Monetary

Highlights Stage 1: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. Stage 2: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by expectations for the terminal fed funds rate. Assuming a 3% terminal rate, we would expect the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%. Risks: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Feature Some degree of calm returned to financial markets last week. The S&P 500 bounced back above 2700 and the VIX fell back below 20. Corporate bond spreads also tightened somewhat - the average High-Yield index spread tightened from 369 bps to 341 bps and the investment grade spread tightened from 95 bps to 93 bps - but the factors we are monitoring to determine the end of the credit cycle continue to send warning signs (Chart 1). We view the recent turmoil as markets adjusting to a Fed that must now become less responsive to financial conditions because inflationary pressures are mounting. As we discussed in last week's report, this dynamic is best explained using our Fed Policy Loop.1 It follows from our Fed Policy Loop analysis that we should track measures of inflation and inflation expectations and start taking credit risk off the table as these indicators rise. In that regard, neither TIPS breakeven inflation rates nor commodity prices - an indicator of pipeline inflation pressure - corrected much in the past few weeks (Chart 1, bottom panel). This suggests that the end of the credit cycle is approaching. We reiterate our view that it will soon be time to scale back the credit risk in our recommended portfolio. We will likely begin this process once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We discuss the intuition behind this target range in the section titled "A Fair Value For TIPS Breakevens" below. Currently, the 10-year TIPS breakeven inflation rate sits at 2.09% and the 5-year/5-year forward rate is 2.18%. Unlike credit spreads, the sell-off in Treasuries did not abate at all last week. Volatility also returned to the rates market, coinciding with a steeper yield curve (Chart 2). We are not nearly as anxious to increase the duration of our recommended portfolio as we are to scale back on credit risk, and believe that Treasury yields still have considerable cyclical upside. Chart 1No Correction In Breakevens Chart 2No Correction In Bond Yields In this week's report we discuss how we see the Treasury bear market proceeding in two stages, and also start the process of thinking about how high the 10-year Treasury yield can get before the next recession hits. We also highlight several near-term risks that could temporarily derail the cyclical bond bear market. The Two-Stage Treasury Bear Market. Stage 1: Re-Anchoring Of Inflation Expectations For some time it has been our view that the economic recovery is unlikely to end before inflation returns to the Fed's 2% target. This is simply because when inflation is very low the Fed has an incentive to keep policy accommodative, and restrictive monetary policy is typically a pre-condition for recession. It therefore struck us as odd that as recently as June 2017 the 10-year TIPS breakeven inflation rate was only 1.66%, well below levels consistent with the Fed's target. It was as though the market expected that inflation would never move higher no matter how long the Fed maintained an easy policy stance. That notion always seemed far-fetched, and this is why the first stage of the cyclical bond bear market was always likely to be driven by the re-anchoring of inflation expectations. This is the stage we are in currently, and indeed it is almost complete. We will deem that inflation expectations have become re-anchored (and the first stage of the cyclical bond bear market is complete) when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. This means that, assuming unchanged real yields, the nominal 10-year Treasury yield has another 21 bps to 41 bps of upside in Stage 1. A Fair Value For TIPS Breakevens To arrive at our fair value target for the inflation compensation embedded in the 10-year Treasury yield, we looked back to the last period when inflation was well-anchored around the Fed's 2% target. This occurred between July 2004 and June 2008. We note that during this timeframe the 10-year TIPS breakeven inflation rate spent 56% of its time between 2.3% and 2.5%. The 5-year/5-year forward TIPS breakeven rate spent 73% of its time in that range (Chart 3).2 The 2.3% to 2.5% range therefore seems like a good starting point, but we must also consider whether something has changed since the mid-2000s that might lead to a different fair value range today. One possible difference would be if the spread between CPI and PCE inflation changed significantly. The Fed targets 2% PCE inflation, but TIPS are linked to CPI inflation. CPI inflation was somewhat higher than PCE inflation in the mid-2000s, and this is one reason why TIPS breakevens were somewhat higher than 2% throughout that period. At present, we observe that the spread between CPI and PCE inflation is only slightly above where it was in the mid-2000s (Chart 4), and note that it will probably trend lower in the coming months. Chart 3TIPS Breakevens When Inflation Is ##br##Anchored (July 2004 to June 2008) Chart 4CPI Versus ##br##PCE The two biggest reasons for divergences between PCE and CPI inflation are: The different treatment of medical care inflation in the two indexes. CPI includes only out-of-pocket medical care expenses. PCE includes spending by the government on a person's behalf. The greater weight of shelter in CPI. Lately, the difference in medical care inflation between the two indexes has narrowed considerably and our models suggest that shelter inflation will continue to moderate in the months ahead (Chart 4, bottom 2 panels). This suggests that the spread between CPI and PCE inflation will continue to tighten. If the spread were to fall much below its average level from the mid-2000s, then we would revise our target range for TIPS breakevens down accordingly. The second reason why the fair value range for TIPS breakevens might be different than it was in the mid-2000s is if the inflation risk premium has undergone a structural shift. The compensation for inflation priced into bond yields can be split into (i) an expectation for future inflation and (ii) a risk premium to compensate investors for the uncertainty in that expectation. Other factors, such as changes in the post-crisis regulatory environment that impact the attractiveness of TIPS as an investment vehicle, could also potentially cause a structural shift in the inflation risk premium. We addressed this possibility in a report last year, but so far we see no conclusive evidence that such a structural shift has occurred.3 Indeed, the fact that breakevens have risen back close to their pre-crisis range in recent months suggests that the inflation risk premium is probably not structurally lower. Bottom Line: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. The nominal 10-year Treasury yield has another 21 bps to 41 bps of upside before this phase of the bear market is complete. The Two-Stage Treasury Bear Market. Stage 2: Fed Rate Hikes & The Terminal Rate Debate Once inflation expectations are re-anchored the cyclical bond bear market will shift into Stage 2. With no further upside in the cost of inflation protection the emphasis in this stage will be on the path of real yields. The main question will be: How high will the Fed have to lift the real interest rate to contain inflationary pressures? Or alternatively: What is the terminal fed funds rate in this cycle? The answers to the above questions will ultimately determine how high the real 10-year Treasury yield can rise, and provide us with an end-of-cycle target for the nominal 10-year yield. Anchoring Around The Fed's Projections Chart 5Stage 2 Is All About The Terminal Rate At the moment, most FOMC participants estimate the terminal fed funds rate to be in the range of 2.75% to 3%. This may or may not be proven correct, but at least for now the market is likely to anchor around that expectation. In other words, the only way we will find out if that projection is too low is if the fed funds rate is lifted close to the 2.75% to 3% range but inflation continues to rise and economic growth shows no signs of slowing. With the fed funds rate still at 1.42%, we are at least four rate hikes away from that range. This means that any potential upward revisions to the Fed's terminal rate projections are more likely a story for late-2018 or early-2019. Notice in Chart 5 that the Fed has responded to falling inflation by lowering its median projected terminal fed funds rate, but has been more hesitant to increase its projection in response to rising inflation. This means the Fed could wait until inflation is much closer to its target before making any significant upward revisions to its terminal rate projection. The market would likely react more quickly than the Fed, but not by much. Notice that the decline in the 5-year/5-year forward overnight index swap rate was more or less coincident with the downward revisions to the Fed's projected terminal rate between 2014 and 2016 (Chart 5, bottom panel). Our view is that the market will anchor around the Fed's terminal rate projections for at least the next six months. With that in mind, we can make some back-of-the-envelope calculations for how high the 10-year Treasury yield will get before the end of the cycle. To do this we consider that the nominal 10-year yield consists of four components: Inflation expectations Inflation risk premium Real rate expectations Real risk premium Our target range of 2.3% to 2.5% for the 10-year TIPS breakeven inflation rate encompasses both the inflation expectations and inflation risk premium components. If we then assume a terminal fed funds rate of 3%, we get a real rate expectation of 1% (we subtract the Fed's 2% inflation target). This means that even if we assume no real risk premium, we get a conservative estimate for the end-of-cycle level of the nominal 10-year Treasury yield of 3.3% to 3.5%. Turning To The Models As a check on our back-of-the-envelope calculations we created simple fair value models for both the 2-year and 10-year Treasury yields (Chart 6). Both models have three independent variables: The fed funds rate Our 12-month fed funds discounter (to capture expectations for future changes in the fed funds rate) The MOVE index of implied interest rate volatility (as a proxy for the term premium) These models allow us to input various scenarios for the expected path of rate hikes and implied volatility, and then come up with appropriate fair value targets for the 10-year and 2-year Treasury yields. The results from various scenarios are shown in Table 1. Chart 6Treasury Yield Models Table 1End-Of-Cycle Treasury Yield Projections Under Different Scenarios For example, let's assume that the terminal fed funds rate is 3%. Let's also assume that the Fed delivers four rate hikes this year and the market moves to expect another two rate hikes in 2019. That would mean the market is pricing-in a fed funds rate of 2.92% by the end of 2019 - very close to a 3% terminal rate assumption. If we further assume that implied rate volatility stays flat at its current level, then our model gives us a target of 3.59% for the 10-year Treasury yield. This would seem like a reasonable end-of-cycle target for the 10-year Treasury yield in an environment with a 3% terminal fed funds rate. Table 1 also demonstrates the importance of interest rate volatility. If we assume the exact same scenario for rate hikes but also allow the MOVE index to return to its recent lows, then our end-of-cycle target for the 10-year Treasury yield falls to 3.08%. Conversely, if we allow the MOVE index to rise to its historical average, the target for the 10-year yield rises to 4.25%. As we discussed in last week's report, interest rate volatility is more likely to fall than rise between now and the end of the cycle.4 This is due to the strong correlation between interest rate volatility and the slope of the yield curve. As the Fed tightens and the curve flattens, implied volatility tends to decline. In fact, because of its strong correlation with the slope of the yield curve, any scenario where implied rate volatility increases significantly would coincide with an environment where the terminal fed funds rate is being revised higher. If 3% turns out to be a reasonable estimate for the terminal fed funds rate, then implied rate volatility is much more likely to fall than rise. All in all, if we assume that the fed funds rate will only return to 3% before the next recession, then we should expect the 10-year Treasury yield to eventually settle into a range between 3.08% and 3.59% by the end of the second stage of the cyclical bond bear market. We plan to explore whether 3% is a reasonable expectation for the terminal fed funds rate in future reports. Bottom Line: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by how expectations for the terminal fed funds rate evolve. If, for now, we assume that the Fed's 3% terminal rate projection is roughly correct, then the 10-year Treasury yield will peak somewhere between 3.08% and 3.59%. Three Risks To The Bond Bear Market It is important to point out that the two-stage cyclical bond bear market described above may not play out un-interrupted. In this section we highlight three potential risks that could cause us to, at least temporarily, increase the duration of our recommended portfolio. Risk 1: Positioning One risk that could flare up in the near-term is that short positioning in the Treasury market has ramped up significantly in recent weeks. Since the financial crisis, net short positions in 10-year Treasury futures have often coincided with a lower 10-year Treasury yield three months later (Chart 7). Similarly, we have also seen positioning in oil futures become extremely net long (Chart 7, bottom panel). In a recent report we analyzed the strong correlation between oil prices and TIPS breakeven inflation rates and concluded that the correlation would likely persist throughout Stage 1 of the bond bear market.5 A significant relapse in oil prices would very likely filter through to lower bond yields. Chart 7Risk 1 = Positioning Risk 2: Unrealistic Expectations Much like how consensus is forming around short bond positions, consensus economic expectations are also being revised higher. This is what happens when the economic data surprise positively for a significant period of time. Expectations eventually ratchet up and then become too optimistic for the data to surpass. It is this dynamic that causes the Economic Surprise Index to be mean reverting (Chart 8). In previous reports we have shown that months with negative data surprises tend to coincide with falling Treasury yields, and vice-versa.6 While negative data surprises are not an imminent risk - a simple auto-regressive model of the Economic Surprise Index shows we should expect an index reading of +15 in one month's time - the surprise index will eventually move below zero and this will likely coincide with at least some pull-back in bond yields. Risk 3: Global Growth Slowdown A third risk to the cyclical bond bear market is that we see a relapse in global growth that derails the economic recovery before Treasury yields reach our target range. At the moment our 2-factor Treasury model - based on Global Manufacturing PMI and bullish sentiment toward the dollar - still posits a fair value 10-year Treasury yield of 3.01% (Chart 9), but a significant growth scare emanating from outside the U.S. would cause both the Global PMI to fall and bullish sentiment toward the dollar to rise. Both of those factors are bullish for U.S. bonds. Chart 8Risk 2 = Economic Surprises Chart 9Risk 3 = China/EM Slowdown For now there is no strong signal that global growth is about to slow, but some trends in China and other emerging markets bear monitoring. Our Foreign Exchange strategists' Carry Canary Indicator tracks the performance of EM / JPY carry trades.7 These trades go short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian Real, Russian Ruble or South African Rand), and as such they are highly geared to a positive global growth back-drop. Historically, a deterioration in the performance of these carry trades has often coincided with a slowdown in global growth and we notice that the outperformance of these trades has moderated in recent weeks (Chart 9, panel 2). Further, we have also seen some coincident and leading indicators of Chinese economic activity start to roll over (Chart 9, bottom 2 panels). The slowdown appears relatively benign for now but could eventually morph into a significant global event. This could occur if the growth deterioration accelerates and infects the Global PMI, or if Chinese policymakers react too strongly to slowing growth and engineer a sharp depreciation of the currency (as in August 2015). The latter scenario would impart increased bullish sentiment to the U.S. dollar and cause U.S. bond yields to fall. Both risks seem low at the moment, but are still worth monitoring during the next few months. Bottom Line: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 2 Percentages calculated using daily values. 