Europe

Highlights The U.S. dollar is likely to correct further over the coming weeks. The CAD should benefit as it is cheap and oversold, and the inflationary back-drop warrants tighter monetary conditions. This will be a bear market rally, not the ultimate trough for the loonie. EUR/SEK should correct as the Riksbank will start tightening policy in December; a pause in the global growth slowdown should also give the cheap SEK a welcome boost. Cheap long-term valuations will not help the yen in the coming weeks; instead, falling Japanese inflation expectations and growing investor expectations of Chinese stimulus will weigh on the JPY. A better opportunity to buy the yen on its crosses will emerge later this year. EUR/CHF has upside over the coming months; the swissie needs additional global growth weakness to rally further. This is unlikely to happen for a few months. Feature Chart I-1DXY Correction Has Further To Run By the middle of the summer, the dollar had hit massively overbought levels, which left it vulnerable to any signs of stabilization in global growth, especially if some key U.S. activity gauges began to soften (Chart I-1). This is exactly what is transpiring. As we highlighted last week, BCA's Global LEI Diffusion Index is rebounding, EM and Japanese exports are stabilizing and U.S. core inflation and building permits have disappointed. This bifurcation in the data suggests the dollar has more room to correct, as neither our Capitulation Index nor our Intermediate-Term Technical Indicator have hit technically oversold levels. Last week we also argued that this correction in the dollar is likely to prove a temporary reprieve, but that in the interim the euro and the Australian dollar were well placed to experience significant rebounds.1 This week, we explore if the same case can be built for the Canadian dollar, the Swedish krona, the yen and the Swiss Franc. CAD: The Bank of Canada Will Proceed Cautiously The first half of 2018 has not been kind to the Canadian dollar. A rout in EM assets, signs of softening global growth and tough rhetoric from the White House on trade generally and NAFTA and Canada in particular have conspired to create fertile grounds for loonie-selling. Since the end of June, the CAD has managed to regain some composure, rallying by 3.3% against the USD. Essentially, much bad news has been embedded in this currency, which now trades at a significant discount to BCA's estimate of its short-term fair value (Chart I-2). Moreover, speculators, who had been aggressively buying the CAD at the end of 2017, now hold large short positions in the currency (Chart I-2, bottom panel). This combination is now resulting in a situation where any pause in the USD's strength is being mirrored in CAD strength. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Chart I-2No One Is Going Crazy For The Loonie Chart I-3Canada: Growth Picture Is Mixed The weakness in Canadian consumption partly reflects the underperformance of Canadian employment relative to the U.S. However, the slowdown in house prices has played a bigger role (Chart I-4). Canadian households are burdened by a debt load of 170% of disposable income. Now that mortgage rates are rising, Canadians are spending more than 14% of their disposable income servicing their debt, a burden last experienced in 2008 when mortgage rates were 220 basis points higher. Without the benefit of rapidly rising real estate assets, it is much more difficult for Canadian retail sales to grow at an 8.7% annual rate as they did three quarters ago. Despite these weaknesses, it is hard to justify that Canadian monetary conditions - as approximated by the slope of the yield curve, the level of real rates, and the trade-weighted CAD - should be as easy as they are today (Chart I-5). This is even truer when we take into account Canadian inflationary conditions. Chart I-4Canadian Consumers Have A Problem Chart I-5Canadian Monetary Conditons Are Very Easy The three inflation gauges targeted by the Bank of Canada stand between 1% and 3%, or at its objective. This means that the BoC's 1.5% policy rate is negative in real terms. Moreover, this inflationary pressure is unlikely to abate. The BoC estimates that the output gap has closed, and companies are running into growing capacity constraints (Chart I-6, top panel). Despite a correction last month, wages are in an uptrend, powered by growing and severe labor shortages (Chart I-6, bottom panel). Thanks to these conditions, we anticipate that the BoC will track the pace of rate increases by the Federal Reserve over the next 12 months. This is not very different from what is currently priced into Canadian money markets. Chart I-6Canadian Capacity Pressures Point To A Hawkish ##br##BoC Inflation Will Force The BoC's Hand If the BoC does not disappoint, the combination of a cheap and oversold CAD should help the loonie rally against the USD, so long as the current stabilization in global growth continues. A move toward USD/CAD 1.26 is likely. The biggest risk to this view is that trade negotiations between the U.S. and Canada deteriorate further. While we do not anticipate an imminent breakthrough in these negotiations, we do not see much scope for significant deterioration in the relationship either. The energy market could prove to be another positive for the loonie. Bob Ryan, who leads BCA's Commodity and Energy Strategy service, argues that the oil market is currently very tight and vulnerable to supply disruptions.2 Under these circumstances, the removal of Iranian exports, tensions in Iraq, declining Nigerian production and Venezuela's cascading implosion all risk causing a melt-up in oil prices by the first half of 2019. This could help the CAD as well, even if the Canadian oil benchmark remains at a large discount to Brent. Longer-term, the upside in the CAD is likely to be capped. There is only one rate hike priced into the U.S. OIS curve from June 2019 to December 2020. We expect the Fed to hike rates by more than that. Meanwhile, the emerging softness in the Canadian household sector suggests it will be much more difficult for the BoC to keep following the Fed higher over that period. The CAD is not cheap enough to compensate for these long-term headwinds (Chart I-7). Bottom Line: On a short-term basis, the Canadian dollar is cheap and oversold. While the Canadian consumer has begun to disappoint, the inflationary pressures present in Canada should keep the BoC on track to follow the Fed and push rates higher over the coming 12 months. The CAD should therefore benefit from any USD weakness, with USD/CAD moving toward 1.26. Once the short-term undervaluation and oversold conditions are corrected, USD/CAD should rebound toward 1.40. Chart I-7We Like The CAD For Now, But The Rally Has A Limited Shelf Life EUR/SEK Will Trade Heavy Any which way we cut it, the SEK is cheap. The trade-weighted krona is trading at its cheapest levels relative to BCA's long-term fair value since the Great Financial Crisis (Chart I-8). The SEK is not only trading at a 32% discount to its purchasing-power parity against the greenback, it is also trading at a 10% discount against its PPP relative to the euro. Chart I-8The SEK Is An Attractive Long-Term Buy... The SEK is not only cheap on a long-term basis, it is also cheap on a short-term basis. This is most evident against the euro. Currently the SEK trades at a 7% discount to the euro according to our short term fair value model based on real rate differentials, commodity prices and global risk aversion. Historically, this kind of discount in the SEK has been followed by a prompt rebound (Chart I-9). Are there any catalysts to convert this good value into good returns? We see many. First, as was the case in Canada, Sweden's Monetary Gauge has not been at such easy levels since the Great Financial Crisis (Chart I-10). Meanwhile, the economy is also experiencing rising capacity pressures. The OECD's estimate of the output gap stands at 0.7% of GDP, and inflationary pressures are building, as evidenced by the Riksbank's Capacity Utilization measure (Chart I-11). Chart I-9...And A Short-Term One As Well Chart I-10The Riksbank Is Too Easy Chart I-11Swedish Inflation Has Upside This set of circumstances suggests the Riksbank could start hiking rates as early as this coming December, well ahead of the European Central Bank. As a result, we project that Swedish real interest rates could rise further relative to the euro area. Historically, falling euro area / Swedish real interest rate spreads precede depreciations in EUR/SEK (Chart I-12). Chart I-12Real Rate Differentials Point To A Lower EUR/SEK Chart I-13Chinese Liquidity Injections Point To A Lower EUR/SEK The global context also points toward an imminent correction in EUR/SEK. The krona is much more pro-cyclical than the euro. This reflects the more volatile nature of the Swedish economy and the extraordinarily large role of trade in its GDP. EUR/SEK greatly benefited from the tightening in Chinese liquidity conditions, as evidenced by the widening between the 1-month and 1-week Chinese interbank rate (Chart I-13). EUR/SEK essentially sniffed out a slowdown in Chinese capex, a key source of ultimate demand for Swedish goods. However, now that the PBoC is injecting liquidity in the Chinese interbank system, EUR/SEK is likely to suffer. Moreover, the outperformance of Chinese infrastructure and real estate stocks in recent weeks also suggests the SEK could appreciate further against the EUR. The rally of risk assets on the day that U.S. President Donald Trump announced an additional 10% tariff on US$200 billion worth of Chinese exports further confirms that investors may be in the process of discounting additional stimulus out of China, which would further hurt EUR/SEK. To be clear, we have already noted that we do not anticipate the Chinese authorities to attempt to boost growth - we only expect them to limit the damage created by an intensifying trade war with the U.S. As a result, the positive impact of China on the krona should prove transitory. But for the time being, it could be enough to help correct the SEK's 7% discount to the euro. Since we anticipate the USD to continue to correct in the coming weeks, this also implies that USD/SEK possesses ample tactical downside. This negative EUR/SEK view is not without risks. The first comes from the fact that the Swedish current account surplus is now smaller than the euro area's, something not seen since the early 1990s. This is mitigated by the fact that Sweden's net international investment position is now 10% of GDP, while it used to be negative as recently as 2015. The euro area NIIP is still in negative territory. The second risk is that Swedish house prices have begun to contract in response to macroprudential measures. However, we believe that Sweden's inflationary backdrop is likely to dominate the Riksbank's reaction function. Bottom Line: The SEK is cheap against the dollar and the euro on both long-term and short-term metrics. As the Riksbank is set to lift rates in December, we expect EUR/SEK to decline significantly. Recent injections of liquidity by the PBoC and growing expectations among investors of Chinese stimulus could create additional downward impetus under both EUR/SEK and USD/SEK. This is a tactical view. We anticipate the reprieve in the global growth slowdown to be temporary. Once it resumes, the SEK will find it difficult to rally further. JPY: Down Now, Up Later Investors are well aware that the yen is one of the cheapest G10 currencies on a long-term basis. BCA's long-term fair value model shows that the real trade-weighted yen is trading at a 17% discount, close to its cheapest levels in 36 years. However, despite its prodigious long-term cheapness, the yen is not nearly as attractive when compared to its short-term determinants, which show a small premium in the price of the yen versus the dollar (Chart I-14). This means the direction of Japanese monetary policy and global growth will remain more important for the yen's price action over the coming months than its long-term cheapness. When it comes to growth, Japan is doing okay. We witnessed a decline in industrial production driven by foreign demand this summer, but domestic machinery orders are improving and export growth is finding a floor. Actually, BCA's real GDP model for Japan is suggesting that growth could re-accelerate significantly next quarter (Chart I-15). In our view, this improvement reflects the fact that business credit is once again growing after decades of hibernation. Chart I-14Is The JPY A Bargain? Long Term, Yes; Short Term, No! Chart I-15Japanese Growth Doing Just Fine However, we doubt this is enough to prompt any tightening in the Bank of Japan's policy. The most immediate problem facing the BoJ is that Japanese inflation expectations are in free fall (Chart I-16). Since the BoJ assigns the blame of low realized inflation on depressed inflation expectations, this aforementioned weakness, despite the yen's softness, guarantees that the BoJ will stay on the sidelines for much longer. After all, if any little shock can spur such a sharp impact on Japanese inflation expectations, despite an unemployment rate at 2.5% and an output gap at 0.8% of GDP, the BoJ has not anchored inflation expectations higher. Further reinforcing our bias that the BoJ is not set to tighten policy for many more quarters, the VAT is set to be increased to 10% in October 2019. The LDP leadership race is currently underway, and no one is mentioning postponing that hike. This suggests that significant fiscal tightening could emerge next year. The fact that the BoJ will continue to lag behind other global central banks forces us to be negative on the yen. However, could an external event push the yen higher, despite this absence of domestic support? A big downgrade in EM asset prices and global growth would do the trick. While we do think this is likely to happen over the next six to nine months, now does not appear to be the moment to implement such a bet. As we highlighted above, the deceleration in global growth seems to be pausing, and Chinese liquidity conditions have eased. Seven weeks ago, we introduced our China Play Index to track whether or not investors were discounting additional easing on the part of China.3 This indicator looks as if it is forming a base right now (Chart I-17), indicating that pro-growth plays could perform well over the coming weeks while countercyclical plays, like the yen, could perform poorly. Until this indicator begins a new down leg - something we anticipate for the backend of the year - the yen will remain under downward pressure against the dollar, the euro or the aussie. Chart I-16The BoJ's Problem Chart I-17Chinese Plays Are Stabilizing As a result, while we continue to expect more upside in the yen in the latter part of the year, for the time being we will remain on the sidelines as neither short-term valuations, monetary policy dynamics or the global growth environment point to an imminent rally in the yen. Bottom Line: The yen is an attractive long-term play as it displays prodigiously cheap long-term valuations. However, the short-term outlook is less favorable. The yen is not cheap enough based on our augmented interest rate differentials models, the BoJ will remain dovish for the foreseeable future, and an uptick in our China Play Index bodes poorly for countercyclical currencies like the yen. However, since we do expect that global growth will stabilize only on a temporary basis, we will look to open some long yen bets later this fall. Close Short EUR/CHF Trade Last March, we argued that EUR/CHF had more cyclical upside, but that bouts of volatility in global markets would cause periods of weaknesses in the cross.4 Based on this insight, we proceeded to sell EUR/CHF on April 6 as we worried that markets were set to price in a period of weakness in global growth.5 We closed this trade in August, but EUR/CHF kept falling. Now, is EUR/CHF more likely to rally or selloff in the coming quarter? We think a rebound is in the cards. First, the franc is once again highly valued, based on the Swiss National Bank's assessment. It is true that the SNB has not intervened to limit the franc's upside recently, but the CHF's strength is likely to short-circuit the increase in inflation that could have justified betting on the Swissie moving higher (Chart I-18). Ultimately, there is limited domestic inflationary pressures in Switzerland. Moreover, since the import penetration of goods and services in Switzerland is the highest of all the G10, imported deflation will soon be felt. Further, as Swiss labor costs remain very high internationally, the large improvement in full-time jobs witnessed this year is likely to peter off as Swiss businesses work to maintain their competitiveness. Second, the franc received an additional fillip this year as the breakup risk premium in Europe surged (Chart I-19). Every time investors perceive that the probability of a disintegration of the euro rises, they end up pouring money into stable Switzerland. Marko Papic, BCA's Geopolitical Strategy expert, believes that the euro break-up risk will continue to be a red herring in the coming few years. Investors will therefore price out this risk, pulling money out of Switzerland where interest rates remain 30 basis points below the euro area, and boosting EUR/CHF in the process. Chart I-18The Swissie's Strength Will Be Deflationary Chart I-19If A Euro Break-Up Is A Red Herring... Finally, if a temporary stabilization in global growth will hurt the yen, it will also hurt the Swiss franc. As a result, the stabilization in the China Play Index should support EUR/CHF. While we expect EUR/CHF to rally over the coming months, we worry that any such rebound will prove temporary. The current expansion in Chinese stimulus is only a passing phenomenon, and not one powerful enough to put a durable bottom under global growth and EM assets. Hence, while EUR/CHF could easily rally to 1.15, any such rebound should be faded. This move, if followed by a deterioration in our China Play Index, should be used to re-open EUR/CHF shorts. Bottom Line: The Swiss franc remains in a cyclical bear market, punctuated by occasional rallies against the euro when global growth sentiment sours. We just experienced such a rally in the Swissie, but it is ending as the deflationary impact of the CHF's rally will soon be felt. Moreover, the breakup risk premium in the euro is currently too large, and the pricing-in of slowing global growth is likely to take a breather. As a result, EUR/CHF is likely rally over the coming months. We will look to bet again on a CHF rally once the reprieve in global growth ends. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergence Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Retail sales and retail sales ex autos yearly growth underperformed expectations, coming in at 0.1% and 0.3% respectively. Capacity utilization and building permits also surprised to the downside, coming in at 78.1% and 1.229 million respectively. However, Housing starts and the Michigan Consumer Sentiment Index surprised positively, coming in at 9.2% and 100.8 respectively. DXY has fallen by nearly 1% this week. Overall, we continue to be bullish on the dollar on a cyclical basis, as inflationary pressures inside the U.S. will force the Fed to hike more than the market expects. That being said, the slowdown in the dollar's momentum, the growing Chinese stimulus, and accumulating signs of stabilizing global economic activity are likely to further weigh on the dollar on a more immediate basis. We will monitor these factors closely in order to gauge whether or not this pullback will remain a garden-variety correction or something more serious. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been positive: Labor costs growth outperformed expectations, coming in at 2.2%. Moreover, construction output yearly growth also surprised positively, coming in at 2.6%. Finally, both core and headline inflation came in line with expectations, at 1% and 2% respectively. EUR/USD has rallied by 1.1% this week We are bearish on the cyclical outlook for the euro, given that core inflation measures are continue to be too weak for the ECB to meaningfully change their dovish monetary policy stance. However, the current tactical rebound is likely to continue, as the weakness in the euro this year has eased financial conditions, which could lead to a temporary boon for the economy. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Industrial production yearly growth surprised negatively, coming in at 2.2%. Moreover, capacity utilization also underperformed expectations, coming in at -0.6%. Finally, both export and import yearly growth outperformed expectations, coming in at 6.6% and 15.4% respectively. USD/JPY has been relatively flat this week. We are bearish on the yen on a structural basis, given that the economy continues to suffer from strong deflationary forces, which will force the Bank of Japan to keep their ultra-easy monetary policy. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: The retail price index yearly growth surprised to the upside, coming in at 3.5%. Moreover, both core and headline inflation outperformed expectations, coming in at 2.1% and 2.7% respectively. Finally, the DCLG House Price Index also surprised positively, coming in at 3.1%. GBP/USD has rallied by roughly 1.5% this week. The GBP's vol is likely to increase further going foirward, as very little political risks is priced into it. A practical strategy will be to lean against large weekly moves, both on the upside and downside. This strategy should be particularly profitable versus the euro. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: The participation rate surprised to the upside, coming in at 65.7%. Moreover, the total change in employment also outperformed expectations, coming in at 44 thousand. Finally, the house price index yearly growth also surprised positively, coming in at -0.6%. AUD/USD has risen by roughly 1.8% this week. We continue to be cyclically bearish on the Australian dollar, as the deleveraging campaign in China will weigh on demand for industrial metals, Australia's main export. Moreover, the AUD will also have downside against the CAD, as oil should continue to hold up relative to other commodities thanks to supply cuts from OPEC. That being said, the AUD's recent rebound is likely to continue on a short-term basis. Hence, investors already shorting the Aussie should consider buying hedges. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied nearly 1.9% this week. We are negative on the New Zealand dollar on a structural basis due to the measures taken by the Ardern government, which include reducing immigration, and adopting_a dual mandate for the RBNZ. Both of these measures will weigh on the real neutral rate, which means that the RBNZ will have to hold rates lower than otherwise. However, on a more tactical basis, this cross could rally, thanks to the temporary stimulus by the Chinese authorities which will help risk assets. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Manufacturing shipments monthly growth outperformed expectations, coming in at 0.9%. However, capacity utilization surprised to the downside, coming in at 85.5%. Finally, the new house price index yearly growth was in line with expectations, coming in at 0.5% USD/CAD has depreciated by 1% this week. We remain bullish on the CAD among the dollar bloc currencies, given that inflationary pressures continue to be strong in Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has rallied by 0.5% this week. We continue to be bullish on this cross on a cyclical basis, as the Swiss economy is still too fragile for the SNB to remove its ultra-dovish monetary stance. Moreover, the recent appreciation in the franc that has taken place over the last four months should be very negative for inflation, as Switzerland is the country with the most imports as a percentage of demand in the G10, and thus the country with the most sensitive inflation to currency movements. Finally, on a tactical basis we are also bullish on this cross, as the recent easing of monetary policy by Chinese authorities should be weigh on safe heaven assets like the franc. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Yesterday, Norges Bank increased rates for the first time since 2011, yet the NOK was flat against a weak USD, and fell against the euro and the Swedish krona, suggesting that the hike was well anticipated by market participants. Despite this price action, USD/NOK has depreciated by 1.2% this week. We are positive on the NOK against other non-oil commodity currencies, as oil should outperform base metals in the current environment. After all, OPEC supply cuts and geopolitical risk in the Middle East should provide a boon for oil prices. On the other hand, while temporary easing is likely, the Chinese deleveraging campaign will continue once the Chinese economy has stabilized. Finally, the positive NIIP, and positive current account of the NOK should give it an additional advantage against the rest of the commodity currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Headline inflation underperformed expectations, coming in at 2%. Moreover, the unemployment rate increased from 6% in July to 6.1% on the August reading. USD/SEK has depreciated by almost 2.8% this week. We expect the Riksbank to begin tightening policy in December, as Swedish inflationary pressures remain strong. Moreover, the recent stimulus from the PBoC should put additional downward pressure on EUR/SEK, given the krona's more pro-cyclical profile than the euro. Finally, valuations also support the SEK, as the krona is cheap according to multiple measures. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Prediction 1: A major financial downturn will trigger the next major economic downturn, and not the other way round. Prediction 2: The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. But for those who can fine tune, the global long bond yield must rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice. Take short-term profits in the overweight position in 30-year government bonds. Take short-term profits in the underweight position in basic materials. Take short-term profits in the underweight positions in Italy (MIB) and Spain (IBEX) and overweight position in Denmark (OMX). Feature The twenty-first century has witnessed three major downturns: the first started in 2000; the second started in 2007 culminating in the Lehman crisis a year later; and the third started in 2011 (Chart of the Week). Today, we are going to stick our necks out and make two predictions about the century's fourth major downturn. Chart of the WeekThree Episodes When Equities Underperformed Bonds By 20 Percent Or More A major financial downturn will trigger the fourth major economic downturn. The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. Where The Consensus Is Very Wrong As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major downturn in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months.1 All the same, our market based definition of a major downturn perfectly captures the three occasions that the European economy went into recession or stagnation (Chart I-2). Does this mean that the economic downturns triggered the financial market downturns? No, quite the reverse. The onset of the three major financial downturns clearly preceded the onset of the three major economic downturns. Chart I-2Three Episodes When The Euro Area Economy ##br##Contracted Or Stagnated On reflection, this is hardly surprising. The twenty-first century's major economic downturns have all resulted from financial market distortions and fragilities: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-3); the mispricing of U.S. mortgages and credit in 2007 (Chart I-4); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-5). Therefore, it makes perfect sense that the downturns in financial markets should precede the downturns in the economy, even when both are measured in real time. Chart I-3The Major Downturns Stemmed From##br## Financial Market Distortions: The Dot Com ##br##Bubble In 1999/2000... Chart I-4...The Mispricing Of U.S. ##br##Mortgages And Credit##br## In 2007/2008... Chart I-5...And The Mispricing Of Euro Area ##br##Sovereign Credit Risk##br## In 2010/2011 Today, the consensus overwhelmingly believes that an economic downturn will cause the next major downturn in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Why not learn the lesson? So here's our first prediction: a major financial downturn will trigger the fourth major economic downturn, and not the other way round. This prediction raises some obvious questions: what could be the major fragility in financial markets, and what could fracture it? A Sharp Rise In Bond Yields Triggered The Last Three Major Downturns Look carefully at the financial market downturns that started in 2000, 2007 and 2011, and you will see another striking similarity. In each episode, the global long bond yield rose by 60 bps or more in the months that preceded the onset of the financial market downturn: April 1999 through January 2000 (Chart I-6); March through July 2007 (Chart I-7); and October 2010 through April 2011 (Chart I-8). This strongly suggests that the spike in the bond yield was the trigger for the subsequent major downturn in financial markets. Chart I-6A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2000 Chart I-7A Sharply Rising Bond Yield Triggered##br## The Major Downturn Of 2007 And 2008 Chart I-8A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2011 A sharp rise in bond yields is usually the straw that breaks the back of financial market fragilities, in (at least) one of three ways: it flushes out those actors that are reliant on cheap liquidity; it pressures interest rate sensitive sectors in the economy; and it weighs on the valuations of other assets such as equities, especially if those valuations are already extremely elevated. Which segues us neatly to the current fragility in the global financial system. As we wrote last week, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies across all asset-classes. And the total value of those global risk-assets is $400 trillion, equal to about five times the size of the global economy.2 We have also consistently highlighted that not only do the rich valuations of $400 trillion of risk-assets depend (inversely) on bond yields, but that this relationship is an exponential function.3 So here's our second prediction: the straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time - just as it did in 2000, 2007 and 2011. But Bond Yields Haven't Gone Up Far Enough... Yet Now comes some bullish news, at least for those who can play shorter-term moves in the market. The global long bond yield has been trapped within a tight channel and is only 20 bps up from its recent low in April (Chart I-9). Therefore, it has the scope to rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice and unleashing a 'risk-off' phase. Chart I-9In 2018, The Bond Yield Has Not Risen Sharply...Yet For those who want to fine tune their investment strategy, the journey up to that turning point would define a phase when many of this year's cyclical sector underperformances would end or even switch to a phase of modest outperformances. Bear in mind that the cyclical sector underperformances this year have been substantial: European banks have underperformed healthcare by 35 percent; global basic materials have underperformed the market by 10 percent; emerging market equities have underperformed developed market equities by 15 percent. So it is prudent to take some short-term profits, especially as these trends are likely to end, at least in the near term. Hence, three weeks ago we closed our underweight banks versus healthcare position, booking a tidy profit of 23 percent. Today, we are closing our underweight position in basic materials versus the market, booking a profit of 6 percent. In a similar vein, we are taking the modest profits in our overweight position in 30-year government bonds. Sector allocation has unavoidable implications for stock market allocation - because the mainstream stock market indexes all have dominant sector skews which determine their relative performances (Chart I-10). Chart I-10Italy Vs. Denmark = Banks Vs. Healthcare On this basis, closing our underweight banks versus healthcare removes the justification for being underweight bank-dominant Italy (MIB) and Spain (IBEX) and the justification for being overweight healthcare-dominant Denmark (OMX). These three positions now move to neutral. While we consider our next shift, our European stock market allocation is temporarily reduced to just five positions. Overweight: France, Ireland, Switzerland. Underweight: Sweden, Norway. Finally, just to say that there will be no report next week as I will be attending our annual Investment Conference which is in Toronto this year. I look forward to seeing some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. 2 Please see the European Investment Strategy Weekly Report 'Trapped: Have Equities Trapped Bonds?' September 13 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report 'The Rule Of 4 For Equities And Bonds' August 2 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week, we note that the very strong recent outperformance of U.S. telecoms versus U.S. autos is technically extended, reaching a fractal dimension that has previously signalled the start of a countertrend move. Hence, the recommended trade is short U.S. telecoms, long U.S. autos. Set a profit target of 9% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. The message now conveyed by the Monitors is that divergences between the cyclical pressures faced by the individual central banks are growing larger. This is occurring within some countries, where the growth and inflation indicators are trending in opposite directions. This is also visible across countries, with not every Monitor calling for rate hikes - a significant shift from the coordinated backdrop seen in 2017 (Chart of the Week). Chart of the WeekFrom Convergence To Divergence In The BCA Central Bank Monitors The combined message from the Monitors is that the slower pace of global growth seen in 2018 has not been enough put a serious dent in inflation pressures stemming from a dearth of spare capacity in most major countries. Perhaps that changes if a full-blown U.S.-China trade war develops, or if the tensions in emerging markets spill over more broadly into global financial conditions, but that remains to be seen. Add it all up, and a below-benchmark stance on overall global duration exposure remains appropriate. Feature An Overview Of The BCA Central Bank Monitors Chart 2CB Monitor Divergence = Bond Yield Divergence 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). Our current recommended country allocation for global government bonds reflects the trends seen in the Central Bank Monitors - underweighting countries were the Monitors are most elevated (the U.S., Canada) in favor of regions where the Monitors are lower (Australia, Japan, euro area, New Zealand). 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 the relative returns for each country versus the overall Bloomberg Barclays Global Treasury index (shown inversely in the charts so that a rising line means underperformance versus the benchmark index). Fed Monitor: Still On A Gradual Rate Hike Path Our Fed Monitor remains in the "tight money required" zone, signalling that the cyclical backdrop justifies additional Fed rate hikes (Chart 3A). Resilient U.S. growth, a dearth of spare capacity and an acceleration of both wage growth and core inflation are all consistent with a U.S. economy starting to overheat and requiring tighter monetary policy (Chart 3B). Chart 3AU.S.: Fed Monitor Chart 3BU.S. Inflation On The Rise The growth and inflation components of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published back in April. Most notably, the inflation component has blasted through the zero line to the highest level since 2008 (Chart 3C). The financial conditions component has retreated from very elevated (i.e. growth-supportive) levels, mostly due to the stronger U.S. dollar but also because of wider corporate credit spreads seen since the start of 2018. Importantly, the financial conditions component has not tightened enough to offset the impact on the Monitor from faster growth and inflation. Chart 3CAll Fed Monitor Components Now Above Zero Recent comments from senior Fed officials (Chair Jay Powell and Governor Lael Brainard) have indicated that the Fed is less confident in its own estimates of the full-employment NAIRU or the appropriate neutral level of the funds rate. Our read on this is that the Fed will instead continue to raise the funds rate at a gradual 25bp per quarter pace until there are signs that U.S. monetary policy has become tight (i.e. an inverted yield curve, wider credit spreads, softer U.S. economic data). Until then, the message sent by the Fed Monitor is to remain underweight U.S. Treasuries with below-benchmark duration, as market pricing of expectations for both the funds rate and inflation remain too low (Chart 3D). Chart 3DU.S. Treasury Underperformance Will Continue - Stay Underweight BoE Monitor: Brexit Uncertainty Trumps Inflation Pressures The BoE Monitor remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has kept monetary policy at highly accommodative levels, only raising the base rate 50bps over the past year. The BoE Monetary Policy Committee remains torn between signs that inflation risks are tilted to the upside and the downside risks to U.K. growth from an uncertain Brexit outcome. 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, with core inflation drifting back below 2%. Wages are finally starting to grow in real terms, which the BoE cites as an important factor underpinning consumer spending, but the pace remains modest. Chart 4AU.K.: BoE Monitor Chart 4BNo Spare Capacity, Yet Has Inflation Peaked? Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator have recently reaccelerated (Chart 4C). Yet U.K. leading economic indicators continue to decline and dampened business confidence measures reflect the heightened uncertainty over the future relationship between the U.K. and the European Union. Chart 4CBoth Growth & Inflation Components Are Boosting The BoE Monitor The performance of U.K. Gilts has diverged from the Monitor since the 2016 Brexit vote (Chart 4D), as the BoE has been more worried about Brexit than inflation and has stayed accommodative. Stay overweight U.K. Gilts within global government bond portfolios, even with the more bearish signal implied by our BoE Monitor, given the weakening trend in leading economic indicators and persistent Brexit uncertainty. Chart 4DBrexit Uncertainty Preventing More BoE Hikes - Stay Overweight Gilts ECB Monitor: No Pressure To Hike Rates Quickly Post-QE Our European Central Bank (ECB) Monitor has fallen sharply since we last published this Chartbook back in April, and it now sits below the zero line (Chart 5A). The growth deceleration in the first half of the year from the rapid pace seen in 2017 is the main reason for this move, as inflation pressures have not subsided (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEuro Area At Full Capacity ECB President Mario Draghi noted last week that the plan remains in place to end the net new buying phase of the ECB's Asset Purchase Program at the end of 2018. Policymakers' have grown more confident that their inflation forecasts will be met as most measures of euro area wage growth (and headline inflation) have accelerated to 2% over the past year. It remains to be seen if those expectations are too optimistic, as the growth component of our ECB Monitor remains well below the zero line, while the inflation component is no longer rising (Chart 5C). Chart 5CGrowth Component Dragging Down The ECB Monitor For now, we recommend a neutral stance on core euro area government bonds with an underweight posture on Peripheral sovereign debt as a way to manage these conflicting trends. The overall performance of euro area bonds versus global benchmarks has followed the pace of the ECB's bond-buying since 2015, and not the pressures suggested by our ECB Monitor (Chart 5D), suggesting a bearish stance as the bond buying ends. Yet from a more bullish perspective, the mixed message on growth and lack of immediate pressures on core inflation (still at 1%) imply that the ECB will not deviate from its current dovish forward guidance of no interest rate hikes until at least September 2019. Chart 5DECB Will Not Hike Rates Quickly After QE Ends - Stay Neutral Core European Bonds BoJ Monitor: Too Soon To Consider Policy Changes Our Bank of Japan (BoJ) Monitor has stayed just barely in the "tighter money required" zone since last October, due mostly to growing inflation pressures (Chart 6A). Yet with the Japanese labor market now as tight as it has been in decades, headline and core CPI inflation are only at 0.9% and 0.3% respectively, well below the BoJ's 2% target (Chart 6B). Chart 6AJapan: BoJ Monitor Chart 6BInflation Pressures Slowly Building In Japan Japanese firms appear to finally be reacting to the tightness of the labor market, however, as wage growth has accelerated in recent months. The pick-up in wages has helped boost inflation expectations, both of which are part of the inflation component of the BoJ Monitor that is now at the highest level since 2008 (Chart 6C). However, the growth component just rolled over and now sits at the zero line, as the Japanese economy has lost some momentum. Chart 6CInflation Boosting BoJ Monitor We continue to recommend an overweight stance on JGBs, based on our view that the BoJ will maintain hyper-easy monetary policy settings - especially compared to the rest of the developed markets - until there is much higher realized inflation in Japan. JGBs have indeed been outperforming over the past year, even with the less dovish signal sent by the BoJ Monitor (Chart 6D). Yet the absolute level of the Monitor remains around zero, suggesting that no policy changes should be expected. That means no upward adjustment of the BoJ's 0% yield target on 10-year JGBs or major further reductions in the annual pace of BoJ JGB buying (even though the central bank is hitting capacity constraints as it now owns close to ½ of all outstanding JGBs). Chart 6DBoJ In No Hurry To Turn Hawkish - Stay Overweight JGBs BoC Monitor: Rate Hikes - More To Come The Bank of Canada (BoC) Monitor has stayed in "tighter money required" since the beginning of 2017 and is now well above the zero line (Chart 7A). The BoC has been following our BoC Monitor, hiking rates by a cumulative 100bps since July 2017. Chart 7ACanada: BoC Monitor Chart 7BAn Overheating Canadian Economy? The BoC has been responding to the growing inflation pressure in Canada. There is no evidence that spare economic capacity exists, while realized inflation is near the upper bound of BoC's target range of 1-3% (Chart 7B). There is a growing divergence between the growth and inflation subcomponents of the BoC Monitor, with the latter decelerating over the past several months. That was due to a combination of slowing Chinese import demand and the imposition of trade tariffs on Canada by the Trump administration (Chart 7C). Yet the domestic economy remains in good shape, with the overall indicator from the BoC's Business Outlook Survey at the highest level since 2010. Chart 7CInflation Component Boosting BoC Monitor We continue to recommend an underweight stance on Canadian government bonds, as the relative performance has broadly followed the path of the BoC Monitor over the past three years (Chart 7D). The BoC tends to follow the policy actions of the Fed with a short lag, thus our bearishness on Canadian government bonds is related to our more hawkish views on the Fed. Yet the surge in Canadian inflation, at a time when the economy has no spare capacity, suggests that there are good domestic reasons to expect more rate hikes from the BoC over the next year than what is currently discounted by markets. Chart 7DBoC Not Done Yet - Stay Underweight Canadian Bonds RBA Monitor: Easier Policy Needed The Reserve Bank of Australia (RBA) monitor has rapidly fallen below the zero line for the first time since 2016, and now indicates that easier monetary policy is required (Chart 8A). This stands out from the more stable trajectory of the rest of the BCA Central Bank Monitors. Unlike most other developed countries, there is still excess capacity in the Australian economy. Australia's output gap has not closed while the current unemployment rate is just at the OECD's NAIRU estimate of 5.3%. Headline and core inflation are at the low end of the RBA's 2-3% target and struggling to gain much upward momentum (Chart 8B). Chart 8AAustralia: RBA Monitor Chart 8BMinimal Inflation Pressure In Australia While both the growth and inflation components of the RBA Monitor have fallen, the biggest decline has come from the inflation side (Chart 8C). The sluggishness of Australia's economy is due to the slow growth of consumer spending and a big deceleration in exports related to softer Chinese demand. On inflation, excess labor market slack, with an underemployment rate close to 8.5%, is the main factor explaining soft wage growth and overall sluggish inflation. Chart 8CInflation Component Weighing On RBA Monitor Our highest conviction country allocation call this year has been to overweight Australian Government bonds, and we see no need to change that given the bullish signal from our RBA Monitor (Chart 8D). It would likely take a rise in unemployment, a renewed decline in realized inflation or a big external shock for the RBA to actually cut rates as our Monitor suggests, but the signal is still bullish for Australian debt on a relative basis. Chart 8DRBA A Long Way From A Hike - Stay Overweight Australian Government Bonds RBNZ Monitor: Policy On Hold For A While Longer The Reserve Bank of New Zealand (RBNZ) Monitor is currently just above the zero line, indicating that tighter monetary policy is required (although just barely) (Chart 9A). This is consistent with the mixed messages in the New Zealand economic data. For example, there is no spare capacity in the economy according to estimates of the output and employment gaps, yet both headline and core inflation have decelerated to the lower end of the RBNZ's 1-3% target band (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BNo Spare Capacity In NZ, But No Inflation Either Looking at the components of the RBNZ Monitor, the growth factors have continued to plunge whereas the inflation factors have been increasing (from below zero) since the start of 2018 (Chart 9C). New Zealand's economic growth has slowed because of softer consumer spending and weaker housing activity, the latter of which is related to lower net immigration. Yet business confidence is falling, both the manufacturing and services PMIs have also declined, and export growth has cooled thanks to weaker growth from China and Australia. Meanwhile, the uptick in the inflation components has not yet translated into any broader improvement in realized inflation that would cause the RBNZ to take a more hawkish turn. Chart 9CConflicting Trends Within The RBNZ Monitor We continue to recommend an overweight stance on New Zealand Government Bonds, in line with the bullish signal sent by our RBNZ Monitor (Chart 9D). The RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will stay unchanged until 2020, and it will take some time before there is evidence that the recent hook down in inflation is nothing more than a temporary blip. Chart 9DRBNZ To Remain On Hold - Stay Long New Zealand Bonds Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The USD remains supported by fundamentals, especially now that its late-2016 excesses have been purged. Solid U.S. growth contrasts with weaker growth in the rest of the world, which will incentivize further inflows into the U.S. dollar. Despite this positive cyclical view, the tactical outlook remains risky for dollar bulls. In the immediate term, the euro will benefit from easing Italian tensions and as well as from the dollar's correction, but its six-month outlook remains poor. The AUD could also rebound right now, but any such rally should be used to build further short positions. Feature After a furious rally from February to August, the dollar has been weakening since the middle of last month. Since July, we have been worried that the dollar could stage a bit of a correction,1 but we remained committed to the view that ultimately the greenback would rise further in 2018. It is now time to review whether this thesis still holds. BCA believes that the USD's correction could run through the fall, but that the final quarter of 2018 should still prove a rewarding period for dollar bulls. Ultimately, policy divergences will remain a crucial support for the dollar, especially as EM weakness continues to affect the distribution of growth across the globe. USD: Not Yet Extended The dollar ultimately follows the path implied by its fundamental drivers - whether they are interest rate spreads, growth and inflation differentials, relative equity prices, or even relative money-supply growth. However, the path taken by the USD around its drivers is rather wide, and the dollar regularly overshoots and undershoots the equilibrium implied by the aggregation of all these fundamentals (Chart I-1). Academics call this the "band of agnosticism." Chart I-1The Dollar To Follow Fundamentals Higher This cycle was no exception. BCA's Fundamentals Index for the dollar hooked up in 2011, a move associated with a turning point in the greenback itself. However, the dollar remained in undershoot territory for many years. Then suddenly, in 2014, the coiled spring was released and the dollar surged higher, moving above its "band of agnosticism" in 2015 - a moved exacerbated by the sudden rally that followed the election of Donald Trump in November 2016. Once the dollar had become over-loved, over-owned and expensive, it also became vulnerable. The pick-up in global growth that was so evident in 2017 caused a serious correction in this vulnerable currency. However, the selloff had a positive impact: U.S. growth, interest rates, equities and so on continued to move favorably, and the dollar is now positioned to rebound anew, having purged its most egregious excesses. The global economic backdrop is also positive for the dollar. For one, the theme of monetary divergences is still at play. Boosted by a healthy banking sector, healthy household balance sheets and an untimely fiscal stimulus of 1.7% of GDP, U.S. growth has hit 2.8%, well above potential. Moreover, growth has been above potential for eight years, and now U.S. capacity utilization is at its tightest level since the late 1980s. Historically, so large an absence of slack has been linked to higher U.S. interest rates (Chart I-2). Yet interest rate markets are pricing in roughly four increases over the next 24 months, even as Lael Brainard warned that the Federal Reserve could move beyond the hikes implied by its own forecast, the "dot plots." Chart I-2Tight Capacity Utilization Implies Higher U.S. Rates... The U.S. economy continues to fare well, as U.S. real interest rates remain 60 basis points below neutral rates and the yield curve has yet to invert. However, U.S. rates matter for the rest of the world as well. There, the picture is less pretty. EM dollar debt stands near record levels (Chart I-3). Hence, EM financial conditions have been hit by the combined assault of higher U.S. rates and an appreciating dollar. Nowhere is this clearer than when looking at the interplay between U.S. bond yields and the South African rand or AUD/JPY, a cross highly correlated to EM currencies. This cycle, rising U.S. bond yields have most often been associated with a rising ZAR or a rising AUD/JPY (Chart I-4). However, this time around, as was the case during the May 2013 Taper Tantrum, rising bond yields are linked to these pro-cyclical currency pairs falling. This suggests that rising yields are not reflecting global growth anymore, and are in fact restrictive for the rest of the world, even if they are not a problem for the U.S. Chart I-3... Which Will Hurt EM Economies Chart I-4Higher U.S. Rates Now Hurt Global Growth This inference is underpinned by the decline in BCA's U.S. Financial Liquidity Index, which heralds additional weakness in global growth and commodity prices (Chart I-5). Already we are seeing symptoms of the malaise. Japanese foreign machine tool orders are contracting, and BCA's Asian Leading Economic Indicator is in deep contraction (Chart I-6). Chart I-5Dollar Liquidity Is A Problem For Growth Chart I-6Signs That Global Growth Is Already Suffering A rising fed funds rate and falling ex-U.S. growth is likely to continue to support the dollar. The dollar loves nothing more than falling global growth. The U.S. economy has low exposure to global trade and to the global industrial sector, and therefore when global growth slows, the U.S. economy is relatively insulated from foreign shocks. This means that U.S. rates of return do not suffer as much as foreign ones. This is even truer in the rare instances when global growth slows while U.S. economic activity continues to power ahead, especially when artificially inflated by untimely fiscal stimulus. This is a characterization of the current environment. Hence, money will continue to flow into the U.S. economy on a two- to three-quarter horizon. In fact, portfolio flows into the U.S. remain well below the levels that prevailed during the previous decade (Chart I-7). The current account deficit is also smaller, hence, if net foreign portfolio flows can increase due to the attraction of higher U.S. rates of return, the U.S. balance of payments will move into a greater surplus, creating a strong underpinning for the dollar. This positive cyclical backdrop for the greenback is not without impediments. Most crucially are the short-term dynamics. Since July, we have been warning clients that a tactical correction in the dollar was likely. While EUR/USD has indeed rebounded, most other currencies have displayed rather tepid performances. This does not mean that the tactical risks to the dollar have abated. Quite the opposite, they are rising. As Chart I-8 illustrates, a large buildup in dollar longs has materialized, yet the G10 economic surprise index is making a trough. Moreover, the diffusion index of the BCA Global Leading Economic indicator is also stabilizing. Additionally, USD /CNY has failed to make new highs and the Turkish central bank just raised rates to 24% - which if Argentina is any guide is likely to provide only temporary relief for the TRY. This means that a period of risk-on sentiment in EM could emerge. Stretched dollar positioning, a temporary stabilization in global growth and EM inflows could precipitate a serious correction in the dollar. Chart I-7Dollar Favorable Flows Chart I-8Tactical Risks To The Dollar Bottom Line: The dollar is still supported by potent cyclical tailwinds. The U.S. economy is roaring and at full employment, yet global growth is suffering because global liquidity conditions are deteriorating. Higher rates of return in the U.S. will therefore attract additional capital, supporting the greenback in the process. Despite this positive cyclical backdrop, the short-term outlook is murkier. Speculators have aggressively bought the dollar, leaving them vulnerable to any positive surprises in global growth, even temporary ones. Fade The Euro Rebound The euro has benefited from the cool-off in Italian politics. The populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels, as Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit, while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. As a result, the spread between Italian BTPs and German bunds has fallen from 193 basis points at the beginning of the month to 150 basis points this week (Chart I-9). Since gyrations in Italian spreads reflect the evolution of the perceived probability that the euro area will fall apart, the fall in the spreads has implied a fall in the euro area-breakup risk premium. This has created a boon for the euro. Another support for the euro emerged yesterday. At his press conference, European Central Bank President Mario Draghi divulged that the ECB has curtailed its growth forecast for 2018 and 2019, but not its inflation forecast. In fact, Draghi went as far as mentioning that his confidence that euro area inflation would move back to target in the medium term has increased. There is no denying that the inflationary backdrop has improved as European wages and labor costs have indeed starting to recover (Chart I-10). However, the picture is not that straightforward. The lagged impact of the previous fall in euro area inflation relative to the U.S. is likely to continue to be felt in EUR/USD moving forward, as has been the case over the past 10 years (Chart I-11). Chart I-9The Euro Area Break Up Risk Premium Is Declining Chart I-10Rising Euro Area Labor Costs Chart I-11Relative Inflation Backdrop Is Still Euro Bearish This risk is compounded by developments in China. As we have often argued, the growth differential between the euro area and China can largely be explained by growth dynamics in China. As Chart I-12 illustrates, when Chinese monetary conditions tighten, or when China's marginal propensity to consume - as approximated by the gap between M1 and M2 - declines, this often leads to underperformance of European economic activity relative to the U.S. Chart I-12AChinese Economy Still Hurting Euro Area Vs U.S. (I) Chart I-12BChinese Economy Still Hurting Euro Area Vs U.S. (II) Today, Chinese monetary conditions have improved somewhat as the Chinese authorities try to combat the shock to the Chinese economy created by the growing trade war between the U.S. and China. However, Matt Gertken, BCA's Geopolitical Strategy service's expert on Chinese policy, believes that Chinese policymakers do not intent to actually cause economic growth to pick up. Indeed, they are committed to reform and deleveraging, and only want to limit downside to the Chinese economy.2 Thus, the large growth gap between the U.S. and the euro area is here to stay. As markets absorb news of Chinese stimulus, EUR/USD could rebound toward 1.19, but we are inclined to fade such a rebound. For one, the growth and inflation gap between the U.S. and the euro area remains euro bearish. Additionaly BCA's Central Bank Monitor for the Fed clearly points toward the need to tighten U.S. monetary policy, while our indicator for the ECB points to the need to maintain an extremely loose policy setting in Europe (Chart I-13). With the euro still trading above its intermediate-term fair value estimate (Chart I-14), beyond any short-term rally the euro still possesses ample downside in the fourth quarter. As such, we would use the current rebound in the euro as an opportunity to buy the dollar once again. Chart I-13The U.S. Needs More Tightening, Europe Does Not Chart I-14The Euro Possesses Downside Bottom Line: Falling risk premia in Italy, a pick-up in European wages and signs of stimulus in China are creating some support under the euro. However, European growth and inflation are set to continue to lag well behind the U.S. as China's stimulus is not designed to reverse its deleveraging campaign and boost growth, but instead to limit downside to growth created by the U.S.-China trade war. Hence, we will use the current rebound in the euro and correction in the USD to buy the greenback again in the coming weeks. What's Going On Down Under? In recent months, the Australian economy has managed to generate some impressive numbers on the employment front. However, until recently this was not enough to prompt investors to push the AUD higher. In fact, as recently as Monday, AUD/USD was trading at 0.71. Investors are skeptical about the Australian economy's underlying strength. The NAB Business Confidence for the Next Period has weakened sharply, while mortgage approvals and house prices have also sagged. This suggests that new orders, employment and consumption could follow lower (Chart I-15). This represents a big problem for the Aussie, as our central bank monitor for the Reserve Bank of Australia is already in "easing required" territory (Chart I-16). The RBA will therefore not be able to hike rates any time soon, despite the fact that U.S. interest rates are currently in an uptrend. As such, interest rate differentials between Australia and the U.S. will continue to deteriorate. Chart I-15Australia Is Set To Slowdown Chart I-16China And Australia Are Joined At The Hip Moreover, Australia has been hit directly by the decline in Chinese industrial activity. As Chart I-17 illustrates, Australian exports are a direct function of China's Li-Keqiang index. This has two implications. First, the current rebound in the Li-Keqiang index suggests that investors could bid up the AUD with great alacrity if the USD were to correct further, a thesis we espouse. However, since we do not anticipate the rebound in the Li-Keqiang indicator to have much longevity, nor do we anticipate the greenback's correction to morph into a bear market, this also means that we would use any rebound in the AUD to sell more of it. Beyond China, EM at large still constitutes a risk for AUD/USD. Arthur Budaghyan, our Chief EM strategist, argues that the period of weakness in EM assets has further to run. Our views on the U.S. dollar, on declining global liquidity and on Chinese policy corroborate this assessment. If EM economies slow further, the still-elevated expected long-term growth rate in EM earnings could decline further as well. Since growth expectations on EM EPS are indicative of expected interest rates and terms-of-trade for Australia, this also suggests that the AUD could suffer significant downside in the coming quarters (Chart I-18). Finally, the AUD remains a pricey currency. AUD/USD continues to trade significantly above its purchasing-power-parity fair value, and the real trade-weighted AUD remains above its long-term average (Chart I-19). As such, the AUD does not possess the required valuation cushion to make it a buy in this challenging context. Chart I-17RBA ##br##Cannot Hike Chart I-18EM Has Yet To Be Fully Re-Rated, ##br##And So Does The AUD Chart I-19No Valuation Cushion##br## In The AUD Bottom Line: The Australian economy has posted some solid employment numbers, but the trends in business confidence and the housing market augur poorly. Australian monetary policy will have to remain very loose. Moreover, since China's stimulus is likely to be limited, any rebound in the AUD on the back of a dollar correction should be faded, especially as the Aussie does not offer any valuation cushion. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Time To Pause And Breathe", dated July 6, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "China: How Stimulating is The Stimulus?", dated August 24, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Average hourly earnings growth outperformed expectations significantly, coming in at 2.9%. Moreover, nonfarm payrolls also surprised to the upside, coming in at 201 thousand, but this was mitigated by large downward revisions to the previous two months. Additionally initial jobless claims surprised positively, coming in at 203 thousand. However, core inflation underperformed expectations, coming in at 2.2%. Finally, DXY has been flat for the past couple of weeks. We continue to be bullish on the dollar on a cyclical basis, as inflationary pressures will continue to accumulate in the U.S., causing the fed to hike more than expected, particularly in 2019. Moreover, high U.S. borrowing cost will likely weigh on global growth, giving an additional boost to the dollar, as the U.S. has a lower beta than other DM economies to the global economic cycle. Report Links: The Dollar And Risk Assets Are Beholden To China’s Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the euro area has been negative: Both headline and core inflation surprised to the downside, coming in at 2% and 1% respectively. Moreover, industrial production yearly growth also surprised to the downside, coming in at -0.1%. Finally, retail sales yearly growth also underperformed expectations, coming in at 1.1%. EUR/USD has been flat the past two weeks. Yesterday, however the market rallied as the ECB confirmed that it expects to wind down its bond-buying program. Nevertheless, it also lowered growth forecast for this year and next. We continue to believe that the euro will have downside until the end of the year, as a policy and regulatory tightening in China will weigh on the global industrial cycle, to which Europe is highly levered. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: Tokyo ex fresh food inflation outperformed expectations, coming in at 0.9%. Moreover, overall household spending yearly growth also surprised positively, coming in at 0.1%. However, labor cash earnings yearly growth underperformed expectations substantially, coming in at 1.5%. Finally, Markit Services PMI surprised to the downside, coming in at 51.5. USD/JPY has been flat the past couple of weeks. Overall, we are bullish on the yen against the euro and the commodity currencies, as the tightening in monetary policy in the U.S. as well as in China should create a risk off environment where safe heavens like the yen benefits and cyclical currencies suffer. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been mixed: Average hourly earnings yearly growth excluding and including bonuses both came in above expectations, at 2.9% and 2.6% respectively. Moreover, Markit Services PMI also outperformed expectations, coming in at 54.3. However, industrial production surprised to the downside, coming in at 0.9%. Finally, nationwide housing prices yearly growth also surprised negatively, coming in at 2%. GBP/USD has rallied by roughly 0.5% the past couple of weeks. We believe that the pound could have some short term upside, as positioning continues to be significantly bearish. That being said, we are bearish on the pound on a cyclical basis, particularly against the yen. At this moment, the pound does not appear to have much of a geopolitical risk premium embedded in its price. Thus, any turbulence in the Brexit negotiations could result in significant downside for the GBP. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Gross domestic product yearly growth came in above expectations, at 3.4%. However, building permits month-on-month growth surprised to the downside, coming in at -5.2%. Finally, the RBA Commodity Index SDR yearly growth surprised positive, coming in at 6.7%. After a bout of pronounced weakness, AUD/USD has been flat for the past couple of weeks. We believe that the Australian dollar has further downside particularly against the yen and the dollar. Australia's economy is very sensitive to the Chinese industrial cycle, as iron ore is Australia's main commodity export. However, the overleveraged industrial complex is precisely the economic sector where Chinese policymakers want to rein in credit excesses. This will curb industrial activity in China, and hurt the economies of commodity supplies like Australia. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar Recent data in New Zealand has been mixed: Retail sales and retail sales ex autos yearly growth both outperformed expectations, coming in at 1.1% and 1.4% respectively. Moreover, the trade balance also surprised to the upside, coming in at -4.4 billion dollars/ However, the terms of trade Index underperformed expectations, coming in at 0.6%. NZD/USD has fallen by roughly 0.8% against the dollar for the past couple of weeks. We continue to be bearish on kiwi on a cyclical basis. The combination of high U.S. rates and deleveraging in China will weigh on carry currencies like the NZD. Furthermore, we also hold a bearish view on a structural basis, given that the new government has vowed to curb immigration and add an unemployment mandate to the RBNZ, both developments which are negative for the currency. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Both core and headline inflation outperformed expectations, coming in at 1.6% and 3% respectively. Moreover, manufacturing shipments month-on-month growth also outperformed expectations, coming in at 1.1%. However, retail sales month-on-month growth surprised to the downside, coming in at -0.2%. USD/CAD has been flat for the past couple of weeks. We are short this cross as a hedge to our dollar bullish view, as inflationary pressures in Canada remain strong. Moreover, the CAD will continue to outperform the AUD, as the divergence between Canada's and Australia's main export markets- China and the U.S. - will persist. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc Recent data in Switzerland has been mixed: Gross domestic product yearly growth outperformed expectations, coming in at 3.4%. The SVME PMI also surprised to the upside, coming in at 64.8. However, the KOF leading indicator surprised negatively, coming in at 100.3. Finally, real retail sales growth also underperformed expectations, coming in at -0.3%. EUR/CHF has risen by roughly 0.5% this past two weeks. We continue to be bearish on the franc on a long-term basis, as inflationary pressures in Switzerland are still too weak for the SNB to remove its accommodative monetary policy, or stop its currency intervention. That being said, the CHF could experience some short term upside if the sell-off in emerging markets continues. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone Recent data in Norway has been mixed: Both headline and core inflation outperform expectations, coming in at 3.4% and 1.9%. Moreover, the Labour Force survey also surprised to the upside, coming in at 3.9%. However, retail sales growth underperformed expectations, coming in at 0.7%. USD/NOK has fallen by nearly 2% over the last two weeks. We are bullish on the NOK against other commodity currencies like the AUD and the NZD. This is because oil will likely outperform within the commodity space. After all, Our commodity strategist have explained at length why political risk in Iraq and Venezuela could cause a shortage of supply in the oil markets, while Chinese deleveraging in the industrial sector will weigh on base metal demand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at -1.2%. However, consumer confidence outperformed expectations, coming in at 102.6. The krona has been the best performing currency during the past two weeks, with USD/SEK falling by roughly 2% over this period. At the moment we continue to be bullish USD/SEK, as the krona is the most sensitive currency to the dollar's strength. However, on a longer term basis, we believe that inflationary pressures in Sweden will ultimately force the Riskbank to hike more than the market expects, providing support for the SEK. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights In an environment where both interest rates and inflation are low but rising at a time of stretched equity valuations, what can investors do to enhance risk-adjusted portfolio returns? In this report, we investigate the roles of three types of popular instruments in a portfolio context: 1) Floating-Rate Notes, 2) Leveraged Loans and 3) Danish Mortgage Bonds. Floating-rate notes benefit from rising interest rates, but they are not a free lunch. Leveraged loans also benefit from rising interest rates; their very high correlation with high-yield bonds make them a good substitute for a portion of high-yield exposure in a rising-rate environment. Danish mortgage bonds have attracted foreign investors in recent years, but foreign ownership already accounts for about a quarter of the less than half a trillion USD market. Their positive correlation with aggregate bonds and negative correlation with equities in both Japan and the euro area make them a possible substitute for a portion of the bond basket in a balanced portfolio. Feature BCA has upgraded cash to overweight in the current environment, where inflation and interest rates are both low but rising, and equity valuations are stretched.1 For U.S. investors, holding cash is quite attractive as the cash yield is now higher than the equity dividend yield. For investors in the euro area, Switzerland, Sweden, Denmark and Japan, however, holding cash actually is a sure way to eat into portfolio returns, given the negative yields in these countries (Table 1). Table 1Current Yields* (%) Some clients, particularly those in Europe, have asked where to put cash to get higher returns. Unfortunately, it's hard to increase return without assuming additional risk. As shown in Table 1, investors could pick up some yield by putting money in 3-month deposits instead of 3-month Treasury bills, but even 3-month deposit rates are still negative in some European countries. In this report, we investigate the roles of three types of popular instruments in a low but rising rate environment: 1) Floating-Rate Notes (FRNs), 2) Leveraged Loans (LLs) and 3) Danish Mortgage Bonds (DMBs). 1. Floating-Rate Notes An FRN offers coupon payments that float or adjust periodically based on a predetermined benchmark rate. Typical benchmarks in the U.S. are Treasury bills, LIBOR, the prime rate or some other short-term interest rate. Once the benchmark is chosen, the issuer will establish an additional spread that it is willing to pay over the chosen benchmark rate. The spread mainly reflects an issuer's credit quality and the time to maturity of the note. Even though coupon reset frequency can vary between daily, weekly, monthly, quarterly and yearly, the average coupon rate has responded quickly to the fed funds rate, as shown in Chart 1. Issuers can be both government-sponsored enterprises and investment-grade corporations. Before the 2008 Great Financial Crisis, FRNs were mostly issued by corporations. Some of the notes, however, performed badly during the financial crisis, causing a drop in both total issuance and the share of corporate issuance (Chart 2). FRNs can be either callable or non-callable with or without caps and floors, so FRNs carry credit risk - and callable ones also carry call risk. In terms of interest rate risk, it applies mostly to the income received. Chart 1Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Because of the nature of floating rates, FRNs can benefit from rising interest rates and have limited price sensitivity to interest rates. As shown in Chart 3, the Bloomberg/Barclays U.S. Floating-Rate Note index has lower duration than the cash index, as represented by the Bloomberg/Barclays Treasury (<1 year) index, while it offers a nice yield pickup. Since the inception of the index in December 2003 it has, in general, outperformed the cash index. This reward, however, has come at a cost: it does not provide cash-like protection when such protection is needed in times like the Great Financial Crisis and the euro debt crisis in 2011 (Chart 3, panels 3 and 4). This is because the majority of FRNs are offered by corporations that carry credit risk. Consequently, FRNs have higher correlations to high-yield bonds and equities than to the aggregate bond index, as shown in Chart 4. Chart 3FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds The ideal time to invest in FRNs is when rates are low and are expected to rise. This is essentially our view on rates now. Instead of thinking of it as a cash alternative with higher risk, however, we recommend clients take the funding from the high-yield bucket, in line with our downgrade of high yield to neutral from overweight, and also our call of reducing portfolio duration. So how to invest in FRNs? According to Bloomberg Barclays, the U.S. FRN market has a market value of US$505.8 billion, which is small compared to the US$1,267.5 billion high-yield bond market. As such, FRNs are relatively less liquid to trade than corporate bonds. Therefore, they are mostly suitable for purchasing and holding to maturity. One can purchase individual floating-rate securities through a broker, or can invest in mutual funds that invest only in FRNs. Also, there are ETFs that only hold FRNs. Table 2 shows some basic information on three dedicated FRN ETFs. Table 2FRN ETFs* 2. Leveraged Loans Leveraged loans, also known as bank loans or senior secured loans, are a type of corporate debt that also have floating coupon rates, which, like the FRNs, adjust to changes in prevailing interest rates and hence benefit from rising rates. These loans tend to be senior to an issuer's traditional corporate bonds, and are collateralized by a pledge of the issuer's assets. However, secured does not mean safe. These loans are private investments which are generally held by funds or large institutional investors. Most of them carry sub-investment-grade ratings and can default. They also tend to be very illiquid to trade, because physical delivery to the buyer is often needed from a seller (by faxing the paperwork, for example). As such, during periods of market volatility, these loans can be subject to significant price declines. Even though bank loans share the same feature of having "floating coupon rates" as FRNs, they are higher risk securities. In the U.S., bank loans have been mostly inferior to FRNs on a risk-adjusted return basis, as their higher return is offset by much higher volatility (Chart 5A). In the euro area, however, these loans have become more favorable than FRNs since the start of 2018 (Chart 5B). Chart 5ALeveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Historically, when interest rates have risen, bank loans have outperformed traditional fixed-income securities, and vice versa, because of their floating-rate feature, as shown in Charts 6A and 6B. This positive correlation with rates has been more consistent when the relative performance of bank loans is compared to government bonds and investment-grade corporate bonds. When compared to high-yield bonds, however, the correlation appears weak, as shown in the bottom panels of Charts 6A and 6B. This is not surprising given that these loans share similar "sub-investment grade" credit quality with junk bonds. In fact, as shown in Chart 7, bank loans have a highly positive correlation with junk bonds, yet a mostly negative correlation with the aggregate bond index both in the U.S. and the euro area. Chart 6ALLs Outperform When Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds This correlation feature has two very interesting implications: a) Adding bank loans to a standard aggregate bond portfolio could add diversification, and b) replacing some high-yield holdings with bank loans could generate a sub-investment grade basket with a better risk/reward profile compared to high-yield alone. Chart 8 and Table 3 show that historically there has existed an "optimal" combination of bank loans and high-yield bonds that somewhat improves the risk-adjusted return of the sub-investment grade basket. It's worth noting, however, that this historically "optimal" combination is subject to data frequency and time period, as is the case for the U.S. where the optimal weight for bank loans has been about 40% from 2002 to the present, but about 80% in the period from 1997 to the present. As such, in addition to thorough credit analysis to evaluate the suitability of bank loans, investors should also consider the variable nature of correlation when considering replacing part of their high-yield bond exposure with bank loans. Chart 8Junk Bonds - Leverage Loans Basket Profiles Table 3Risk Return Profiles Of Sub-Investment Grade Baskets 3. Danish Mortgage Bonds A Danish mortgage bond (DMB) is essentially a loan to a borrower who has taken out a mortgage on his or her home. Mortgage bonds are issued by mortgage credit institutions which often have high credit ratings. Some DMBs have fixed rates, while others have floating rates with a minimum of zero percent. Some of these bonds can also be callable, often at par (100). With a solid history of over 200 years, the DMB market has survived numerous occasions of economic and political turmoil, including the bankruptcy of the Kingdom of Denmark in 1813, the Great Depression of the 1930s and the Great Financial Crisis and ensuing recession in 2008. Over its entire history, every single issued bond has been repaid in full to investors, in large part due to the strong legislative framework that protects the bond investors (see Appendix 1). As of the end of July 2018, the DMB market consisted of kr. 2.672 trillion of AAA-rated covered bonds. Once largely dominated by local pensions and insurance companies, the DMB market has seen increasing interest from foreign investors in recent years. According to data from the Danish central bank, foreign ownership of fixed rate mortgage bonds stood at kr. 295 billion (29%) in July 2018 compared to kr. 154 billion (18%) in January 2016 (Chart 9). In terms of total holdings of all mortgage bonds (fixed rate, variable rate and bonds backing interest adjustment loans), foreigners held kr. 614 billion (23%), an increase of kr. 27 billion compared to the beginning of 2016. Japanese investors, who have suffered many years of extremely low yields domestically, have been quite active in the DMB market. According to data from the Bank of Japan, Japanese investors purchased some kr. 50 billion of long-term Danish non-government bonds in the period from 2016 to June 2018.3 In June 2018, Nykredit, the largest Danish mortgage bank with a market share of about 40%, even created a DMB index hedged to yen using one-month forward rates due to popular demand and corresponding requests from Japanese investors. As shown in Chart 10, since 2009, the DMB index hedged to yen has outperformed both JGBs and Japanese corporate bonds. Chart 9Foreign Ownership of Danish Fixed Rate Mortgage Bonds* Chart 10DMBs For Japanese Investors Even though interest rates in the U.S. are much higher than those in the euro area, investing in the U.S. after hedging the currency is not really attractive for euro investors. For example, U.S. bank loans have outperformed European bank loans in local currency terms; after being hedged into euro, however, the yield advantage disappears. In terms of government bonds, euro investors really have no incentive to invest in U.S. Treasurys, hedged or unhedged (Chart 11). Given the Danish krone's peg to the euro, it is natural for euro investors to look at the DMB market. Chart 12 shows that DMBs have indeed outperformed both government and corporate bonds in the euro area when 3-month deposit rate turns negative. During the 2008 financial crisis, DMBs also outperformed euro area corporate bonds. However, they did underperform both euro area corporate and government bonds when the European Central Bank started buying bonds after the euro debt crisis. So, how would the exposure of DMBs impact a portfolio's risk/return profile? We have two interesting observations from Chart 13: Chart 11Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? In Japan, hedged DMBs have a very low correlation with equities, corporate bonds and JGBs, even though the correlation with equities has generally been negative, and with bonds generally positive. In the euro area, DMBs have a negative correlation with equities, but a highly positive correlation with both government and corporate bonds. And the correlation to government bonds is quite similar to that of corporate bonds. Therefore, in theory, replacing part of a standard bond portfolio with DMBs could improve a balanced portfolio's risk/return profile for both Japanese and euro area investors. Table 4 shows the risk/return profiles of hypothetical 60/40 standard domestic equity/bond portfolios for Japan and euro area that have a certain percentage of domestic bonds replaced with Danish mortgage bonds: for Japan, the DMBs are hedged to yen, and for the euro area they are unhedged but converted into euros. Table 460/40 Equity/Bond Portfolio Profile with DMB Exposures As expected, for Japan, substituting domestic aggregate bonds with hedged DMBs increases portfolio return more than volatility, thereby improving risk/adjusted returns. For the euro area, however, the story is not straightforward. Over a longer time frame, DMBs have not been a good substitute for euro area aggregate bonds. Since the 3-month euro rate turned negative in June 2015, however, DMBs have largely improved a balanced portfolio's risk/return profile. It is also worth noting that, unlike Japanese investors who benefit from a positive hedging gain since the Danish three-month rate has been lower than Japan's since 2015, euro area investors do not have such a benefit. Also, even though the DMB market is the largest covered bond market in the world, its market size is less than half a trillion USD. Given the fact that foreign investors already account for about a quarter of the market, it is not clear how euro area investors can significantly deploy more capital to enhance portfolio returns. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1: The Danish Mortgage Act4 Danish mortgage bonds are issued under the Danish Mortgage Act. Two key features of the Act protect investors in DMBs. First, the central element in the Danish Mortgage Act is the "balancing principle." This principle requires that there is a match between the inflows and outflows of a mortgage-issuing bank, and limits the amount of risk (interest rate, FX, volatility and liquidity) that a Danish mortgage bank can undertake. In addition, Danish mortgage banks must meet minimum capital requirements of 8% of risk-weighted assets. Second, the "Danish title number and land registration systems and efficient compulsory sale procedure" ensures well-defined property rights through a general register of all properties in Denmark. Ownership and encumbrances on individual properties are easily identified, and that information is available to the public. If a borrower defaults on a payment, the mortgage bank can take over the property and the compulsory sale procedure ensures that a mortgage bank can sell the property in the real estate market or through a forced sale. The period from default to a forced sale to be completed can be as short as six months. 1 Please see Global Investment Strategy Special Report entitled, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 2 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 3 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 4 Please see "Danish Covered Bond Handbook," Danske Bank, dated September 15, 2017.

Special Report

Dear Client, I am travelling in Europe this week visiting clients. Instead of our Weekly Report, we are sending you a Special Report written by my colleague Xiaoli Tang of BCA's Global Asset Allocation. The report examines three types of instruments investors can look to in order to enhance risk-adjusted portfolio returns at a time when interest rates and inflation are low but rising: floating-rate notes, leveraged loans and Danish mortgage bonds. I trust you will find it informative. Best regards, Peter Berezin, Chief Global Strategist Highlights In an environment where both interest rates and inflation are low but rising at a time of stretched equity valuations, what can investors do to enhance risk-adjusted portfolio returns? In this report, we investigate the roles of three types of popular instruments in a portfolio context: 1) Floating-Rate Notes, 2) Leveraged Loans and 3) Danish Mortgage Bonds. Floating-rate notes benefit from rising interest rates, but they are not a free lunch. Leveraged loans also benefit from rising interest rates; their very high correlation with high-yield bonds make them a good substitute for a portion of high-yield exposure in a rising-rate environment. Danish mortgage bonds have attracted foreign investors in recent years, but foreign ownership already accounts for about a quarter of the less than half a trillion USD market. Their positive correlation with aggregate bonds and negative correlation with equities in both Japan and the euro area make them a possible substitute for a portion of the bond basket in a balanced portfolio. Feature BCA has upgraded cash to overweight in the current environment, where inflation and interest rates are both low but rising, and equity valuations are stretched.1 For U.S. investors, holding cash is quite attractive as the cash yield is now higher than the equity dividend yield. For investors in the euro area, Switzerland, Sweden, Denmark and Japan, however, holding cash actually is a sure way to eat into portfolio returns, given the negative yields in these countries (Table 1). Table 1Current Yields* (%) Some clients, particularly those in Europe, have asked where to put cash to get higher returns. Unfortunately, it's hard to increase return without assuming additional risk. As shown in Table 1, investors could pick up some yield by putting money in 3-month deposits instead of 3-month Treasury bills, but even 3-month deposit rates are still negative in some European countries. In this report, we investigate the roles of three types of popular instruments in a low but rising rate environment: 1) Floating-Rate Notes (FRNs), 2) Leveraged Loans (LLs) and 3) Danish Mortgage Bonds (DMBs). 1. Floating-Rate Notes An FRN offers coupon payments that float or adjust periodically based on a predetermined benchmark rate. Typical benchmarks in the U.S. are Treasury bills, LIBOR, the prime rate or some other short-term interest rate. Once the benchmark is chosen, the issuer will establish an additional spread that it is willing to pay over the chosen benchmark rate. The spread mainly reflects an issuer's credit quality and the time to maturity of the note. Even though coupon reset frequency can vary between daily, weekly, monthly, quarterly and yearly, the average coupon rate has responded quickly to the fed funds rate, as shown in Chart 1. Issuers can be both government-sponsored enterprises and investment-grade corporations. Before the 2008 Great Financial Crisis, FRNs were mostly issued by corporations. Some of the notes, however, performed badly during the financial crisis, causing a drop in both total issuance and the share of corporate issuance (Chart 2). FRNs can be either callable or non-callable with or without caps and floors, so FRNs carry credit risk - and callable ones also carry call risk. In terms of interest rate risk, it applies mostly to the income received. Chart 1Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Because of the nature of floating rates, FRNs can benefit from rising interest rates and have limited price sensitivity to interest rates. As shown in Chart 3, the Bloomberg/Barclays U.S. Floating-Rate Note index has lower duration than the cash index, as represented by the Bloomberg/Barclays Treasury (<1 year) index, while it offers a nice yield pickup. Since the inception of the index in December 2003 it has, in general, outperformed the cash index. This reward, however, has come at a cost: it does not provide cash-like protection when such protection is needed in times like the Great Financial Crisis and the euro debt crisis in 2011 (Chart 3, panels 3 and 4). This is because the majority of FRNs are offered by corporations that carry credit risk. Consequently, FRNs have higher correlations to high-yield bonds and equities than to the aggregate bond index, as shown in Chart 4. Chart 3FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds The ideal time to invest in FRNs is when rates are low and are expected to rise. This is essentially our view on rates now. Instead of thinking of it as a cash alternative with higher risk, however, we recommend clients take the funding from the high-yield bucket, in line with our downgrade of high yield to neutral from overweight, and also our call of reducing portfolio duration. So how to invest in FRNs? According to Bloomberg Barclays, the U.S. FRN market has a market value of US$505.8 billion, which is small compared to the US$1,267.5 billion high-yield bond market. As such, FRNs are relatively less liquid to trade than corporate bonds. Therefore, they are mostly suitable for purchasing and holding to maturity. One can purchase individual floating-rate securities through a broker, or can invest in mutual funds that invest only in FRNs. Also, there are ETFs that only hold FRNs. Table 2 shows some basic information on three dedicated FRN ETFs. Table 2FRN ETFs* 2. Leveraged Loans Leveraged loans, also known as bank loans or senior secured loans, are a type of corporate debt that also have floating coupon rates, which, like the FRNs, adjust to changes in prevailing interest rates and hence benefit from rising rates. These loans tend to be senior to an issuer's traditional corporate bonds, and are collateralized by a pledge of the issuer's assets. However, secured does not mean safe. These loans are private investments which are generally held by funds or large institutional investors. Most of them carry sub-investment-grade ratings and can default. They also tend to be very illiquid to trade, because physical delivery to the buyer is often needed from a seller (by faxing the paperwork, for example). As such, during periods of market volatility, these loans can be subject to significant price declines. Even though bank loans share the same feature of having "floating coupon rates" as FRNs, they are higher risk securities. In the U.S., bank loans have been mostly inferior to FRNs on a risk-adjusted return basis, as their higher return is offset by much higher volatility (Chart 5A). In the euro area, however, these loans have become more favorable than FRNs since the start of 2018 (Chart 5B). Chart 5ALeveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Historically, when interest rates have risen, bank loans have outperformed traditional fixed-income securities, and vice versa, because of their floating-rate feature, as shown in Charts 6A and 6B. This positive correlation with rates has been more consistent when the relative performance of bank loans is compared to government bonds and investment-grade corporate bonds. When compared to high-yield bonds, however, the correlation appears weak, as shown in the bottom panels of Charts 6A and 6B. This is not surprising given that these loans share similar "sub-investment grade" credit quality with junk bonds. In fact, as shown in Chart 7, bank loans have a highly positive correlation with junk bonds, yet a mostly negative correlation with the aggregate bond index both in the U.S. and the euro area. Chart 6ALLs Outperform When Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds This correlation feature has two very interesting implications: a) Adding bank loans to a standard aggregate bond portfolio could add diversification, and b) replacing some high-yield holdings with bank loans could generate a sub-investment grade basket with a better risk/reward profile compared to high-yield alone. Chart 8 and Table 3 show that historically there has existed an "optimal" combination of bank loans and high-yield bonds that somewhat improves the risk-adjusted return of the sub-investment grade basket. It's worth noting, however, that this historically "optimal" combination is subject to data frequency and time period, as is the case for the U.S. where the optimal weight for bank loans has been about 40% from 2002 to the present, but about 80% in the period from 1997 to the present. As such, in addition to thorough credit analysis to evaluate the suitability of bank loans, investors should also consider the variable nature of correlation when considering replacing part of their high-yield bond exposure with bank loans. Chart 8Junk Bonds - Leverage Loans Basket Profiles Table 3Risk Return Profiles Of Sub-Investment Grade Baskets 3. Danish Mortgage Bonds A Danish mortgage bond (DMB) is essentially a loan to a borrower who has taken out a mortgage on his or her home. Mortgage bonds are issued by mortgage credit institutions which often have high credit ratings. Some DMBs have fixed rates, while others have floating rates with a minimum of zero percent. Some of these bonds can also be callable, often at par (100). With a solid history of over 200 years, the DMB market has survived numerous occasions of economic and political turmoil, including the bankruptcy of the Kingdom of Denmark in 1813, the Great Depression of the 1930s and the Great Financial Crisis and ensuing recession in 2008. Over its entire history, every single issued bond has been repaid in full to investors, in large part due to the strong legislative framework that protects the bond investors (see Appendix 1). As of the end of July 2018, the DMB market consisted of kr. 2.672 trillion of AAA-rated covered bonds. Once largely dominated by local pensions and insurance companies, the DMB market has seen increasing interest from foreign investors in recent years. According to data from the Danish central bank, foreign ownership of fixed rate mortgage bonds stood at kr. 295 billion (29%) in July 2018 compared to kr. 154 billion (18%) in January 2016 (Chart 9). In terms of total holdings of all mortgage bonds (fixed rate, variable rate and bonds backing interest adjustment loans), foreigners held kr. 614 billion (23%), an increase of kr. 27 billion compared to the beginning of 2016. Japanese investors, who have suffered many years of extremely low yields domestically, have been quite active in the DMB market. According to data from the Bank of Japan, Japanese investors purchased some kr. 50 billion of long-term Danish non-government bonds in the period from 2016 to June 2018.3 In June 2018, Nykredit, the largest Danish mortgage bank with a market share of about 40%, even created a DMB index hedged to yen using one-month forward rates due to popular demand and corresponding requests from Japanese investors. As shown in Chart 10, since 2009, the DMB index hedged to yen has outperformed both JGBs and Japanese corporate bonds. Chart 9Foreign Ownership of Danish Fixed Rate Mortgage Bonds* Chart 10DMBs For Japanese Investors Even though interest rates in the U.S. are much higher than those in the euro area, investing in the U.S. after hedging the currency is not really attractive for euro investors. For example, U.S. bank loans have outperformed European bank loans in local currency terms; after being hedged into euro, however, the yield advantage disappears. In terms of government bonds, euro investors really have no incentive to invest in U.S. Treasurys, hedged or unhedged (Chart 11). Given the Danish krone's peg to the euro, it is natural for euro investors to look at the DMB market. Chart 12 shows that DMBs have indeed outperformed both government and corporate bonds in the euro area when 3-month deposit rate turns negative. During the 2008 financial crisis, DMBs also outperformed euro area corporate bonds. However, they did underperform both euro area corporate and government bonds when the European Central Bank started buying bonds after the euro debt crisis. So, how would the exposure of DMBs impact a portfolio's risk/return profile? We have two interesting observations from Chart 13: Chart 11Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? In Japan, hedged DMBs have a very low correlation with equities, corporate bonds and JGBs, even though the correlation with equities has generally been negative, and with bonds generally positive. In the euro area, DMBs have a negative correlation with equities, but a highly positive correlation with both government and corporate bonds. And the correlation to government bonds is quite similar to that of corporate bonds. Therefore, in theory, replacing part of a standard bond portfolio with DMBs could improve a balanced portfolio's risk/return profile for both Japanese and euro area investors. Table 4 shows the risk/return profiles of hypothetical 60/40 standard domestic equity/bond portfolios for Japan and euro area that have a certain percentage of domestic bonds replaced with Danish mortgage bonds: for Japan, the DMBs are hedged to yen, and for the euro area they are unhedged but converted into euros. Table 460/40 Equity/Bond Portfolio Profile with DMB Exposures As expected, for Japan, substituting domestic aggregate bonds with hedged DMBs increases portfolio return more than volatility, thereby improving risk/adjusted returns. For the euro area, however, the story is not straightforward. Over a longer time frame, DMBs have not been a good substitute for euro area aggregate bonds. Since the 3-month euro rate turned negative in June 2015, however, DMBs have largely improved a balanced portfolio's risk/return profile. It is also worth noting that, unlike Japanese investors who benefit from a positive hedging gain since the Danish three-month rate has been lower than Japan's since 2015, euro area investors do not have such a benefit. Also, even though the DMB market is the largest covered bond market in the world, its market size is less than half a trillion USD. Given the fact that foreign investors already account for about a quarter of the market, it is not clear how euro area investors can significantly deploy more capital to enhance portfolio returns. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1: The Danish Mortgage Act4 Danish mortgage bonds are issued under the Danish Mortgage Act. Two key features of the Act protect investors in DMBs. First, the central element in the Danish Mortgage Act is the "balancing principle." This principle requires that there is a match between the inflows and outflows of a mortgage-issuing bank, and limits the amount of risk (interest rate, FX, volatility and liquidity) that a Danish mortgage bank can undertake. In addition, Danish mortgage banks must meet minimum capital requirements of 8% of risk-weighted assets. Second, the "Danish title number and land registration systems and efficient compulsory sale procedure" ensures well-defined property rights through a general register of all properties in Denmark. Ownership and encumbrances on individual properties are easily identified, and that information is available to the public. If a borrower defaults on a payment, the mortgage bank can take over the property and the compulsory sale procedure ensures that a mortgage bank can sell the property in the real estate market or through a forced sale. The period from default to a forced sale to be completed can be as short as six months. 1 Please see Global Investment Strategy Special Report entitled, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 2 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 3 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 4 Please see "Danish Covered Bond Handbook," Danske Bank, dated September 15, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades