The Good Vibes Chart I-5Small Caps Point To##br## A Bright Outlook Small Caps Point To A Bright Outlook Small Caps Point To A Bright Outlook Chart I-6Japanese Growth ##br##Has Momentum Japanese Growth Has Momentum Japanese Growth Has Momentum But what underpins these improvements? First, the fiscal thrust in Japan has changed. Fiscal policy was a drag in Japan from 2012 to 2016, creating an average brake on economic activity of 0.6% of GDP per year. However, in 2017, fiscal policy eased to add 0.2% to GDP. Second, Japan has greatly benefited from the rebound in EM growth. According to the IMF, a 1% growth shock in EM affects Japanese growth by 50 basis points - nearly five times more than the effect of the same shock on the U.S. economy. This is because 43% of Japanese exports are shipped to EM economies. Third, the impact of EM activity on Japan is amplified by the countercyclical nature of the JPY. As global and EM growth expands more vigorous, the yen weakens, which eases Japanese financial conditions. This phenomenon was in full display last year, as financial conditions eased by a full standard deviation over the past 16 months. These developments are what have laid the ground for better growth and the change in the BoJ's tone. Bottom Line: Japan is doing very well. Consumers and businesses are upbeat, spending is on the rise and GDP is forecasted to accelerate even further. Easing fiscal belt-tightening, stronger EM economies, and the softening financial conditions are the factors behind these improvements. The BoJ is taking notice. How Far Can The BoJ Go? The BoJ had been itching to move policy for a few months now. In November 2017, BoJ Governor Haruhiko Kuroda was making noise about the concept of the "reversal rate." The reversal rate is the interest rate below which additional interest rate cuts become contractionary for economic activity. This is because below this level, lower rates hurt bank interest margins to such a degree that commercial banks start curtailing their lending to the private sector. The reason why the BoJ was getting more vocal about the reversal rate was because this rate is inversely related to the amount of securities held on commercial banks' balance sheets. If commercial banks hold plenty of government bonds, as interest rates fall to very low levels, the value of these securities increases, offsetting the negative impact of lower interest rate margins. The problem in Japan is that as the BoJ mopped up more JGBs than was issued by the government, and therefore the bond holdings of banks were dwindling at an alarming rate (Chart I-7). This meant that the reversal rate was rising, implying that the BoJ had less control over policy. When inflation surprised to the upside in December, financial markets reacted violently. While Japanese nominal yields did not budge much, Japanese inflation expectations surged, which prompted a collapse in Japanese real rates (Chart I-8). This produced a de facto easing in Japanese monetary conditions, creating the perfect cover for the BoJ to adjust its asset purchases: any negative impact from tweaking bond purchases would be mitigated and the BoJ, according to its view, would not lose control of financial conditions because of a falling reversal rate. Despite this shift in policy action and rhetoric, we do not yet foresee the end of the Yield Curve Control program. Inflation excluding food and energy only stands at a paltry 0.3%, still well below the BoJ's 2% target or even 1% - a level that is likely to result in a more real removal of easing. Additionally, the BoJ is in somewhat of a bind. It is true that the economy is doing much better, but this does not really help explain inflation dynamics. Japanese capacity utilization only explains 3% of the movements in Japanese core inflation; global utilization, only 10%; and inflation leads credit creation in Japan. Instead, the best factor to explain Japanese inflation has been financial conditions (FCIs). In no other country do FCIs explain inflation dynamics as much as they do in Japan. The recent movements in Japanese inflation are fully consistent with how Japanese FCIs have evolved since 2010. Based on this relationship, CPI excluding food and energy should likely peak at 0.7% in June 2018 (Chart I-9). Chart I-7Japanese Reversal Rate##br## Is Falling Because Of QQE Japanese Reversal Rate Is Falling Because Of QQE Japanese Reversal Rate Is Falling Because Of QQE Chart I-8Sudden Pick Up In##br## Inflation Expectations Sudden Pick Up In Inflation Expectations Sudden Pick Up In Inflation Expectations Chart I-9Inflation Is Picking Up Because##br## Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased However, if the BoJ removes accommodation too fast, the yen would rally and financial conditions would tighten sharply. In all likelihood, inflation would weaken substantially, nullifying the very reason to tighten policy in the first place. These very dynamics point to a continuation of YCC for at least the next 12 to 18 months. Bottom Line: Japan will soon fully do away with its QQE program. However, this is not indicative of a removal of yield curve controls. This is not only because Japanese inflation is extremely far off from the BoJ's target, but also because Japan's inflation rate is hyper-sensitive to financial conditions. Therefore, any tightening in financial conditions created by a stronger yen - the likely market response of tighter policy - will cause inflation to collapse, nullifying the very need for tighter policy. Investment Implications USD/JPY is expensive, trading 16% above the fair value implied by purchasing power parity. Additionally, the yen is supported by a generous current account surplus of 4% of GDP. Moreover, global investors have been underweighting duration. This phenomenon tends to be negative for the yen. When investors are as underweight duration as they are currently, the yen becomes more likely to rally (Chart I-10). It is true that in 2014, investors were as negative on bonds as they are today, but USD/JPY sold off. This was because back then, the BoJ announced an increase to its asset purchase program. Today, the BoJ is moving toward ditching its QQE program, which is likely to prompt a short-covering rally. Now, the key question for investors is what currency should be sold against the yen. We posit the euro is an interesting alternative to the USD. EUR/JPY is exceptionally expensive at present. On a long-term basis, EUR/JPY is trading well outside its normal range on a purchasing-power-parity basis (Chart I-11). Moreover, while USD/JPY is mildly expensive according to metrics that incorporate rate differentials and risk appetite, EUR/USD is very dear based on a similar comparison. The implication is that EUR/JPY is trading at an exceptionally demanding level in terms of short-term valuations (Chart I-12). Hence, tactically, the timing is becoming increasingly ripe to short this cross Chart I-10Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Chart I-11EUR/JPY Is Expensive EUR/JPY Is Expensive EUR/JPY Is Expensive Chart I-12Tactical Risk For EUR/JPY Tactical Risk For EUR/JPY Tactical Risk For EUR/JPY . Further arguing in favor of shorting EUR/JPY instead of USD/JPY are relative financial conditions. Euro area financial conditions have tightened much more than U.S. financial conditions relative to Japan's (Chart I-13). As a consequence, even when adjusting for sector biases, European stocks are currently underperforming Japanese equities by a greater margin than the underperformance of U.S. equities. This highlights that Japan's relative economic outlook burns brighter when compared to the euro area than when compared to the U.S. This also means that the yen has more room to rally against the euro than the USD. Finally, relative positioning between the euro and the yen is also exceptionally skewed. As Chart I-14 illustrates, when speculators are simultaneously long the euro and short the yen, EUR/JPY tends to experience subsequent corrections. Chart I-13Euro Area FCIs Tightened ##br##More Than U.S. Ones Euro Area FCIs Tightened More Than U.S. Ones Euro Area FCIs Tightened More Than U.S. Ones Chart I-14Skewed Positioning##br## In EUR Skewed Positioning In EUR Skewed Positioning In EUR The aforementioned factors point to a potentially large yen rally, but the durability of this rally is likely to be limited. The BoJ will only be dropping a QQE program that it had already only half-implemented in recent months, as bond purchases were well below its JPY80 trillion-yen objective. The BoJ is still committed to its YCC program for the foreseeable future. Only a rejection of this program will create a durable support for the yen. In the meanwhile, as any yen rally will tighten financial conditions and hurt inflation, any yen rally is to be rented rather than owned, as terminal policy rates in Japan still have little scope to rise. Bottom Line: Ditching QQE is likely to result in a yen rally. Such a rally is likely to be most pronounced against the euro as valuations, positioning, and financial conditions are especially exacerbated when compared to the European currency. To be clear, the yen rally is likely to be a countertrend move, as a strong yen will exert serious deflationary pressures on Japan, which means the BoJ's YCC program will remain firmly in place. We are shorting EUR/JPY at 133.79. CAD: Stuck Between The BoC And NAFTA Chart I-15Canada Will Experience Rising Wages Canada:##br## Inflationary Conditions Emerging Canada Will Experience Rising Wages Canada: Inflationary Conditions Emerging Canada Will Experience Rising Wages Canada: Inflationary Conditions Emerging The Bank of Canada (BoC) is meeting next week and the odds are rising that it will lift policy rates this month. The Canadian economy is very strong too, led by the domestic sector. Real consumer spending is growing at its fastest pace in nearly 10 years, the unemployment rate is at 40-year lows, and capex is recovering after having been decimated by the collapse in oil prices from 2014 to 2016. Thanks to this backdrop, the Canadian economy is hitting its own capacity constraints. The BoC estimates that the Canadian output gap has closed. Moreover, the recent Business Outlook Survey confirms this message: A record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints, and the growing number and intensity of labor shortages points to a tight labor market (Chart I-15). Tight capacity and higher wages will support the already-visible rebound in core inflation, which has already reached 1.8%. As a result, we expect the BoC to tighten rates as much as the Federal Reserve this year. However, the impact of this development on the CAD might be limited. Investors are already pricing in more hikes in Canada than in the U.S. over the next 12 months - 82 basis points versus 60 basis points, respectively. Moreover, speculators are once again very long the loonie, implying an elevated hurdle for strong economic data to actually lift CAD further. Moreover, NAFTA remains a major risk for Canada. As Marko Papic, our Chief Geopolitical Strategist, wrote in a November Special Report, President Trump does have uninhibited power when it comes to abrogating NAFTA (Table I-I).1 If NAFTA were to collapse, Canada