3 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Expectations that the BoJ's yield curve control strategy is toward its tail end, general USD weakness, and brewing EM troubles are conspiring to push the yen higher. Tactically, the yen has more upside. Global financial markets are set to remain volatile and softness in China point to a tougher environment for EM bonds and commodity prices. In the coming months, USD/JPY will fall to the 104 to 102 range, and maybe even test 100. Beyond this point, the outlook remains negative for the yen. It is too early for investors to bet on the end of YCC, especially as the current yen strength hurts Japan's inflation outlook. While EUR/JPY and USD/JPY still have tactical downside, AUD/JPY and NZD/JPY are much more vulnerable. Feature No matter what happens to U.S. asset prices, bond yields, or inflation, the yen continues to rally unabashedly. A month ago, we argued that a countertrend bounce in the yen was likely as the Bank of Japan was tweaking its bond purchases. We also thought this rally would have a limited shelf life as the BoJ's yield curve control strategy is still firmly in place.1 Considering the yen's recent strength, it is an opportune time to revisit this theme. We do believe that the yen still has room to rally on a three- to six-month basis. However, a move beyond USD/JPY 100 is unlikely as the BoJ's YCC program remains firmly entrenched, only more so now that the yen is appreciating once again. Why Is The Yen Strong? We think the yen's strength can be attributed to three factors: domestic economic conditions, the dollar's weakness, and brewing EM trouble. Domestic Conditions The strength of the Japanese economy has played an important role in the yen's appreciation. Japanese industrial production is growing at an impressive 4.4% annual pace. Also, the labor market is tight: Japan's unemployment rate is 0.8% below equilibrium, the active job openings-to-applicant ratio is at a 44-year high and job creation remains decent at 1% per annum. The output gap corroborates this picture, with GDP standing 1.1% above the OECD's estimate of potential GDP. The economic wellbeing seems generalized. Exports are growing at a brisk pace, and are strong across the board. This is a consequence of perky global growth, which always tends to help export-oriented nations. Moreover, this export boom is filtering through to the domestic economy. The share of corporate profit stands near record levels at 15% of GDP. This is incentivizing firms to invest, which should push capex higher (Chart I-1). Chart I-1Japanese Capex Is Set To Rise Chart I-2Japan Needs Tighter Policy? Investors are beginning to replay the story of the euro in 2017 in their minds. As the narrative goes, a booming economy is giving monetary authorities a chance to move away from extraordinarily accommodative conditions. Therefore, investors are lifting their estimates of where Japanese policy will stand in three or five years. This could be even truer in Japan than in the euro area last year: unlike Europe, Japan is at full employment and the BoJ has not achieved its bond purchase objective of JPY80 trillion per year since mid-2016. However, the BoJ is keeping a firm lid on interest rates up to 10 years ahead, making it harder to observe in interest rate derivatives whether or not investors are lifting their estimates of the Japanese terminal rate. Yet a few signs exist. For one, our Bank of Japan Monitor has moved into "tighter policy territory" (Chart I-2). While this does not guarantee that Japanese rates will rise, this indicator is comprised of variables2 that most investors follow to form their expectations of the path of Japanese monetary policy. Thus, it suggests that based on historical experience, investors are potentially in the process of re-assessing the future of Japanese monetary policy. Moreover, while interest rate markets may be artificially congealed by the BoJ, other asset prices are not. If the BoJ were indeed to lift interest rates earlier than had been previously anticipated, Japanese financials should outperform the market as a more rapid and sharper lift-off would boost Japanese banks' net interest margins. Indeed, Japanese financials experienced an expansion of their multiples relative to the broader market at the onset of the yen's most recent rally (Chart I-3). Additional fuel comes from credit conditions. Over long periods of time, easy lending standards support the yen: an improving outlook for credit growth prompt investors to expect a less accommodative BoJ stance. Today, private-sector deleveraging is over and Japanese credit standards are very loose, suggesting the yen is somewhat of a coiled spring that could easily be shocked higher. It is the dovish policy of the BoJ that has made the yen softer than normally implied by credit standards. However, any hint that easy policy could be nearing an end would once again cause investors to push the yen higher. A stronger economy is currently giving traders the justification to do exactly that (Chart I-4). Chart I-3Symptoms That Investors ##br##See Higher Rates Ahead Chart I-4Orders Are Lifting The Yen Because They ##br##Point Toward Tighter Policy Bottom Line: Not only is the Japanese labor market very tight, the economy is growing strongly. As a result, investors seem to be anticipating an earlier hawkish shift by the BoJ, which is lifting the yen. Dollar Weakness Another factor that has pushed the yen sharply higher has been the weakness in the U.S. dollar. As have other currency pairs, USD/JPY has decoupled from interest rate differentials. This weakness in the dollar can be understood under many lights. First, since the end of the Bretton Woods system, the dollar has been following an interesting pattern of 10 down years followed by five to six up years. The dollar rally from 2011 to 2016 seemed to fit this mold, suggesting we have entered a protracted period of dollar weakness (Chart I-5). Second, the dollar tends to fare poorly in the last years of an economic expansion. This is because the global economy tends to outperform the U.S. during this time frame. Today, the U.S. business cycle looks long in the tooth. Companies are reporting increasing difficulty finding qualified labor, very few are worried about the outlook for demand, and the yield curve is flattening. These developments are historically associated with the last innings of a business expansion (Chart I-6). Chart I-5USD Entering The Negative Part Of Its Cycle Chart I-6Late Cycle Dynamics In The U.S. Finally, the global economy is experiencing a synchronized boom. As we have previously highlighted, when global economic strength is robust and felt around the world, the dollar performs poorly.3 Bottom Line: The yen's strength not only reflects domestic considerations, it is also a reflection of the dollar's own weakness. The yen is feeding on this dollar depreciation. Emerging EM Strains EM economic activity seems to be ebbing at the margin. As we showed two weeks ago, EM manufacturing production has been weakening. Additionally, EM economies, which normally magnify booms in advanced economies, are currently experiencing a relative contraction in their PMIs (Chart I-7). China probably explains this strange softness. We have long argued that Chinese monetary conditions have been tightening, which has caused a sharp deceleration in the Keqiang index, a measure of industrial activity based on credit growth, electricity production and freight volumes. We are now seeing additional signs of this mini-malaise. China's orders-to-inventories ratio has begun to contract, import volumes are weak, export price growth is slowing sharply and the volume of cargo handled at seaports is decelerating (Chart I-8). This is because the tightening in Chinese monetary conditions is beginning to affect the channels through which China impacts the rest of the world. EM tends to be at the forefront of such waves; weakness in the highly sensitive Swedish PMI supports this interpretation. This development has visible market implications. EM stocks are rebounding in unison with DM equities, but EM bonds are not. This suggests that while higher U.S. bond yields are not yet causing much pain in advanced economies, EM economies, already facing headwinds from China, are more vulnerable to the tightening in financial conditions caused by higher Treasury rates. Yield-starved Japanese investors have been heavy buyers of EM bonds. Hence, the weakness in EM bonds could be prompting a closing of EM carry trades. This favors the yen; under these circumstances, Japanese investors repatriate their money home. These dynamics can become vicious. The more Japanese investors suffer losses on their EM holdings, the more they repatriate funds at home, which lifts the yen further, pushes bond prices lower and also tightens liquidity conditions in EM economies. As a result, EM/JPY carry trades tend to lead global industrial activity (Chart I-9). These dynamics seem to be playing a role in the current phase of yen strength. Chart I-7EM Growth Is Underperforming Chart I-8Chinese Slowdown Is Becoming Impactful Chart I-9EM Carry Trades Flashing A Slowdown Bottom Line: Not only domestic conditions in Japan and the generalized weakness in the dollar are helping the yen, but strains in EM economies are also aiding. EM manufacturing activity is slowing and EM bond prices are falling, creating an environment normally associated with a strong yen. Outlook For The Yen Tactical Outlook Over the next three to six months, we do see further upside for the yen. To begin with, the yen can get more overbought than it currently is. Peaks in the yen have historically materialized at higher levels in our capitulation index, especially as the yen tends to display strong momentum (Chart I-10).4 Moreover, the weakness of the dollar in the face of a strong CPI report and a steepening yield curve suggests that the dollar is under immense selling pressure. Additionally, even if the yen trades at a large discount of 12% relative to purchasing power parity, speculator are short a near-record 50% of the open interest. This means that as the yen strengthens, it could become very vulnerable to a short covering rally that would mechanically push the JPY significantly higher. The growing international impact of the policy induced Chinese soft patch could also gather further momentum, and support the yen in the process. As Chart I-11 illustrates, when Chinese imports of copper concentrates slow, it often leads to substantial depreciation in USD/JPY. These copper imports are currently decelerating sharply. Chart I-10More Upside For The Yen Chart I-11Chinese Dynamics Favor The Yen The large amount of complacency still present in the market further suggests that risks remain skewed to the upside for the yen. Not only could potential EM weakness weigh on commodity prices - a crucial component of our Complacency Index - but also volatility clustering suggests it is likely to spike again repeatedly in the coming months, despite having fallen precipitously after last week's surge. This combination would cause our Complacency Index to fall, a climate historically associated with a strong yen, unless the BoJ eases aggressively (Chart I-12). This picture is corroborated by the general positioning in the FX market. Speculators are massively long risky currencies versus safer ones. Historically, such skewed positioning tends to be followed by rallies in the yen, unless the BoJ eases aggressively (Chart I-13). Looking outside the FX market, investors still hate bonds. Sentiment toward Treasurys is very depressed, speculators are very short 10-year bonds and portfolio managers are massively underweight duration (Chart I-14). This makes bond yields vulnerable to a pullback. For this to materialize, Ryan Swift, who writes BCA's U.S. Bond Strategy service, argues that the U.S. surprise index has to fall back below zero.5 The more than 90-basis-point rise in U.S. bond yields since September will clip some momentum from U.S. growth - not enough to cause a large slowdown, but potentially enough to generate a patch of negative surprises. Chart I-12Less Complacency Equals Stronger Yen Chart I-13More Signs Of Complacency Chart I-14Duration Positioning Points To Upside Risk For The Yen Bottom Line: The international factors that have helped the yen over the past two months will be driving the tactical strength in the JPY. The BoJ is already trying to lean against the yen's strength, as it has recently increased its JGB purchases. While we do not think it is has done enough to weaken the yen in the short term, in our view, the BoJ will remain the biggest headwind for the yen beyond the next six months. Cyclical Outlook This naturally brings us to the cyclical outlook for the yen. We believe that USD/JPY is most likely to settle in the 104 to 102 range, and maybe even test 100. At these levels, we would buy this pair. Why? Simply, for the yen to rally durably, it will require an end to YCC. While markets are probably pricing this outcome right now, we think it is too early to do so. The rhetoric of the BoJ remains very clear: The central bank is committed to maintaining YCC until inflation overshoots its 2% target. Not only are we not there yet, but there are still many obstacles to beat in order to achieve this objective. Moreover, some of these hurdles are becoming more potent. First, while Japan's labor market seems at full employment, industrial capacity is still replete with excess slack. As Chart I-15 shows, Japanese capacity utilization may be near cycle highs, but it remains well below the levels that prevailed before the Great Financial Crisis. Moreover, since Japanese growth has been lifted by the recent EM boom, the country's own mini-boom will suffer from the EM slowdown. As the bottom panel of Chart I-15 illustrates, like China's, Japan's shipments-to-inventories ratio is falling. This is a reliable leading indicator of industrial production. So not only is Japan growth set to slow in the second half of 2018, but low capacity utilization will still be muting inflationary pressures. Second, as we highlighted one month ago, Japan's inflation is hyper sensitive to Japanese financial conditions. The recent improvement in Japan's consumer prices excluding food and energy reflects the lag impact of the previous easing in financial conditions (Chart I-16), which itself is courtesy of the prior weakness in the trade-weighted yen. However, this positive inflationary impulse is set to fade, and the stronger the yen gets, the more likely that inflation slows. The fall in money supply resulting from a strong yen only adds credence to this assertion (Chart I-17). This will reinforce the BoJ's willingness to keep YCC in place and could even incentivize the central bank to increase its asset purchases closer to target in order to clearly communicate its intentions to the market. Chart I-15Will The BoJ Stand##br## Idly By? Chart I-16Inflation Is Picking Up Because ##br##Financial Conditions Eased Third, the yen's strength could hurt Japan's competitiveness and increase domestic deflationary pressures. As the top panel of Chart I-18 illustrates, CNY/JPY has broken down through a key trend line, heralding additional weaknesses. Moreover, the yen has begun to appreciate against other Asian currencies (Chart 18, bottom panel). Our Emerging Markets Strategy service is initiating a long JPY/KRW trade this week, betting on further strength in the yen against other Asian currencies. The BoJ will pay attention to these matters. This combination suggests it is premature for investors to begin betting on an end to YCC in Japan. Thus, the domestic underpinning of the yen's rally seems flawed right now. Only once inflation is more clearly vanquished, or the yen falls substantially in value - enough to generate another outsized gain in Japanese inflation - will this bet become more justified. Chart I-17The Yen Is Already Hurting Money Supply Chart I-18The Yen Hurts Japan Competitiveness Bottom Line: While we do continue to see room for the yen to strengthen over the course of the next three to six months, we think such a move will not be durable. We will look to buy USD/JPY once it falls below 104. We believe the yen's short-term strength is more likely to be powered by external factors, as it is still too early to bet on the end of YCC. The yen will be able to embark on a clear cyclical bull market once conditions fall into place for the BoJ to abandon this policy. We are not there yet. Implementation Considerations We have recommended investors sell EUR/JPY for safety reasons. From a contrarian perspective, positioning in EUR/JPY is even more skewed than positioning in USD/JPY (Chart I-19, left panel). Moreover, EUR/JPY trades at a significant premium to our short-term fair value model, adding a significant margin of safety (Chart 19, right panel). While we still like this position, the dismal trading in the USD this week underscores that USD/JPY still offers plenty of downside as well. Chart I-19ARisks To EUR/JPY (I) Chart I-19BRisks To EUR/JPY (II) We are also very negative on commodity currencies versus the yen. Weakness in EM growth and in EM bonds should be particularly unkind to AUD/JPY and NZD/JPY. Additionally, from a valuation perspective, these two crosses represent attractive shorting opportunities (Chart I-20). Of the two, shorting AUD/JPY should be the most profitable bet. As we wrote three weeks ago, the Australian dollar seems especially vulnerable right now because nominal growth is set to fall and the labor market continues to be weak. Moreover, Australia's terms of trade is more exposed to a fall in the share of capex in China than in New Zealand.6 Chart I-20ACommodity Currencies Look Especially ##br##Vulnerable Against The Yen (I) Chart I-20BCommodity Currencies Look Especially##br## Vulnerable Against The Yen (II) Bottom Line: While shorting EUR/JPY remains a safe way to play a continuation of the tactical rebound in the yen, shorting USD/JPY may offer a potential higher reward, but at higher risk. Shorting commodity currencies versus the yen, especially the AUD, still remain the vehicles with the highest potential payoffs. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com 2 Based on output prices, overall business conditions, and consumer confidence. 3 Please see Foreign Exchange Strategy Weekly Report, titled "A Cold Snap Doesn't Make A Winter", dated January 5, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, titled "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, titled "From Davos To Sydney, With a Pit Stop In Frankfurt", dated January 26, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Inflation beat expectations, coming in at 2.1% for the headline measure and 1.8% for the core measure; Retail sales contracted by 0.3% on a monthly rate, with the core measure experiencing no growth; In line with expectations, initial jobless claims increased to 230,000; Capacity utilization came down a little at 77.5%;as Industrial production contracted by 0.1% on a monthly pace; Not even a strong inflation report was able to lift the greenback, which is a very negative sign. This could indicate that the dollar is experiencing a capitulation. A rebound in the USD is likely in the coming quarter, but this is likely to require a slowdown in global growth. Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German 2017 Q4 GDP growth mixed expectations of 3%, coming in at 2.9%; German CPI was in line with expectations at 1.6%; European GDP in Q4 of 2017 grew by 2.7% annually, as expected; Industrial production increased by 5.2%, beating expectations; While the euro had a strong week, the long euro trade is very overcrowded. Early signs of weakening in various indicators reflect signs that tightening financial conditions could start hurting growth. The most recent selloff in risky assets further proves this point. A short-term correction is likely to come in the following months, but the euro's cyclical bull market remains intact. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: The leading economic indicator surprised to the downside, coming in at 107.9. This measure also declined from the previous month. Moreover, annualized gross domestic product growth also underperformed expectations coming in at 0.5%. Finally, machinery orders yearly growth underperformed expectations substantially, coming in at -5%. This growth rate declined from 4% in the previous month. USD/JPY has depreciated by more than 2.5% this past week. This cross is now at its lowest point since Trump's election in late 2016. Overall we think that USD/JPY has more downside, as the rise in yields, coupled with a potential slowdown in global trade, and reduced industrial activity in China should continue to weigh on EM assets. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Both core and headline inflation surprised to the upside, coming in at 2.7% and 3% respectively. However, the retail price index yearly growth underperformed expectations, coming in at 4%. This measure also declined from last month's number. Moreover, industrial production yearly growth also underperformed expectations, coming in at 0%. This measure also declined from 2.6% the previous month. GBP/USD has rallied by nearly 1% this week. This has been mostly due to the weakness in the dollar as the trade-weighted pound continued to depreciate since it texting the upper-bound of its range on tk. Overall, we expect that inflation should ease from here on out, as the pound strength should start to translate into lower prices from imported goods, this will limit the number of hikes currently priced into the SONIA curve. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - ­February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data out of Australia was mixed: NAB Business Confidence and Business Conditions both outperformed expectations, coming in at 12 and 19, respectively; The Westpac Consumer Confidence declined to -2.3% from 1.8%. The unemployment rate declined to 5.5%, in line with expectations; Part-time employment increased by 65,900, while full-time employment declined by 49,800. At a speech on Monday, RBA Assistant Governor Luci Ellis brought forward important arguments regarding the macroeconomic situation of Australia. She highlighted the lack of wage growth and high household debt, and pointed specifically to the low household consumption growth which stand in sharp contrast to the experience of other developed countries. Recent data continues to highlight the slack in the Australian labor market, and the AUD is likely to suffer this year due to these factors and its large overvaluation. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The participation rate outperformed expectations, coming in at 71%. Moreover, the unemployment came below expectations, coming in at 4.5%. It also declined from last quarter number. Finally, RBNZ inflation expectations also increased from 2% in Q3 to 2.1% in Q4. On February 8th, the RBNZ elected to keep the policy rate unchanged. In its projections, the RBNZ expects that the trade weighted exchange rate will ease over the projection period. Overall, we expect that the New Zealand dollar will outperform the Australian dollar, given that New Zealand's economy is in a much better footing to sustain rate hikes than Australia. Moreover, a slowdown in the Chinese industrial sector would affect Australia much more than New Zealand, given that New Zealand exports are geared more towards the Chinese consumer. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD strengthened against the greenback by almost 1% this week. This was largely a result of the setback in the USD, and we remain neutral on the CAD for the year. That being said, Canada's superior growth position relative to most other DM commodity producers mean that the CAD is set to appreciate against the AUD. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Producer and import price yearly growth outperformed expectations, coming in at 1.8%. Moreover, the unemployment rate came in line with expectations at 3%. However, headline inflation underperformed expectations, coming in at 0.7%. EUR/CHF has been relatively flat this past week. The recent negative inflation release is a prime example of the entrenched deflationary pressures in Switzerland in spite of a weak franc. Overall, we believe that the SNB will be maintain their ultra-dovish monetary policy as well as their currency interventions, as long as prices remain contained. This means that while bouts of risk-off sentiment will cause temporary corrections in EUR/CHF, the primary trend for this cross still points upward. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Core inflation underperformed expectations substantially, coming in at 1.1% against anticipations of 1.5%. It also declined from 1.4% on the previous month. However, manufacturing production outperformed expectations After rallying by more than 5% in the first week of February, USD/NOK has given up some of those gains, falling by nearly 3% last week. Overall we expect that the Norwegian krone should outperform other commodity currencies, given that a slowdown in industrial activity in China will cause oil to outperform metals. Moreover, the market is only expecting roughly one rate hike in the next year by the Norges Bank, while anticipating nearly three hikes in Canada. We expect this spread in expectations to converge, putting downward pressure on CAD/NOK. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Riksbank's monetary policy meeting on Wednesday contradicted remarks by officials earlier this year regarding a possible policy move in early 2018. In a mild volte face, Riksbank deputy governor Per Jansson pointed to Sweden's "problem with underlying price" pressures to argue in favor of a summer hike. Riksbank officials fear that tightening ahead of the ECB may lead to too strong a currency and depress prices. They also pointed to falling wage growth despite the increasingly tightening labor market. While we are optimistic on Sweden's growth prospects, this development was highlight that Ingves' dovish inclinations still linger within the walls of this central bank. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Japan Economy & Inflation: Japan is in the midst of a solid cyclical upturn, driven by strong exports and rising investment spending. Yet despite signs that the economy is running at an above-potential pace with no spare capacity in labor or product markets, inflation remains tame. This puts no immediate pressure on the Bank of Japan (BoJ) to move away from its easy policy stance. Future BoJ Options: When the BoJ does finally consider a shift in its monetary policy, the first thing it will do is raise its yield target on the 10-year JGB. Before doing that, three things must happen - yen weakness, higher core Japanese inflation and much higher non-Japanese global bond yields. Feature Chart 1A 'Non-Systemic' Vol Spike Global financial markets appear to be calming down a bit after the Great Volatility Scare of 2018. While the equity market sell-off and spike in volatility was intensely compacted into a brief period of time, the changes has been relatively modest when looked at against the broader history of the past decade (Chart 1). This may have been a serious market tremor, but it is not clear that this was the beginning of "The Big One." What could turn investor sentiment into a more permanently bearish state would be a sign of a coordinated move to tighter monetary policy by all the major global central banks. The Federal Reserve is in the midst of a prolonged tightening cycle, while the European Central Bank (ECB) is more openly debating the future of its asset purchase program. Yet amidst all the current investor worries about higher inflation and rising global bond yields, any sign that the hyper-easy BoJ is openly moving to a less accommodative monetary policy could be the trigger for the next wave of market volatility. The BoJ's current policy is to manage short-term interest rates and asset purchases to keep the benchmark 10-year Japanese Government Bond (JGB) yield around 0%. What would it take for the BoJ to make a change to that policy? In this Special Report, we take a look at the current cyclical dynamics for Japanese economic growth and inflation, and determine what it would take to force the BoJ to consider altering its current policy. We conclude that three things that must ALL happen before the BoJ could possibly change its strategy: The USD/JPY exchange rate must increase back to at least the 115-120 range Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5% The 10-year JGB yield must reach an overvalued extreme versus the 10-year U.S. Treasury Strong Japanese Growth, But Where's The Inflation? If it was strictly a growth story, the BoJ could have a case to begin formally removing monetary accommodation relatively soon. The Japanese economy is enjoying a broad-based upturn led by robust export demand and a pickup in capital spending (Chart 2). Private consumption and government spending have also provided smaller, but still positive, contributions to Japanese GDP growth in the current cycle. The BoJ stated in its latest Outlook for Economic Activity and Prices (January 2018) that Japan's economy has entered a virtuous cycle from income to spending that would support continued growth this year. The leading economic indicator estimated by Japan's Cabinet Office is expanding at a solid rate that suggests real GDP growth could accelerate to a well-above potential pace around 2.5% in 2018. The manufacturing PMI is now at the highest level in four years, while the December Tankan survey was the highest reading since Japan's asset bubble burst in the early 1990s. The cyclical upturn in growth has boosted corporate profits, business confidence and capital spending (Chart 3). This is especially so on the manufacturing side of the Japanese economy, where machinery orders and capacity utilization are at the highest levels in almost three years and the level of industrial production is now back to pre-crisis highs. The high level of capacity utilization is a boost both to the economy - through capital spending, as firms need to invest to keep up with underlying demand - and to corporate profits as companies can spread their fixed costs of production over more units sold. Against this backdrop, it is no surprise that Japanese business confidence is solid (bottom panel). Chart 2Lots Of Good Economic News In Japan Chart 3A Cyclical Rise In Production & Confidence Japan's economy remains highly levered to global growth, as the pickup in machinery orders has been focused on foreign demand (Chart 4, bottom panel). With the global leading economic indicator still in a steady uptrend, however, overall export growth should remain in good shape in the next few quarters. For most countries, a solid economic upturn like Japan is currently enjoying would potentially trigger some inflationary pressures. Alas, Japan is not most countries. Over the past several years, the BoJ has consistently projected that Japanese inflation will be on a path to reach its 2% target. That can be seen in Chart 5, which shows Japanese core CPI inflation (ex fresh food) with the annual forecasts produced by the BoJ each year (the dotted lines). Yet the only time that core inflation got remotely close to that level was in 2014 - and, only then, after global oil prices had breached the $100/bbl level. Inflation expectations momentarily rose at that time, but plunged in 2015 as oil prices collapsed. Since then, CPI swaps have struggled to trade much above 0%, only starting to perk up last year as oil prices began rising once again (bottom panel). Chart 4Japan Is Benefiting From##BR##Strong Global Growth Chart 5Watch Oil & The Yen,##BR##Not The BoJ Inflation Forecasts Having inflation consistently below its target rate is frustrating to the BoJ. By its own estimates, Japan's output gap closed in 2016 and now sits at +1.35% - levels that have been consistent with headline CPI inflation rates of 2% or greater since the mid-1980s (Chart 6, top panel). Our own Japan headline CPI diffusion index, which measures the breadth of the moves in inflation across ten CPI sectors, is struggling to stay above the 50 line, unlike those previous periods where Japan had a large positive output gap. The main reason for this is that Japanese service sector inflation, consisting of around ½ of the total Japanese CPI index, remains anemic at 0.8% or a massive 2.3 percentage points below the rate of goods inflation (bottom panel). The odds of the BoJ successfully seeing Japanese inflation reach its target are low without any meaningful pickup in services inflation. The latter requires a boost to household purchasing power, which is next to impossible without faster wage growth. One of the fundamental reasons for Japan's low inflation continues to be the surprising lack of wage inflation despite strong Japanese profitability and a very tight labor market. Japanese firms are enjoying an extended period of robust earnings growth, with corporate profits up nearly 500% since the trough during the 2009 recession (Chart 7, top panel). Moreover, firms have not been cutting back on labor over that period. The jobs-to-applicant ratio has steadily climbed and is now at the highest level since 1974, and while the annual rate of employment growth remains well above the historical average (2nd panel). The result is an unemployment rate that is currently at 2.8%, well below the OECD's estimate of the full employment NAIRU at 3.6% (3rd panel). Yet despite firms remaining desperate to hire new employees to fill empty or newly created positions, at a time when there is no spare labor capacity, wage growth remains stagnant. Nominal wage growth is only 0.6%, or -0.6% in real terms. The problem of low real wage growth is not unique to Japan, of course (bottom panel), but it is unusual given how far the Japanese unemployment rate is below NAIRU. The subject of persistent low wages has become an important political matter for Japanese PM Shinzo Abe, given that breaking Japan out of its low inflation trap has become critical to the long-term success of his "Abenomics" program. Our colleagues at BCA Geopolitical Strategy discussed this exact topic in a Special Report published last week, noting that: Wages will be a decisive factor in Abe's economic success .... In this spring's "shunto" negotiations between businesses and unions, both the Abe administration and Keidanren, the top business group, are asking for 3% wage increases. The biggest union, Rengo, is only asking for one percentage point more. Abe has dedicated the current Diet session, beginning January 22, to "work-style reforms" that should be, on net, positive for wage growth. He wants to remove disparities between regular and irregular workers, particularly regarding wages, training opportunities, and welfare benefits. He also wants to impose limits on the workweek - putting a cap on the average 80-hour workweek of Japan's full-time workers so as to force companies to hire more irregular workers on a full-time basis (and to encourage employed people to have children). Companies that raise wages by 3% or more will see a cut in the corporate tax rate from around 30% to 25%.1 If Abe is successful in convincing Japanese companies to boost wages, this can help broaden the current cyclical economic upturn in Japan through faster consumer spending. Consumption has lagged other more robust parts of the economy during the current cycle (Chart 8, top panel), even though consumer confidence has surged in response to the healthy labor market (middle panel). Real disposable income growth has been unable to exceed 1% since 2010, a problem for consumer spending that has been exacerbated by the five percentage point rise in the household saving rate since 2013 (bottom panel). Chart 6Domestic Inflation,##BR##Like Services, Is Anemic Chart 7Japanese Companies##BR##Are Not Sharing The Wealth Chart 8Poor Fundamentals For##BR##The Japanese Consumer Putting it all together, the Japanese economy is in good shape, but inflation continues to undershoot the BoJ's goals. Bottom Line: Japan is in the midst of a solid cyclical upturn, driven by strong exports and rising investment spending. Yet despite signs that the economy is running at an above-potential pace with no spare capacity in labor or product markets, inflation remains tame. This puts no immediate pressure on the BoJ to move away from its easy policy stance. Plausible Next Steps For The BoJ The BoJ is in a difficult spot at the moment. The underwhelming pace of inflation is forcing the central bank to continue committing to its aggressive monetary easing programs, which include large-scale purchases of Japanese Government Bonds (JGBs) and Japanese equities via ETFs. Yet the BoJ already shifted from a quantity target for its JGB purchases to a price target back in September 2016 when it introduced the "Yield Curve Control" (YCC) element to its overall Quantitative & Qualitative Easing (QQE) program. By switching to a price level on the 10-year, the BoJ was aiming to reduce the amount of JGBs it was buying from 80 trillion yen per year to whatever level was required to keep the 10-year yield at 0%. After switching to the YCC framework, the growth in the BoJ's JGB holdings slowed sharply to a pace that is now below the pace of new JGB issuance for the first time since the QQE program started in 2013 (Chart 9). It is no coincidence that the peak in the pace of BoJ buying coincided with the cyclical trough in our own BoJ Central Bank Monitor, which suggests that tighter monetary policy is now required in Japan (top panel). The BoJ has been successful in keeping the 10-year JGB yield near its 0% target, but that outcome will be operationally harder to achieve in the future. The BoJ currently holds about 70% of all 10-year JGBs outstanding, and the increase in ownership has risen by 5-7% in each quarter (Chart 10). In other words, if this pattern lasts, without a major increase in issuance at that maturity, the BoJ will effectively own all the 10-year JGBs outstanding by the middle of 2019. Already, the BoJ owns around 43% of the entire stock of JGBs, draining liquidity away from the market for the risk-free asset (government bonds) that is needed by Japanese banks and major investors like pension funds and insurance companies (Chart 11). Chart 9BoJ Has Already 'Tapered'##BR##Its Bond Purchases Chart 10The BoJ Is Cornering##BR##The JGB Market With the BoJ unwilling to continue impairing the liquidity in the JGB market, it will be forced to consider alternatives to its current YCC program settings. Last week, the Japanese government nominated BoJ Governor Haruhiko Kuroda for another five-year term as the head of the central bank. Kuroda has received the full trust from PM Abe in his handling of monetary policy. However, maintaining the current monetary policy has some limitations. What can the BoJ realistically do? Until realized inflation reaches the BoJ target, there can be no shift to a less accommodative monetary policy involving a full tapering of asset purchases or interest rate increases. Yet the BoJ cannot continue to buy bonds at the current pace without essentially "cornering the market" for 10-year JGBs. The solution that would be the least disruptive, in our view, would be increasing the YCC yield target from the current 0%. It has been rumored over the past year that the BoJ would consider raising that yield curve target, although that idea has been repeatedly shot down by Governor Kuroda - no surprise, given how far inflation is from the BoJ target. The BoJ has been already been effectively "tapering" by buying fewer bonds under YCC than QQE. An explicit announcement to reduce the pace of bond buying, however, would be taken as a hawkish sign by the markets. Just ask the ECB, who is dealing with its own communication problems with the markets as it tries to prepare for the inevitable exit from its bond buying program. Explicitly raising the yield curve target would only be an option for the BoJ if it felt that a) the domestic economy could tolerate some increase in longer-term bond yields; b) Japanese inflation was likely to reach (or even surpass) the BoJ's 2% target; and c) the global economy was strong enough to push global bond yields to a sustained higher trajectory. We see the following as being a necessary "checklist" of events that must occur before the BoJ would even contemplate a more to a higher target on the 10-year JGB yield (Chart 12): Chart 11JGB Ownership Shares##BR##By Investor Category Chart 12These Must ALL Happen Before##BR##The BoJ Lifts Its JGB Yield Target 1) The USD/JPY exchange rate must increase back to at least the 115-120 range The recent rise in the yen versus the U.S. dollar has flied in the face of interest rate differentials that should be highly supportive of the U.S. dollar (top panel). This is not the only currency pair where this has happened, of course, but it matters far more for Japan given the low readings on headline inflation. A strengthening yen makes a difficult job - boosting Japanese inflation sustainably to 2% - almost impossible. 2) Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5% This is fairly obvious, but the BoJ cannot be confident that its 2% inflation target can be reached if core inflation continues to muddle along at levels well below that target. If wage growth were to also rise at the same time and pace as core inflation, both within hailing distance of 2%, then the BoJ would be even more convinced that some modest change to its yield target was required. 3) The 10-year JGB yield must reach an overvalued extreme versus U.S. Treasuries Table 1JGB Yield Model Or put more simply, global bond yields must rise by enough for the BoJ to say that there has been a shift in the global growth/inflation backdrop, justifying a structurally higher level of bond yields. The BoJ could then point to non-Japanese factors as the reason to bump up the target for 10-year JGB yields. We can evaluate this using the BoJ's own model for the 10-year JGB yield that was introduced back in 2016 (Table 1). This model includes Japanese potential GDP growth, the 10-year U.S. Treasury yield and the share of JGBs owned by the BoJ (along with "dummy variables" to identify the dates of the BoJ's QQE and negative interest rate policy). In the bottom two panels of Chart 12, we show a scenario that would lower the residual of the model (i.e. how far JGB yields are below fair value) to the same extremes seen during the QQE era since 2013. That would require a move in the 10-year U.S. Treasury yield to 3.5% AND an increase in the BoJ ownership share of the entire stock of JGBs to 50%. That would increase the fair value of the 10-year JGB yield to 0.18%, leaving the current yield around 10bps too expensive. Importantly, all three items in our checklist would have to happen at the same time for the BoJ to contemplate any shift in its yield curve target. That is especially true for USD/JPY. Japan would face considerable international pressure if the yen was held at undervalued levels by an overly accommodative BoJ policy that was no longer needed with Japanese inflation approaching the 2% target. What are the odds of all three of these items in our checklist being reached in 2018? Quite low, perhaps no more than 20%. For that reason, we do not see the BoJ being a new reason for frazzled global investors to worry about another spike in volatility. Bottom Line: When the BoJ does finally consider a shift in its monetary policy stance, the first thing it will do is raise its yield target on the 10-year JGB. Before doing that, three things must happen - yen weakness, higher core Japanese inflation and much higher non-Japanese global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Kuroda Or No Kuroda, Reflation Ahead", dated February 7th 2018, available at gps.bcaresearch.com.

Highlights The spike in volatility last week led to a sharp correction in equities. However, the bull market in equities is not over yet. The Fed's response to the selloff will be critical. Policymakers will closely monitor financial conditions. The most overvalued assets are at greatest risk during a selloff. Feature Financial markets did not give new Fed Chair Jay Powell a warm welcome last week. Volatility spiked, and risk assets fell sharply. Nonetheless, BCA's view is that strong economic growth and stout earnings growth will keep the bull market intact. The selloff is reminiscent of the 7% drop in the S&P 500 in May of 2006.1 Back in the spring of 2006, then Chairman Ben Bernanke had just taken the helm at the Federal Reserve. Global growth was strong, the U.S. dollar was selling off and global share prices were surging and overbought. From May through June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish, allowing U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM assets. The February 2018 may not play out exactly like May 2006. That said, there are enough similarities to draw parallels. Global growth is robust and inflationary pressures are accumulating. Bond yields are rising, and the greenback is selling off. A new Fed Chairman just took over the reins, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. The Fed's response to the tighter financial conditions will be crucial. The May 2006 selloff turned out to be just a correction in a bull market that lasted another 18 months. Still, investors today are also concerned about what to sell first as the end of the expansion draws closer. A Shake Up BCA strategists believe that the market turmoil since last week reflects a technical correction from overbought and over complacent levels, but the cyclical bull run is not yet over.2 Nonetheless, investors should note that the bull market is entering its late stages. The low inflation and low volatility era is ending as the U.S. economy begins to face late-cycle, supply-side constraints, especially in the labor market. Therefore, the equity advance will be associated with higher volatility than in the past few years. Chart 1 shows that the VIX soared by roughly four times more on February 5 than expected, based on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction in the past few days of other risk gauges, such as junk bonds, EM stocks, and gold prices, is consistent with this thesis. Chart 1Last Monday's VIX Spike Was Abnormally Large Importantly, the implosion of volatility funds is unlikely to reverberate across the global financial system in the same way as it did during the 2007-2009 financial crisis. The mortgage crisis a decade ago was so toxic that the losses were concentrated in the books of highly leveraged financial institutions. However, that does not appear to be the current case with volatility funds. The cyclical underpinnings for the bull market in equities is intact. The odds of a recession remain low (Chart 2). Corporate earnings continue to come in above expectations, aided by a wave of share buybacks linked to the U.S. Tax Cut and Jobs Act (Chart 3). Global economic growth remains upbeat as well. Chart 2Odds Of A Recession##BR##Remain Low Chart 3Buybacks, Surging Capex##BR##Raising The Bar For 2018 EPS Growth Chart 4U.S. Equities And Vol##BR##Climbed Through The 1990s This does not mean that everything will be smooth sailing. Last week's selloff marked an inflection point in the low-volatility world that has prevailed in the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Volatility will stay elevated relative to what investors have come to anticipate. As the experience of the 1990s shows, stocks can still climb when volatility trends higher (Chart 4), but this is going to make for a more challenging investment environment. Bottom Line: Rising volatility does not mean the end of the bull market or the economic expansion. Bear markets outside of recessions are rare, and our view remains that the odds of a recession this year or next remain low. Moreover, the additional dose of fiscal stimulus passed by Congress late last week may extend the expansion into 2020. Stay overweight stocks versus bonds.3 The Policy Response The Fed's reaction to this new regime will be critical. The 7.2% drop in equities last week occurred on Jay Powell's first as Chairman of the Fed. Chart 5 shows that it is not unusual for the equity markets to be in turmoil in the early months of a new Fed Chair's tenure. BCA expects that Powell and his FOMC colleagues will adopt Janet Yellen's gradual approach to raising rates this year. Nonetheless, the January readings on average hourly earnings suggest that supply-side constraints are beginning to bite. The runway for low inflation and easy monetary policy may not be as long as some had hoped. Just like Yellen, Jay Powell will seek a consensus among his colleagues. The composition of the FOMC will probably shift in a more hawkish direction, but the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important and often underappreciated source of continuity. Last week, several Fed speakers reinforced that the central bank will continue to monitor incoming economic and financial data, and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. remain more expansionary than they were six months ago (Chart 6). As a result, U.S. economic growth is poised to accelerate even more in the first half of the year (Chart 7). This will push the unemployment rate further below NAIRU and ultimately force up wage and price inflation. Chart 5New Fed Chairs##BR##And The Equity Market Chart 6Decline In Equity Market##BR##Tightened Financial Conditions However, at 2.1% on February 8, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets need to worry about the Fed falling behind the curve (Chart 8). A shift above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would signal that the FOMC will have to boost the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We will likely take some money off the table if core inflation rises, even if it is still below 2%, when the TIPS breakeven reaches 2.4%. Chart 7Lagged Effect Of Easier##BR##Monetary Conditions Will Boost Growth Chart 8Breaking Down##BR##The Rise In Yields A sustained move above 3% on the nominal 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we think core inflation will move4 above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this probably will be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of a recession (Table 1). If the next recession occurs in late 2019, as we forecast, the equity bull market could last a while longer. The additional fiscal impulse from the spending bill passed by Congress last week may extend the expansion into early 2020. A modest overweight on global risk assets is warranted for now, but investors should consider reducing their risk exposure later this year. Table 1Too Soon To Get Out Bottom Line: The Fed and the market are now in agreement on rate hikes in 2018. BCA's U.S. Bond Strategists' stance is that the 2/10 curve will flatten from here, as the upside in long maturity yields will be limited once the TIPS breakeven inflation rates reach our target fair value range of 2.4-2.5%. Nonetheless, at that point, the nominal 10-year yield5 is likely to be between 3.0 and 3.25%. Stay underweight duration for now. Where Do We Go From Here? Clients have asked our view on the appropriate order in which to reduce risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the most over-valued ones are at greatest risk, and thus profits should be taken here first. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time span? We include multiple measures because there is no widely accepted approach. More than one time period was used in some cases to capture regime changes. Table 2 provides our best approximation for nine asset classes. The approaches range from sophisticated methods6 developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (i.e. oil), to simple deviations from a time trend (i.e. real raw industrial commodity prices and gold). Table 2Valuation Levels For Major Asset Classes We averaged the valuation readings where there were multiple estimates for a single asset class. The results are shown in Chart 9. Chart 9Valuation Levels For Major Asset Classes By far, U.S. equities stand out as the most expensive at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads follow at 0.7, tracked closely by U.S. Treasuries (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are very expensive in absolute terms based on the fact that government bonds are pricey. Oil is sitting very close to fair value, despite the rapid price run up in the past couple of months. This makes oil exposure doubly attractive because the fundamentals point to higher prices when the underlying asset is not expensive. Historical analysis around equity market zeniths provides an alternative approach to the sequencing question. Table 3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table 3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, tech stocks or small-cap versus large-cap relative returns. Sometimes they reached their zenith before the S&P 500, and sometimes after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyze due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time was long and variable. The U.S. corporate bond market offers the most consistent lead/lag relationship. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio before we scale back on equities. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over as expected to the EM economies. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of China's economy in the coming months. Oil is a different story. OPEC 2.0 will likely cut back on supply in the face of an economic downturn, which will help keep prices elevated.7 Therefore, we may not trim energy exposure this year. In terms of equities, our recommended portfolio is still overweight cyclicals for now. Our themes of a synchronized global capex boom, rising bond yield, and firm oil price means we will stay overweight in the industrials, energy and financial sectors. Utilities and homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. Our U.S. Equity Strategists have already started a gradual shift away from cyclicals toward defensives. This transition will continue in the coming months as we reduce risk. We will also shift small caps to neutral on earnings disappointments and elevated debt levels.8 Bottom Line: The economic expansion is not over, but investors are already wondering what to sell first as the next peak in equities nears. Market participants should look to trim credit exposure before scaling back on equities, and BCAs' U.S. Equity Strategy service is already scaling back on cyclicals and reduced small caps to neutral from overweight last month. At under $60/ barrel WTI, oil is 5% below our Commodity & Energy Strategy's target of $63/bbl. Moreover, global inventories will continue to draw on the back of OPEC supply restraint as shale production growth alone will not satisfy stronger global demand driven by stronger global economic growth. If prices hit the low $70 range, supply restraint and demand growth will ebb, capping incremental upside. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Insight "Buy The Dip," published February 8, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's Global Investment Strategy Special Report "The Return Of Vol," published February 6, 2018. Available at gis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Watching Five Risks," published January 24, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 6 Please see BCA Research's The Bank Credit Analyst Monthly Report, published January 25, 2018. Available at bca.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Vs. The Fed," published February 8, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?," published January 22, 2018. Available at uses.bcaresearch.com.

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

Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Japan's reflationary economic policies will be reinforced ahead of the constitutional referendum; The Bank of Japan is a long way from a 2% inflation overshoot; Fiscal thrust will continue to surprise to the upside; Wage law revisions are significant and, on net, inflationary; Go long JPY/EUR as a tactical play on the countertrend yen rally. Feature Despite a 8.5% selloff in Japanese equities over the past week amid the global equity pullback, Japan's underlying economic growth is strong. The unemployment rate has collapsed to 2.8%, the economy is humming along at an impressive 2.1% clip, and inflationary pressures are building at last. A variety of indicators - from sentiment surveys to household incomes to manufacturing output - attest to the fact that "Abenomics" is keeping the fire well lit (Chart 1). Before the pullback began, investors were wondering whether the BoJ's reduction of long-term government bond purchases signaled that a less dovish turn in monetary policy was underway (Chart 2). BoJ Governor Haruhiko Kuroda tried to quiet these rumors by reiterating the need to keep current, easy monetary policy in place. The latest financial shakeup reinforces this message. Chart 1Japan's Macro Fundamentals Are Strong Chart 2The BoJ Has Cut Back Asset Purchases Over the long run, the BoJ's moves, and "Abenomics" in general, should be assessed from the perspective of Japan's broader geopolitical revival.1 Prime Minister Shinzo Abe needs reflation to continue for a range of reasons. Policymakers are not constrained by inflation; rather, inflation is constrained by the yen, global growth, and the increasing danger of a Chinese policy mistake. The BoJ Will Not Betray Abenomics Japan's strong consumer and business confidence, white-hot economic growth, and multi-year equity rally have stemmed from three factors: positive fiscal thrust, an EM rebound, and a weak yen.2 As a result, real interest rates have fallen (Chart 3), prompting the BoJ to downgrade its quantitative and qualitative easing policy (QQE). But cutting back bond-buying does not mean that the BoJ is removing accommodative policy. The central bank stopped targeting the quantity of asset purchases when it introduced its "yield curve control" policy in September 2016. Yield curve control ensures that long-term JGB yields stay around 0%, with a de facto cap of 10 basis points that can be adjusted as needed. Therefore the gross amount of asset purchases is arbitrary; it only needs to be sufficient to achieve the yield target. In fact, the BoJ's official annual target of asset purchases, 80 trillion yen, was until recently well above the annual net issuance of JGBs at 35 trillion yen (Chart 4). Fiscal policy, while surprising upward as expected, has not produced the volumes of new bond issuance that would be necessary to justify such a lofty target. Hence the BoJ can reduce bond-buying without turning more hawkish. As for inflation, the core price level has only barely begun to perk up (Chart 5) - and that has occurred after five years of reflationary efforts, which, in turn, followed a sea change in Japanese politics. Prime Minister Abe came to power by declaring war on deflation, putting Governor Kuroda in charge of the BoJ, and seeking a broad-based revival of Japan from the "lost decades" of the 1990s and 2000s. Neither Abe nor Kuroda can afford to remove accommodation too soon and snatch defeat from the jaws of victory. Chart 3Real Interest##br## Rates Have Fallen Chart 4Bond Purchases Had ##br##Exceeded New Issuances Chart 5Weak Yen, Easier Financial ##br##Conditions Pushed Up Inflation Kuroda has repeatedly stressed that he will allow inflation to "overshoot" the 2% target before normalizing policy.3 While it is possible that he will step down when his first term ends on April 8, it is neither required nor probable. We highly doubt that he will. Further, the likeliest candidates to replace him are those that would maintain policy continuity.4 Hence the wind-down of QQE does not portend any additional moves away from easy policy. Any such moves would drive the yen upward, and neither Kuroda nor his acolytes at the BoJ can allow yen strength to undermine their quest to whip deflation. Bottom Line: The BoJ's yield curve control framework will remain intact even if the quantity of asset purchases remains much smaller. No leadership change at the BoJ will alter this new monetary policy framework. With the Fed and other central banks in the midst of rate-hike cycles, and the ECB winding down its QE, the persistent dovishness of the BoJ will act as a depressant on the yen as it experiences upward pressure from abroad. Policy Is Inflationary... Significant inflationary pressures are building in Japan, and reflationary policy will be resolute in the face of any headwinds. First, Abe's political career depends on maintaining the economic revival. His most treasured policy objective - reforming the Japanese constitution to revise the pacifist Article Nine and clear the legal path for the normalization of the country's military - ultimately requires a majority vote in a popular referendum.5 This is no easy task. Abe will almost certainly win the leadership poll within the Liberal Democratic Party in September this year, but he may not wait till then to try to push a constitutional amendment through the Diet. The tentative plan is to present a bill in March and proceed to the national referendum in late 2018. Certainly it is imperative for him to secure two-thirds majority votes in each chamber before the House of Councillors elections in July 2019, since that event puts his near-supermajority in the upper house at risk (Chart 6). The constitutional referendum could coincide with that vote or precede it, but Abe wants the process finished before the 2020 Tokyo summer Olympics. It will be a stretch but it is feasible. Chart 6Abe Has A Virtual Supermajority In Both Houses, Necessary For Constitutional Change Chart 7A Popular Referendum Will Be Very Close Opinion polls have consistently showed the public almost evenly split on the topic of revising Article Nine, with the hawkish advocates of revision usually trailing dovish opponents (Chart 7). While Abe's approval rating ranges in the high forties, his constitutional tinkering has similar, sub-50% levels of support. Pacifism runs deep in Japan. The LDP and New Komeito ruling coalition has not won more than 47% of the popular vote in the 2012, 2014, and 2017 general elections (Chart 8). And it has never scored above 50% in popular opinion polls over the course of Abe's term (Chart 9). Chart 8Abe's Coalition Has Not Won 50% Of The Vote... Chart 9...Nor Polled Above 50% In Popular Opinion Abe will not have forgotten Italy's former Prime Minister Matteo Renzi, who gambled his political career on controversial constitutional reforms in 2016 only to fall from power when he lost the popular referendum. More to the point, Abe knows that large-scale protests - bigger than those he faced in 2015 - could attend his final push to secure the constitutional revision. After all, Abe's grandfather, Nobusuke Kishi, faced mass protests in 1960 and was forced to resign upon concluding a new Treaty of Mutual Cooperation and Security with the United States. This was a consequential update to the "U.S.-Japan Security Treaty" that enabled Japan to build up de facto military forces despite its pacifist constitution. Kishi fell from power even though he had presided over a rapid expansion of real GDP and real wages and a steep drop in unemployment (Chart 10). True, Japan was a very different place in 1960. At that time, the Cold War was raging, and a large and restless youth population energized the protests. Today's youth are complacent and outnumbered by comparison. Nevertheless, Kishi did not need to put his treaty to a popular vote, unlike Abe's constitutional revisions. His grandson has a higher threshold to overcome. It follows that Japan will maintain dovish monetary policy and will continue to outperform conventional estimates of fiscal thrust (Chart 11).6 Abe's decision to abandon the goal of achieving a primary balance budget surplus by 2020 is a clear indication of this policy direction.7 Chart 10Treaty Protests In 1960 Despite Strong Economy Chart 11Fiscal Thrust Surprises To Upside Wages will be a decisive factor in Abe's economic success.8 Wage growth has remained in the black for most of his term, marking a contrast with the past twenty years of at best sporadic and short-lived wage rises (Chart 12). This is likely to continue. In this spring's "shunto" negotiations between businesses and unions, both the Abe administration and Keidanren, the top business group, are asking for 3% wage increases. The biggest union, Rengo, is only asking for one percentage point more.9 Abe has dedicated the current Diet session, beginning January 22, to "work-style reforms" that should be, on net, positive for wage growth.10 He wants to remove disparities between regular and irregular workers, particularly regarding wages, training opportunities, and welfare benefits. He also wants to impose limits on the workweek - putting a cap on the average 80-hour workweek of Japan's full-time workers so as to force companies to hire more irregular workers on a full-time basis (and to encourage employed people to have children). Companies that raise wages by 3% or more will see a cut in the corporate tax rate from around 30% to 25%. Economic conditions should push wages up regardless of central government policies. The jobs-to-applicants ratio is at the highest level since 1990. The labor participation rate is 60.8%, with female participation at 51.3%, up from 47.8% when Abe took power in 2012. Neither does the adoption of robotics, for which Japan is famous, counteract the tight labor market and inflationary consequences over time.11 In short, wages and core inflation should rise as long as the economic expansion is not derailed. As our colleague Peter Berezin of BCA's Global Investment Strategy has shown, the Phillips Curve will eventually kick in - and it even looks like Japan (Chart 13)!12 Chart 12Wage Growth Is The Key To Abe's Success Chart 13The Phillips Curve In Japan Looks Like Japan Bottom Line: A growing economy with real wage growth is Abe's only hope not only of beating deflation but also of getting his planned constitutional amendments over the line. Reflationary policy is essential to his legacy and vision of reviving Japan. ... But Not Too Inflationary Still, fiscal thrust is hardly going to explode unless an economic slowdown calls for it. Despite Abe's adoption of a twenty first-century "Takahashi Plan," i.e. simultaneous monetary and fiscal expansion, his administration's fiscal spending has remained relatively restrained. Strong revenue growth has actually improved the primary balance (Chart 14). Until very recently, Abe's "fiscal arrow" has disappointed his cheerleaders - he even raised the consumption tax from 5% to 8% in 2014, undermining his pro-growth fiscal packages. By law Abe is required to raise the consumption tax again, from 8% to 10%, in October 2019. In the latest election he campaigned on using the proceeds of this tax increase to expand social spending.13 Of course, he reserves the option of postponing this decision if he should deem a tax hike detrimental to the economic recovery (or to his odds of revising the constitution). But this flexibility means that any and all inflationary pressures in 2018-19 will increase under the shadow of a statutorily scheduled slug to consumer spending. There are also some constraints on wage growth. First, the reforms are intended to liberalize the labor market, which means their effects are not likely to be exclusively inflationary. "Performance" metrics that put less emphasis on seniority and working overtime, insofar as they are successful, could weigh on wage growth, at least initially. Second, Japan is starting to allow immigration - the number of foreign workers hit a record of 1.28 million total in October 2017 (Chart 15).14 This trend runs contrary to Japan's long status as the least hospitable destination for migrants in the developed world. The influx is apparently not limited to construction workers for the 2020 Olympics, as manufacturing is still the sector with the largest number of foreign workers. The Abe administration is committed to breaking the mold in the name of pro-growth structural reform and immigration is a meaningful change, albeit still in its early stages. Given existing labor market tightness and rising labor costs for companies, we expect this trend to outrun expectations, nudging up labor force growth and at least mildly counteracting wage rises, especially in low-skill sectors.15 Chart 14Primary Balance Improves On Growth Chart 15Japan Finally Allowing Immigration Bottom Line: Inflation will continue building if the global economy continues expanding and additional fiscal thrust and wage hikes are added to Japan's negative output gap, tight labor market, and rock-bottom unemployment rate. Nevertheless Japan is far from runaway inflation, and fiscal and labor market policies are nuanced. The BoJ's desired inflation overshoot is still a long way off. China And EM Pose Deflationary Risks Meanwhile deflationary forces lurk in China and emerging markets, which have been key factors in Japan's recent economic outperformance. Japan's trade exposure to China is substantial: The latter accounts for 18% of Japan's total exports, 2.7% of Japan's GDP (Chart 16). At the moment, Japanese manufacturing appears resilient in the face of China's slowdown, especially relative to the "newly industrialized" Asian neighbors. But Chinese Premier Li Keqiang's famous proxy for economic activity is closely correlated with Japanese export growth, and it is slowing. China's monetary conditions and credit and fiscal spending impulse - key leading indicators - also bode ill for Japanese exports (Chart 17). Chart 16Japan Exposed To Chinese Economy Chart 17China Policy Will Hit Japan Directly Beijing has so far tightened policy into the slowdown. It is adding new financial, environmental, and property sector regulations while expanding its anti-corruption campaign into finance, industry, and local government.16 Central government regulatory discipline - and reforms meant to reduce capital and energy intensity - will weigh on China's monetary and credit growth, capex, capital and commodity imports, and hence EM as a whole (Chart 18). And EM ex-China accounts for a further 25% of Japanese exports. In other words, Chinese reforms will bite in 2018-19 and thus encourage Japan to maintain loose fiscal and monetary policy. Recent market turbulence may add to this predicament as it is not easy for China to abandon its newly launched economic reforms - meaning China may ease policy too late if conditions worsen. We put the risk of a policy induced mistake in China at 30%. There are also significant geopolitical risks in East Asia that could cause headwinds to Japan's economy. China's strategic challenge is the key driver of Japan's attempts to revive its economy (including through higher military spending) and normalize its military operations (Chart 19). With Japan re-arming, China and Japan could easily suffer a breakdown in diplomatic relations - and China has already shown the willingness to use sanctions to punish Japan when strategic spats occur.17 Frictions over the Koreas or Taiwan could also encourage safe-haven flows into the yen. In short, Abe and Kuroda must be prepared for any eventuality, which is another reason to expect policy to stay looser for longer. Chart 18China Policy Will Hit Japan Via EM Chart 19Strategic Tensions Still A Serious Risk Bottom Line: Japan's exposure to both China and EM ex-China makes it vulnerable to growth wobbles as China intensifies reforms. Meanwhile Japan's constitutional revisions and remilitarization could spark a spat with China. These are compelling reasons for policymakers to stay the course with loose monetary and fiscal policies. Investment Recommendations In the short run, we would suggest clients go long JPY/EUR. The euro is expensive relative to fair value and purchasing-power-parity models (Chart 20). And investor positioning is skewed heavily in favor of the euro versus the yen (Chart 21).18 Chart 20EUR/JPY Is Expensive Chart 21Skewed Positioning In EUR/JPY We are closing our long USD/JPY for a loss of 3.23%. In the long run, as long as global growth holds up, any yen rally is likely to be a countertrend one, as a stronger yen will exert deflationary pressures and reinforce persistent, easy policy. Japanese policymakers have little need to fear inflation; they will focus on nurturing the country's economic and strategic rebound. Therefore, investors need not worry about the BoJ pulling the rug out from under the equity and bond markets. While BCA's House View favors Japanese equities over the U.S., BCA Geopolitical Strategy's China view prevents us from sharing this conviction in 2018. We would favor U.S. equities, which are low-beta and poised for continued strong earnings growth due to tax cuts and growth. The big risk for Japanese equities comes if China's central government makes a policy mistake and "overcorrects," triggering a precipitous drop in Chinese imports. We put a 30% subjective probability to such a scenario given the difficulty of reforming the financial sector in a highly leveraged economy. The yen would rally on safe-haven flows and Japanese markets would sell off. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 2 Please see BCA Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018, available at fes.bcaresearch.com. 3 See for example Haruhiko Kuroda, "Quantitative and Qualitative Monetary Easing and Economic Theory," speech at the University of Zurich, Bank of Japan, November 13, 2017, available at www.boj.or.jp. 4 Technically, Kuroda's term ends on April 8, 2018 but he can be reappointed by the prime minister for another five-year term. Please see "Experts say Haruhiko Kuroda likely to remain at BOJ helm despite failures," Japan Times, October 7, 2017, available at www.japantimes.co.jp. Both of Kuroda's deputies, Hiroshi Nakaso and Kikuo Iwata, as well as other possible successors (Masayoshi Amamiya, Etsuro Honda, and Takatoshi Ito) are dovish candidates likely to maintain continuity with his policies if at the BoJ helm. Nobuchika Mori is the only potential exception but it is still not clear that he would deviate from Abe's and Kuroda's framework if given the top job. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 7 Abe abandoned the 2020 budget target while campaigning in the general election of October 2017 and has stuck with his higher spending proposals. 8 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. 9 Please see "Japan business lobby seconds call for 3% pay hikes," Nikkei Asian Review, January 17, 2018, available at asia.nikkei.com. 10 Abe is attempting to amend the Labor Standards Law. Please see Heizo Takenaka, "A prologue to work-style reforms," Japan Times, January 30, 2018, available at www.japantimes.co.jp. 11 Despite labor shortages, Japanese firms are using robots less often. Also, companies with high technology and robot usage are actually companies that tend to pay higher wages, contrary to popular belief. Please see BCA's The Bank Credit Analyst Special Report, "The Impact Of Robots On Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 12 Please see BCA Global Investment Strategy, "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 13 Abe reiterated his plans for more social spending, for instance on expanded child care support and free preschool education, in his policy speech ahead of the opening Diet session this year. Please see "Abe delivers policy speech," NHK, January 22, 2018, available at www3.nhk.or.jp. 14 Please see "Number of Foreign Workers in Japan at Record High," NHK, January 26, 2018, available at www3.nhk.or.jp. 15 Please see "Japan quietly accepting foreign workers -- just don't call it immigration," Japan Times, November 3, 2016, available at www.japantimes.co.jp 16 Please see BCA Geopolitical Strategy Special Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 18 For full discussion, see footnote 2 above. Geopolitical Calendar

Dear Client, In light of recent market turbulence, we are publishing our weekly report earlier than usual. Caroline Miller, Garry Evans, and I will also be hosting a webcast Wednesday morning at 10am EST to discuss the investment outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Monday's stock market rout was largely driven by technical factors. Strong economic growth and positive earnings surprises should keep the equity bull market intact. Nevertheless, investors need to adjust to the fact that volatility is likely to pick up, just as it did in the last few years of the 1990s bull market. The market's expectations of where the funds rate will be over the next two years have almost converged with the Fed dots. In the near term, this will limit the ability of the 10-year Treasury yield to rise much above 3%. Looking further out, inflation is likely to move above the Fed's target early next year, setting the stage for a recession starting in late 2019. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Feature VIX Kicks Last week's Global Investment Strategy report, entitled "Take Out Some Insurance," argued that equities had become dangerously overbought and were highly vulnerable to a correction.1 We noted that the VIX had likely bottomed for the cycle and that going long volatility had now become an attractive hedge against stock market declines. As many of my colleagues have noted, betting on continued low volatility had become an increasingly crowded trade in recent years. Back in January, we observed that net short volatility positions had reached record-high levels (Chart 1). We warned that "traders have been able to reap huge gains over the past few years by betting volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility."2 Precisely such a vicious cycle erupted on Monday, causing the S&P 500 to suffer its worst daily percentage loss since August 18, 2011. The question is where do we go from here? So far, the sell-off in stocks looks largely technical in nature. Chart 2 shows that the VIX soared by roughly four times more on Monday than one would have expected based solely on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction of other "risk gauges" such as junk bonds, EM stocks, and gold prices over the past few days is consistent with this thesis. Chart 1Volatility Is Back Chart 2Monday's VIX Spike Was Abnormally Large Cyclical Outlook Still Solid It is impossible to know if today's rebound will persist or if the correction still has further to run. What we do know is that the cyclical underpinnings for the bull market remain intact. Leading economic data remain buoyant (Chart 3). Corporate earnings continue to come in above expectations (Chart 4). Chart 3Global Economic Backdrop Remains Buoyant Chart 4Optimism Over 2018 Earnings Growth None of our recession-timing indicators are flashing red (Chart 5). The Conference Board's LEI is rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator. Likewise, while the U.S. 2/10-year Treasury curve has flattened, it has not inverted yet. Moreover, even once the yield curve inverts, the lags can be quite long before the recession begins. For example, in the last cycle, the yield curve inverted in early 2006, but the recession did not begin until December 2007. This does not mean that everything will be smooth sailing from here. Monday's sell-off marked an inflection point in the low-volatility world that has prevailed over the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Going forward, volatility will remain elevated relative to what investors have come to expect. As the experience of the 1990s shows, stocks can still go up when volatility is trending higher (Chart 6), but this is going to make for a much more challenging investment environment. Chart 5No Signs Of An Imminent End To This Business Cycle Chart 6Volatility Can Increase As Stock Prices Rise The Powell Put? How the Fed and other central banks react to this new world will be critical. It is perhaps not a complete coincidence that Monday's crash occurred on the first day that Jay Powell took over the helm of the Fed. Investors are increasingly worried that the Fed will turn from friend to foe. The faster-than-expected increase in average hourly earnings in January put those fears in stark relief. Accelerating wage growth suggests supply-side constraints are beginning to bite. This, in turn, means that the runway for low inflation and easy monetary policy may not be as long as some had hoped. As BCA editors discussed in our 2018 Outlook, "Policy And The Markets: On A Collision Course," central banks are in the process of winding down the extraordinary stimulus that investors have gotten used to.3 Whether this undermines the case for holding stocks and other risk assets depends on how quickly the adjustment occurs. On the plus side, we continue to think the adjustment will be fairly gradual, at least for the time being. Core CPI inflation outside of shelter is still running at 0.7% (Chart 7). This gives the Fed plenty of wiggle room. Just like Janet Yellen, Jay Powell will seek to build a consensus among his colleagues. Granted, the composition of the FOMC is likely to shift in a somewhat more hawkish direction. However, the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important, and often underappreciated, source of continuity. As in the past, the Fed will continue to monitor incoming economic and financial data and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. and most other countries remain more expansionary than they were six months ago (Chart 8). Chart 7Core Inflation Outside Housing Is Still Low Chart 8Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Just as importantly, the implosion of volatility funds is unlikely to reverberate across the financial system in the same way as it did during the financial crisis. What made the mortgage crisis so toxic was that the losses were concentrated in the books of highly leveraged financial institutions. In the case of volatility funds, that does not appear to be the case. Investment Implications Global bond yields remain quite low by historic standards and this should continue to support stocks. Indeed, even after the recent bond sell-off, average global bond yields are still close to half of what they were in 2011 - a time when global excess capacity was much greater than it is today (Chart 9). In keeping with our structurally bearish view on bonds, which we first articulated on July 5, 2016 in a note entitled "The End of 35-Year Bond Bull Market," we expect global bond yields to grind higher.4 However, in rate-of-change terms, the swift repricing of yields over the past few months has likely run its course. Chart 10 shows that market expectations of where the funds rate will be at the end of 2018 and 2019 have almost converged with the Fed dots. This convergence helped our short December-2018 fed funds futures trade, which we closed at our stop for a gain of 70 bps last Friday. A sustained move above 3% on the 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we do expect core inflation to move above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this is likely to be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of recessions (Table 1). If the next recession occurs in late 2019, as we expect, the equity bull market could last a while longer. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Chart 9Yields Are Still Low By Historic Standards Chart 10Market Pricing Has Almost Caught Up To The Fed's Dots Table 1Too Soon To Get Out Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Please see Global Investment Strategy Weekly Report, "Will Bitcoin Be DeFANGed?" dated January 12, 2018. 3 Please see The Bank Credit Analyst, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017. 4 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Global Bond Rout: Overheated financial markets are going through a much needed correction with higher bond yields being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however. Monetary policy settings remain accommodative in almost all major economies, while global growth momentum is showing no signs of slowing. The current turbulence is an early indication of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. Fixed Income Strategy: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Feature Risk assets worldwide are finally correcting after the relentless run-up seen in January, with the trigger being the steady rise in global bond yields seen since the beginning of the year. The big decline in U.S. equity markets, particularly after the release of last Friday's U.S. employment data which featured the highest year-over-year growth rate in wages seen in almost a decade, suggests that investors are growing increasingly worried about accelerating inflation and a more aggressive tightening response from central banks (NOTE: markets were undergoing another bout of selling yesterday as this publication went to press, but the conclusions reached in this report are unchanged). Chart of the WeekThe Cyclical Rise In Yields##BR##Has Room To Run However, taking a step back to look at the big picture, nothing has really changed in the past few days. Global growth remains strong, which has already steadily increased pressure on policymakers to raise interest rates according to our own BCA Central Bank Monitors (Chart of the Week). In the U.S. - the epicenter of the latest bout of market angst - financial conditions remain highly accommodative and supportive for future growth, while bond volatility remains low by historical standards even after the most recent upward blip. Credit spreads and equity valuations in non-U.S. markets, from Europe to the emerging world, are also no impediment to future growth in those regions. We have been expecting global bond yields to rise in 2018 as markets adjust to both a normalization of global inflation expectations and a shift to a less aggressive pace of bond buying by the Fed, European Central Bank (ECB) and Bank of Japan (BoJ). As we described in our 2018 Outlook report published last December:1 The current low volatility regime will end when higher inflation and less accommodative central banks raise interest rate volatility and, eventually, future growth uncertainty. We see that inflection point occurring sometime next year, leading to a more challenging environment for global fixed income "carry trades" that are also focused on global growth, like developed market corporate bonds and emerging market debt. The current market sell-off is likely too soon to be the ultimate realization of that forecast. Monetary policy settings remain accommodative and inflation is still below central bank targets in almost all major economies, while global growth momentum is showing no signs of slowing. This is an early indication, however, of how the investment backdrop will become much more challenging later in 2018 as global inflation continues to rise. We continue to recommend a pro-growth fixed income investment strategy, staying below-benchmark overall duration, focusing on lower-beta government bond markets, overweighting corporate debt over sovereign debt, and prioritizing inflation protection in bond portfolios. In the coming weeks, however, we will begin to discuss strategies to play for the shift to a more hostile investment backdrop that we expect later in 2018. The U.S. Bond Vigilantes Are Back In Charge Global monetary policies that remain "too" accommodative given robust growth and some pickup in realized inflation have prompted bond markets to reprice, through both higher inflation expectations and real yields. Rising yields have triggered a spike in market volatility measures like the U.S. VIX index, although there were also several bouts of higher volatility in 2017 (Chart 2). Growth-sensitive financial assets shrugged off those higher volatility episodes, mainly because growth expectations were not impacted. We see no reason why this current bout of market turbulence should differ from last year's volatility spikes, and have any meaningful impact on forecasts for future economic growth (and, by extension, corporate profits). At least, not without a more meaningful tightening of global monetary policy, particularly in the U.S. where inflation pressures are gaining steam. The December Payrolls report released last week may finally contain that missing piece of the inflation puzzle - faster wage growth. Headline Average Hourly Earnings expanded 2.9% on a year-over-year basis, with the 3-month annualized growth rate surging to pre-crisis levels above 4% (Chart 3). Coming at a time when the U.S. labor market remains tight by any measure (top panel), a pickup in wage growth supports the other evidence indicating that U.S. inflation is on the upswing, like the modest acceleration in core PCE inflation (3rd panel) and steady climb in TIPS breakevens (bottom panel).2 Chart 2This Is A Correction,##BR##Not A Reversal, In Risk Assets Chart 3U.S. Wage Inflation##BR##Finally Appears A faster inflation backdrop is making the Fed's current monetary policy plans more credible for investors. The U.S. Overnight Index Swap (OIS) curve is now fully pricing in the Fed's three planned interest rate hikes for 2018, and has almost priced in the additional 50bps of hikes the Fed is projecting for 2019 (Chart 4). Rate expectations even further out the curve have been climbing, as well. Our measure of the market's expectation for the so-called "terminal rate" - the 5-year U.S. OIS rate, 5-years forward - is now up to 2.66%, only 9bps below the current median projection ("dot") for the terminal rate. Markets have been highly skeptical that the Fed would ever be able to raise rates as high as its projections in recent years - justifiably so, given that U.S. realized inflation has been persistently falling short of the Fed's 2% inflation target. Now, with core inflation having clearly bottomed out and shorter annualized rates of change closing in on 2%, markets are coming around to the idea that the Fed inflation forecasts will be realized. If that happens, then the Fed should be expected to follow through on its published projections, not only for 2018 but for the remainder of the current tightening cycle. On that basis, there is not a lot more room for the market's pricing of the expected path of U.S. interest rates to converge to the Fed's projections. That suggests that the shorter-end of the U.S. Treasury curve may be approaching a cyclical peak - unless the Fed were to begin revising up its "dots" in response to a faster pace of U.S. economic growth and inflation. That would require the Fed to start believing that a faster pace of rate hikes, or a higher equilibrium real interest rate, was required in the U.S. The current real interest rate remains around 0% (subtracting core PCE inflation from the fed funds rate), as the Fed's rate hikes since beginning the tightening cycle in December 2015 have matched the increase in realized inflation. Measures of the so-called "r-star" equilibrium rate, like the Williams-Laubach measure, are also indicating that the real fed funds rate should be around 0% (Chart 5). The real fed funds rate has historically been highly correlated to the employment/population ratio in the U.S., and the current level of that ratio (60%) suggests that the Fed does not have to target a real funds rate above 0%. The conclusion is that it would take a sign of even greater U.S. labor market utilization - i.e. a rising employment/population ratio - for the Fed to conclude that it must raise its interest rate projections. Chart 4Market Pricing Has Caught Up##BR##To The Fed's Forecasts Chart 5A 0% Real Fed Funds Rate##BR##Is Still Appropriate Without such a boost to the Fed's expected path of interest rates, any remaining increases in U.S. Treasury yields will have to come from higher inflation expectations. On that front, the current level of the 10-year TIPS breakeven at 2.14% remains 30-40bps below the 2.4-2.5% range that is consistent with the Fed's 2% inflation target (adjusting for the typical gap between CPI and PCE inflation and allowing for a small inflation risk premium). That suggests that the 10-year nominal Treasury yield can rise to the 3.10-3.25% range to fully discount a sustainable return of inflation to the Fed's target, with the Fed delivering on its interest rate projections in response. That target range is also not far from the current fair value from our 2-factor 10-year U.S. Treasury yield model, which has risen to 3.01% (Chart 6).3 It will be critical to watch the future behavior of the parts of the U.S. economy that are most sensitive to interest rates, like consumer durables and housing, for signs that the latest rise in U.S. bond yields is having any negative effect on U.S. growth. A slowing trajectory for U.S. growth in response to higher interest rates would certainly give the Fed some second thoughts on moving ahead with its rate hike plans. On that note, the year-over-year change in the 10-year Treasury yield is now in positive territory, which has typically led to a slower contribution to U.S. real GDP growth from consumer durables (Chart 7, top panel). The rise in U.S. mortgage rates should also lead to slower growth in residential investment, although housing has already been providing very little marginal contribution to U.S. growth over the past two years (2nd panel). Chart 6Fair Value On The 10-Year##BR##UST Yield Is 3%...And Rising Chart 7Rising U.S. Capex Should Offset##BR##Slowing Interest-Sensitive Spending The potential offset to any slowdown in interest-sensitive spending, however, is capital spending by businesses, which is being boosted by easy financial conditions (bottom panel), loosening bank lending standards and a rise on the expected after-tax return on investment following the Trump corporate tax cuts. It will likely take higher interest rates, and much tighter financial conditions, before the capex cycle peaks out. Bottom Line: Overheated financial markets are going through a much needed correction, with higher bond yields, most notably in the U.S., being the immediate trigger. The cyclical rise in global bond yields is not yet complete, however, and monetary policies will need to tighten further in response to strong growth and rising inflation pressures. The cyclical interest rate tipping point for risk assets has not yet been reached, even in the U.S., but is getting incrementally closer. Don't Forget The Other Factor Driving Global Bond Yields - Reduced Central Bank Buying Amidst all the worries about higher inflation and the related impact on global bond yields, it should not be forgotten that the major developed market central banks have been cutting back on their bond purchases. Global bond yields have been correlated to the growth rate of the combined balance sheet of the "G-4" central banks (Fed, ECB, BoJ and Bank of England) since the ECB started its bond buying program in 2015 (Chart 8). The current rise in global yields has been in line with the projected slower pace of aggregate bond buying by those central banks. Based on our projection for the year-over-year growth rate of the G-4 central bank balance sheets - which incorporate the Fed letting maturing bonds run off its balance sheet and cutbacks in the pace of buying of new bonds by the ECB and BoJ - there is still more room for bond yields to rise over the course of 2018. A slower pace of central bank "liquidity" creation is something that we anticipated to weigh on risk asset returns in 2018. By driving down the yields on safe assets like government debt to highly unattractive levels, central banks induced huge inflows into global equity and credit markets, both in the developed and emerging worlds. As central banks are now buying fewer bonds, however, there is not only reduced downward pressure on government bond yields but also diminished scope for additional inflows into riskier assets. Looking at the growth rate of the G-4 central bank balance sheet versus the rolling 12-month returns on global equities and credit, the current pullback in overheated risk assets is merely bringing returns back down to levels consistent with central banks taking their foot off the monetary accelerator (Chart 9). Chart 8The Central Bank Impact On##BR##Bond Yields Is Slowly Unwinding... Chart 9...Which Impacts Risk Asset##BR##Returns, As Well For global fixed income markets, we had anticipated that 2018 would be a year of much lower expected returns on spread product like global corporate debt, although those would still beat the returns likely from government debt - at least until government bond yields reached our cyclical targets. Our view has not changed, even in light of the current pullback in risk assets and yesterday's decline in government bond yields. For now, we continue to recommend an overweight stance on global corporate debt, but favoring U.S. Investment Grade and High-Yield debt over European equivalents (and over Emerging Market hard currency debt). We will discuss our eventual recommended exit strategy in upcoming reports, but for now, our advice is to sit tight and ride out this current bout of market turbulence. Bottom Line: Returns on global spread product are still expected to beat those on sovereign debt in the coming months, particularly after the latest market correction restored some value through spread widening. There is no sign yet that the sell-off is damaging future global growth expectations that can stall the move to less accommodative monetary policy. Maintain an overall below-benchmark duration stance, favoring corporate credit over sovereign debt - especially in the U.S. - for now. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th, 2017, available at gfis.bcaresearch.com. 2 It is interesting to note that it took a sharp pickup in the Average Hourly Earnings measure to get the market's attention about wage inflation. Many Fed officials and market commentators (including here at BCA!) have consistently pointed out the inherent flaws in looking at Average Hourly Earnings as an accurate measure of wage pressures in the U.S. Yet the big market response to the latest surge in Average Hourly Earnings is a sign that investors still look at that indicator as the "true" measure of wage inflation. 3 The standard deviation of the fair value estimate from that model is 17bps, which means that yields could rise as high as 3.18% before reaching an "undervalued" level for U.S. Treasuries - assuming no further increases in fair value, of course. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, In light of recent market turbulence, we are publishing our weekly report earlier than usual. Caroline Miller, Garry Evans, and I will also be hosting a webcast Wednesday morning at 10am EST to discuss the investment outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Monday's stock market rout was largely driven by technical factors. Strong economic growth and positive earnings surprises should keep the equity bull market intact. Nevertheless, investors need to adjust to the fact that volatility is likely to pick up, just as it did in the last few years of the 1990s bull market. The market's expectations of where the funds rate will be over the next two years have almost converged with the Fed dots. In the near term, this will limit the ability of the 10-year Treasury yield to rise much above 3%. Looking further out, inflation is likely to move above the Fed's target early next year, setting the stage for a recession starting in late 2019. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Feature VIX Kicks Last week's Global Investment Strategy report, entitled "Take Out Some Insurance," argued that equities had become dangerously overbought and were highly vulnerable to a correction.1 We noted that the VIX had likely bottomed for the cycle and that going long volatility had now become an attractive hedge against stock market declines. As many of my colleagues have noted, betting on continued low volatility had become an increasingly crowded trade in recent years. Back in January, we observed that net short volatility positions had reached record-high levels (Chart 1). We warned that "traders have been able to reap huge gains over the past few years by betting volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility."2 Precisely such a vicious cycle erupted on Monday, causing the S&P 500 to suffer its worst daily percentage loss since August 18, 2011. The question is where do we go from here? So far, the sell-off in stocks looks largely technical in nature. Chart 2 shows that the VIX soared by roughly four times more on Monday than one would have expected based solely on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction of other "risk gauges" such as junk bonds, EM stocks, and gold prices over the past few days is consistent with this thesis. Chart 1Volatility Is Back Chart 2Monday's VIX Spike Was Abnormally Large Cyclical Outlook Still Solid It is impossible to know if today's rebound will persist or if the correction still has further to run. What we do know is that the cyclical underpinnings for the bull market remain intact. Leading economic data remain buoyant (Chart 3). Corporate earnings continue to come in above expectations (Chart 4). Chart 3Global Economic Backdrop Remains Buoyant Chart 4Optimism Over 2018 Earnings Growth None of our recession-timing indicators are flashing red (Chart 5). The Conference Board's LEI is rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator. Likewise, while the U.S. 2/10-year Treasury curve has flattened, it has not inverted yet. Moreover, even once the yield curve inverts, the lags can be quite long before the recession begins. For example, in the last cycle, the yield curve inverted in early 2006, but the recession did not begin until December 2007. This does not mean that everything will be smooth sailing from here. Monday's sell-off marked an inflection point in the low-volatility world that has prevailed over the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Going forward, volatility will remain elevated relative to what investors have come to expect. As the experience of the 1990s shows, stocks can still go up when volatility is trending higher (Chart 6), but this is going to make for a much more challenging investment environment. Chart 5No Signs Of An Imminent End To This Business Cycle Chart 6Volatility Can Increase As Stock Prices Rise The Powell Put? How the Fed and other central banks react to this new world will be critical. It is perhaps not a complete coincidence that Monday's crash occurred on the first day that Jay Powell took over the helm of the Fed. Investors are increasingly worried that the Fed will turn from friend to foe. The faster-than-expected increase in average hourly earnings in January put those fears in stark relief. Accelerating wage growth suggests supply-side constraints are beginning to bite. This, in turn, means that the runway for low inflation and easy monetary policy may not be as long as some had hoped. As BCA editors discussed in our 2018 Outlook, "Policy And The Markets: On A Collision Course," central banks are in the process of winding down the extraordinary stimulus that investors have gotten used to.3 Whether this undermines the case for holding stocks and other risk assets depends on how quickly the adjustment occurs. On the plus side, we continue to think the adjustment will be fairly gradual, at least for the time being. Core CPI inflation outside of shelter is still running at 0.7% (Chart 7). This gives the Fed plenty of wiggle room. Just like Janet Yellen, Jay Powell will seek to build a consensus among his colleagues. Granted, the composition of the FOMC is likely to shift in a somewhat more hawkish direction. However, the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important, and often underappreciated, source of continuity. As in the past, the Fed will continue to monitor incoming economic and financial data and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. and most other countries remain more expansionary than they were six months ago (Chart 8). Chart 7Core Inflation Outside Housing Is Still Low Chart 8Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Just as importantly, the implosion of volatility funds is unlikely to reverberate across the financial system in the same way as it did during the financial crisis. What made the mortgage crisis so toxic was that the losses were concentrated in the books of highly leveraged financial institutions. In the case of volatility funds, that does not appear to be the case. Investment Implications Global bond yields remain quite low by historic standards and this should continue to support stocks. Indeed, even after the recent bond sell-off, average global bond yields are still close to half of what they were in 2011 - a time when global excess capacity was much greater than it is today (Chart 9). In keeping with our structurally bearish view on bonds, which we first articulated on July 5, 2016 in a note entitled "The End of 35-Year Bond Bull Market," we expect global bond yields to grind higher.4 However, in rate-of-change terms, the swift repricing of yields over the past few months has likely run its course. Chart 10 shows that market expectations of where the funds rate will be at the end of 2018 and 2019 have almost converged with the Fed dots. This convergence helped our short December-2018 fed funds futures trade, which we closed at our stop for a gain of 70 bps last Friday. A sustained move above 3% on the 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we do expect core inflation to move above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this is likely to be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of recessions (Table 1). If the next recession occurs in late 2019, as we expect, the equity bull market could last a while longer. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Chart 9Yields Are Still Low By Historic Standards Chart 10Market Pricing Has Almost Caught Up To The Fed's Dots Table 1Too Soon To Get Out Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Please see Global Investment Strategy Weekly Report, "Will Bitcoin Be DeFANGed?" dated January 12, 2018. 3 Please see The Bank Credit Analyst, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017. 4 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016. Strategy & Market Trends* Tactical Trades Strategic Recommendations Trades Closed In 2015-2018