would most likely ultimately revert to the still-preferential Canada-U.S. Free Trade Agreement. Thus, the impact on Canada-U.S. trade would likely be temporary. However, the brunt of the pain should be felt in Canadian capex spending. The high degree of uncertainty associated with unwinding NAFTA would cause companies to abandon expansion plans in Canada, and prompt them to expand their North American capacity directly in the U.S., thereby bypassing the regulatory risk created in the supply chain. This would dampen the future growth profile of Canada. Table I-1Trump Faces Few Constraints On Trade Yen: QQE Is Dead! Long Live YCC! Yen: QQE Is Dead! Long Live YCC! Oil is unlikely to fill the void for CAD. At near US$70/bbl, Brent has hit our Commodity and Energy strategists' target. OPEC 2.0 will be unwilling to accommodate much higher prices, as this would incentivize shale producers to expand capacity, recreating the supply glut dynamics that existed prior to the 2014 crash. Additionally, the West Canada Select benchmark, the oil price most relevant for Canada, remains at a substantial discount to WTI and Brent. This is because there is not enough pipeline capacity to ship oil outside of Alberta. Canada is drowning in its own oil. This situation is not about to change. Chart I-16CAD/NOK Is Stretched CAD/NOK Is Stretched CAD/NOK Is Stretched Based on this combination, we are neutral USD/CAD on a 12-month basis, even if a move back to 1.29 is likely over the coming weeks. However, while Canadian oil is trading at a discount, the CAD has performed better than the NOK, the other petrocurrency in the G10 space. This suggests that shorting CAD/NOK may be a cleaner way to play the risks inherent to the Canadian dollar. First, the Canadian dollar is very expensive relative to the Norwegian krone right now, trading 11% above its purchasing-power-parity rate (Chart I-16). Even when adjusting for other factors like productivity and commodity prices, CAD is trading at its largest premium to the NOK since 1994. This represents a risk for CAD/NOK as the loonie is exposed to trade policy risks, while the nokkie is not. Second, the balance-of-payments picture remains highly favorable for the NOK. Norway runs a current account surplus of 5.5% while Canada runs a deficit of 2.8%. Additionally, Norway sports a Net International Investment position (NIIPs) of 210% of GDP, the largest in the G10. Strong NIIPs are associated with rising real effective exchange rates. Third, while the Canadian economy's momentum is well known by investors - this is the reason why they are so long the CAD and expecting so many hikes from the BoC - the positives in Norway are being ignored. Norway's leading economic indicator is still rising, and Norwegian industrial production and real GDP growth are accelerating. Fourth, the Norges Bank is responding to weakness in the NOK. At its December meeting, it adjusted its tone, as the NOK is easing monetary conditions too much in the eyes of the Norwegian central bank. This suggests the 25-basis-point hike currently expected out of Norway could be too low. It also highlights that the exceptional 60-basis-point gap between Canada and Norway in terms of expected 12-month rate hikes is also likely to normalize. Finally, CAD/NOK is trading toward the top of both its long-term and near-term historical trading ranges. While positioning on the CAD is now quite extended on the long side, speculators are short the NOK, according to Norges Bank data. Thus, with NAFTA in question, a fully priced BoC outlook, and the unlikelihood that the WCS-Brent discount narrows, risks are skewed toward a lower CAD/NOK going forward. Bottom Line: The Canadian economy is booming. This means the BoC will keep pace with the Fed and increase rates at least thrice this year. However, markets are already discounting more hikes in Canada than they are in the U.S. Moreover, oil prices have limited upside from here, and the WCS benchmark will continue to trade at a deep discount to Brent. Thus, while USD/CAD has limited upside, it has limited downside as well. However, CAD/NOK faces plenty of downside risks from current levels. We are shorting this cross this week, with an entry point at 6.398. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism" dated November 10, 2017, available at gis.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 Recent data in the U.S. has been mixed: Nonfarm payrolls surprised to the downside, coming in at 148 thousand. Moreover, labor force participation rate surprised to the downside, coming in at 62.7%. ISM non-manufacturing PMI also underperformed expectations, coming in at 55.9. However, consumer credit change outperformed expectations, coming in at 27.95 billion dollars. The dollar began the week on a strong, which ultimately dissipated, on relatively hawkish ECB minutes and policy tweaks in Japan. Overall, we expect the market to continue to price the fed dot plot, putting upward pressure on the dollar. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 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 Recent data in the Euro area has been positive: Core inflation outperformed expectations, coming in at 1.1%. Moreover, the economic sentiment indicator also outperformed expectations, coming in at 116. Retail sale yearly growth also surprised to the upside, coming in at 2.8%. Finally, the unemployment rate declined from 8.8% to 8.7% In spite of the positive data the euro has fallen this weekThe Euro begun the week on the weak side but surged in the wake of the ECB's hawkish minutes. This has happened due to the surge in rate expectations in the U.S., as the market has continued to price in the fed. Overall, we expect to see downside in EUR/JPY as the BoJ has more room to back off its ultra-dovish policy than the ECB. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Labor Cash earnings yearly growth outperformed expectations, coming in at 0.9%. They also increased relative to October. However consumer confidence surprised to the downside, coming in at 44.7 and declining from the previous month. The yen has been surging this week, with USD/JPY falling by 1.7%. This was caused because the BoJ signaled that they would reduce their buying of long dated bonds. The market interpret this as a signal that the BoJ will start exiting from its ultra-dovish monetary policy. These developments should continue to provide upside to the JPY, particularly against the Euro. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production yearly growth outperformed expectations, coming in at 2.5%. Moreover, manufacturing production yearly growth also surprised to the upside, coming in at 3.5%. However, Halifax House Prices yearly growth underperformed expectations, coming in at 2.7% as the month-on-month growth contracted by 0.6%. The pound has been flat, this week against the dollar, while it has lost about 1% against the euro. Overall, the BoE is limited in the capacity to raise rates meaningfully. Moreover, inflation should start to ease following the rate hike and the rise in the pound. This will put downward pressure on the pound. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been mixed: Building permits yearly growth outperformed expectations, coming in at 17.2%. However, the trade balance in November surprised to the downside, coming in at -628 million. It also decreased from -302 million one month earlier. AUD/USD has been flat this week, however AUD/NZD has fallen by roughly 1%. While it is true that global growth continues to be strong, key indicators like Korean and Taiwanese export growth have rolled over. Moreover money supply growth in China continues to decrease. All of this points to a temporary slowdown in Chinese industrial activity, which would lead to weakness in AUD/USD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 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 has rallied by nearly 5% since the start of the year, as global growth continues to stay robust. Overall, we expect that the NZD will continue to outperform the AUD this year, as New Zealand is less sensitive to a tightening in financial conditions than Australia. However on a longer time horizon, the upside for the Kiwi is limited, as the new populist government has not only vowed to decrease immigration into the country, but also for the RBNZ to have a dual mandate. Both of these policies will depress the neutral rate in New Zealand, and consequently put downward pressure on the kiwi. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 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 Recent data in Canada has been mostly positive: The unemployment rate surprised positively, as it declined to 5.7% from 5.9% Moreover, net change in employment also outperformed expectations, coming in at 78.6 thousand. Housing starts yearly growth also outperformed expectations, coming in at 217 thousand. However, the Ivey Purchasing Manager Index underperformed, coming in at 60.4. USD/CAD jumped on Tuesday following reports that Trump will exit the NAFTA accord. Overall we believe that the Canadian dollar will have limited upside from here on out, as the market is now pricing in more hikes in Canada than in the U.S. This weakness could be taken advantage of by shorting CAD/NOK, as this cross is much overvalued according to multiple metrics. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: Headline inflation came in line with expectations, at 0.8%, meanwhile month on month inflation surprised to the upside, coming in at 0%. The unemployment rate also came in line with expectations, at a very low level, coming in at 3%. Finally, retail sales yearly growth surprised to the upside substantially, coming in at -0.2%, compared to 2.6% last month. EUR/CHF has stayed relatively flat since last week. Overall, we expect limited upside in the franc. As the SNB will stay active in the foreign exchange market. In order for the SNB to change its policy, inflation in Switzerland will have to stay at a high level for a considerable amount of time. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Headline inflation outperformed expectations, coming in at 1.6%. Moreover core inflation also surprised to the upside, coming in at 1.4% However, manufacturing output growth underperformed expectations, coming in at 0.3% USD/NOK is down by roughly 0.7%, as oil prices continue to approach the 70 dollar mark. Nevertheless, we believe that the upside for USD/NOK is limited from here, as the market will start pricing in more rate hikes from the Fed. That being said, investors willing to bet on more oil strength could short EUR/NOK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 After falling precipitously at the end of 2017, USD/SEK has been relatively flat this year. Overall, while Stefan Ingves continues to be very dovish, he conceded in the latest minutes that a change in monetary policy is getting closer. Meanwhile, Deputy Governor Jansson stated that while he supports to continue with asset purchases, to keep the repo rate unchanged would be "difficult to digest". Investors willing to bet on a slowdown in the Euro area caused by tightening financial conditions could short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades