Monetary

Highlights Reflation Trade: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. New Zealand: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean government bond market. Feature "I know it makes no difference to what you're going through; but I see the tip of the iceberg, and I worry about you." - Rush Is The Liquidity Party Starting To Wind Down? Global financial markets continue to enjoy the "sweet spot" of a solidly expanding global economy, but without enough inflation pressure to force central banks to slam on the monetary brakes. That backdrop is starting to change, though. Odds are rising that the European Central Bank (ECB) will begin tapering its bond buying next year, with some hints of that possibly being announced as soon as next week's monetary policy meeting. At the same time, the Bank of Japan (BoJ) - faced with the operational constraints of buying an ever-increasing share of Japanese financial assets - is focused on targeting long-term interest rates rather than increasing liquidity. Even the Federal Reserve is now talking about reducing its massive balance sheet later this year. The liquidity tailwind to global growth and risk assets is now at risk of becoming a headwind. Already, the growth rate of the major central bank balance sheets has rolled over and is on course to decelerate further over the next year (Chart of the Week). Importantly, this downshift in global liquidity momentum is happening as signs of slowing growth have appeared in some major economies like China and the U.S. (Chart 2). Chart of the WeekLiquidity Tailwind To Risk##BR##Assets Is Fading Chart 2Growth Momentum##BR##Already Starting To Cool Off We remain concerned that the Chinese economy will see a policy-induced deceleration in the 2nd half of the year. However, we still expect the U.S. to rebound after the soft patch of growth in the first quarter, and we see nothing in the Euro Area data to suggest that the current solid expansion is at risk of fading quickly. This should allow inflation expectations to drift upward toward the central bank targets given the apparent lack of spare capacity on both sides of the Atlantic (Chart 3). Chart 3Fed & ECB Facing##BR##Economic Capacity Constraints We still expect the Fed to deliver another two rate hikes before year-end and the ECB to begin its exit strategy from the current extraordinary monetary policies by slowing the pace of asset purchases starting early next year. For now, the backdrop will remain supportive for the outperformance of growth-sensitive assets like corporate credit and equities over government bonds in the U.S. and Europe over the balance of 2017. However, the early signals sent by "leading leading" indicators such as our Global Leading Economic Indicator diffusion index (Chart 2, top panel) suggests that liquidity and growth trends will become far more challenging for the markets in 2018. Bottom Line: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. Maintain a below-benchmark duration exposure and an overweight allocation to corporate debt in global fixed income portfolios. New Zealand: Safety From A Global Bond Apocalypse? A growing number of the world's most wealthiest (and, arguably, most paranoid) people are reportedly buying real estate in New Zealand as a safe haven place to live if modern civilization collapses.1 While the immediate need for taking such precautions can be debated, there is sound logic in treating New Zealand as a location far removed from the current geopolitical and socio-economic problems of the world. We now see a case for treating New Zealand bonds as a potential "safe haven" market for global fixed income investors. The Economic Backdrop Has Become More Muddled We have been running a SHORT position in New Zealand (paying 12-month OIS rates) in our Tactical Overlay portfolio since last November. Our view then was that the New Zealand economy would surprise to the upside in 2017 and inflation was likely to start drifting upward. This would pressure the Reserve Bank of New Zealand (RBNZ) to raise the Official Cash Rate (OCR) from the highly accommodative level of 1.75%. So far, that expectation has not panned out as the RBNZ has held rates steady amid a more uncertain outlook for the New Zealand economy. Growth indicators have been a bit mixed over the past few months, but the current uptick in the manufacturing purchasing managers' index (PMI) is pointing to real GDP expanding around 3% on a year-over-year basis (Chart 4). If maintained for the full year, this would be slightly above the RBNZ's estimate of potential growth at 2.8%. There are some downside risks, however, given that consumer and business confidence are both below previous cyclical peaks and fiscal policy is expected to be mildly restrictive in 2017 (bottom three panels). The housing market remains a key cyclical wild card. Residential construction has been a significant source of growth over the past few years, driven by a surge in net immigration into New Zealand and declining interest rates (Chart 5). However, the RBNZ is projecting immigration inflows to slow from the current high level, largely due to improving labor market conditions in the developed economies (most notably, Australia, which is the largest source of New Zealand immigrants). Chart 4Stable NZ Growth...For Now Chart 5NZ Housing Activity Starting To Peak Out Slower immigration would reduce the demand for New Zealand housing at a time when mortgage rates have already been rising off the record lows seen in 2016 (bottom panel). This has occurred without any rate hikes from the RBNZ, as rising global bond yields have put upward pressure on New Zealand bank funding costs, which have been passed through to higher mortgage rates. The RBNZ is currently projecting growth in house prices to slow sharply from last year's robust 15% pace to just 5% in 2017. The main drivers are higher borrowing costs and the ongoing impact of macro-prudential regulations against high loan-to-value ratio mortgage lending. Importantly, slower housing activity will not only have a direct impact on GDP growth through softer construction, but will also indirectly dampen consumer spending growth via wealth effects. Yet even with this expected drag on growth from housing, the New Zealand economy is still expected to face capacity constraints over the rest of the year. Higher Uncertainty Over Price Pressures Both the RBNZ and the International Monetary Fund estimate that the output gap has fully closed and is projected to move into positive territory this year (Chart 6). At the same time, the current unemployment rate of 4.9% is below the OECD's estimate of the full employment level and the RBNZ projects a further decline in joblessness in 2017 (third panel). Despite this evidence of the economy reaching capacity constraints, both wage growth and price inflation remain subdued and inflation expectations remain well-anchored around 2% - the midpoint of the RBNZ's 1-3% target range. Wage costs are particularly depressed, growing only 1% on a year-over-year basis in Q1. This may be related to the rise in the labor force participation rate - up to an all-time high of 70.6% in Q1 from a cyclical low of 68.2% at the end of 2015 - that has increased the available supply of labor. The most recent headline inflation print for Q1 was quite strong, taking the year-over-year growth rate up to 2.2%. Yet in the RBNZ's April Monetary Policy Statement (MPS), the central bank took a surprisingly dovish tone, citing uncertainty over the true degree of slack in the economy and downside risks to growth that would prevent a further acceleration of inflation.2 The RBNZ now forecasts inflation to not rise above 2.2% this year and to fall back to 1.1% in both 2018, led by a sharp decline in growth for tradeables, mostly energy and food inflation (Chart 7). Importantly, this forecast includes the recent decline in the trade-weighted New Zealand Dollar (NZD). Non-tradeables inflation is also expected to stabilize on the back of slower housing-related items in the consumer price index. Chart 6RBNZ Not Expecting A Big Rise In Inflation... Chart 7...As Growth In Tradeables Prices Cools A Weaker Case For Tighter Monetary Policy The official RBNZ projection is that the OCR will stay unchanged at 1.75% until September 2019. The market expectation priced into the NZD OIS curve calls for 27bps of hikes over the next twelve months (Chart 8). Our New Zealand Central Bank Monitor has been suggesting the need for tighter monetary policy since mid-2016, but appears to be rolling over (2nd panel). The diminished rate hike expectations have coincided with a decline in the NZD and a sharp underperformance of New Zealand equities. The markets are giving a consistent signal on softening growth prospects in New Zealand, confirming the central bank's more recent dovish turn. Chart 8Market Expectations Of##BR##RBNZ Hikes Are Fading Given the newfound uncertainties over the New Zealand growth and inflation outlook, the case for owning New Zealand interest rate exposure has grown a little bit stronger. Admittedly, we do not envision a major pullback in growth, and inflation may not fall by as much as the RBNZ is expecting given how little spare capacity there appears to be in the economy. Yet there is now just enough uncertainty to keep the central bank on hold for longer than expected, as was noted in the "scenario analysis" section of the April MPS.3 The RBNZ noted that if the level of spare capacity is smaller than currently assumed, then the latest growth forecast will result in inflation eventually moving to 2.0% in 2018 and 2.3% in 2019, resulting in the OCR needing to rise to 2.25% in two years. Alternatively, if housing demand slows even faster than current projections, inflation would be below the 2% target during the next two years and the OCR would need to fall to 1.25% by the end of 2018. Our takeaway from this is that, even in the more positive scenario, interest rates are not expected to rise by much more than the markets are currently discounting. Position For Tighter New Zealand Spreads Versus Treasuries & Bunds The economic risks in New Zealand now appear evenly balanced. This argues for stable monetary policy and diminished bond volatility. Current market forwards for both government bonds and NZD swaps shows that very little movement in interest rates is expected over the next year (Chart 9). We generally agree with this pricing, although the uncertainty over the degree of spare capacity, and underlying inflation pressures, make a directional view on interest rates or the shape of the yield curve an unattractive risk proposition. A more interesting opportunity presents itself in looking at spread trades between New Zealand government bonds versus other developed market sovereign debt. The yield betas for New Zealand versus the U.S. and Germany have fallen steadily over the past year (Chart 10), indicating that New Zealand bonds can be more insulated from the rise in yields that we expect for U.S. Treasuries and German Bunds over the latter half of 2017. Given the competitively high yields on offer in New Zealand, even on a currency-hedged basis (bottom panel), we see a case for going long New Zealand interest rate exposure versus U.S. and Germany. Chart 9Higher NZ Bond Yields##BR##Priced Into Forwards Chart 10NZ Bonds: Now Lower Beta##BR##With Higher Hedged Yields At current yield levels, going long New Zealand versus Germany looks more compelling relative to spread compression trades versus U.S. Treasuries. We see strong potential for New Zealand-Germany spreads to tighten faster than the forwards over the next six months (Chart 11), largely through rising German yields as the ECB signals that a tapering of bond purchases is set to begin next year. The downside potential for New Zealand-U.S. spread compression looks less likely from current tight levels, although if Treasury yields rise by as much as we expect in the coming months, some spread tightening should occur here, as well. Chart 11Go Long 5Yr NZ Bonds Vs##BR##USTs and German OBLs Based on our analysis, we are closing our current NZD rates trade in our Tactical Overlay portfolio with a tiny profit of +3bps , and entering two new trades: long 5-year NZD government bonds versus 5-year U.S. Treasuries, on a currency-hedged basis; and long 5yr NZD government bonds versus 5-year German government debt, on a currency-unhedged basis.4 We are choosing to hedge the currency exposure back into USD for the former given the view of BCA's currency strategists that the EUR/USD exchange rate is now stretched too far to the upside and is at risk of declining as the Fed delivers on additional rate hikes in the coming months.5 In other words, we see a greater potential for a decline in NZD/USD than NZD/EUR in the next 3-6 months. Bottom Line: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation, in contrast to the strong likelihood of additional Fed rate hikes and an ECB taper announcement in the next few months. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: A Bad Moon Rising For Bond Yields Chart 12Markets Not Worried##BR##About The New President The new South Korean president, Moon Jae-In was elected on May 9th, ending a year of political turmoil after the previous president's scandal and impeachment. Our colleagues at BCA Geopolitical Strategy view Moon and his Democratic Party as a major shift to the political left.6 The new president's policy agenda is aimed at economic stimulus for the working class alongside reforms of the country's chaebol industrial giants. Korean financial markets have greeted the election result positively, with the benchmark KOSPI equity index up 2.7%, and the Korean won up 1% versus the U.S. dollar, from the pre-election levels on May 8th. (Chart 12). This is consistent with past market behavior, as the won tends to be less reactive toward domestic events (i.e. after the previous president's impeachment, the won actually strengthened) and more sensitive to international uncertainties (i.e. North Korea-U.S. military tensions, as occurred in mid-March). Korean interest rates, however, have shown little response to the change in leadership in Seoul, with bond yields unchanged since the election. We see this as presenting an opportunity for fixed income investors. Clearly, the new regime in Seoul represents a real change for the Korean people, but it also represents a potential shift in the economic backdrop - namely, through an expected large fiscal stimulus from the new government - that will impart a steepening bias to the Korean interest rate curve. A Sluggish Economy Greets The New President While the steady, if unspectacular, pace of global growth in the past few years has been enough to absorb spare capacity in many countries, South Korea's sub-par economic performance has left the country with a widening output gap (Chart 13). Policymakers are well aware that consumer spending, which contributes about 60% of GDP, has been steadily weakening alongside slowing credit growth. Chart 13Sluggish Growth In South Korea The new government will attempt to boost domestic consumption, and thus overall growth, by increasing social welfare spending. Moon's economic agenda calls for raising the minimum wage by 55% by 2020, increasing subsidies for education costs and parental leave, and doubling the basic pension payment for the elderly regardless of their income level. It might prove to be very effective in the short term at boosting consumer spending, but this may not prove to be a sustainable driver of growth in South Korea, where the marginal swings in the economy have historically been driven more by exports. Youth joblessness is another problem that Moon will attempt to tackle with his ambitious economic program. While the labor market may appear healthy, with an overall unemployment rate of only 3.7%, the situation is far more challenging for young adults in South Korea - the jobless rate for those aged 20-29 is 11.3%. One of the reasons for such a high unemployment rate among young South Koreans is that university graduates, of which there are many in this highly-educated nation, expect (and look for) high-paying jobs, but cannot find enough of them.7 The labor market has become more competitive in recent years as weak economic growth has limited the ability of private sector, especially large corporations, to hire as much. To solve this problem, the new government has promised to create 810,000 jobs in the public sector. Creating public sector jobs may temporarily solve the high unemployment rate, but in the long run, this will also cause larger fiscal burdens for taxpayers. Position For A Steeper South Korean Yield Curve Headline CPI inflation in South Korea is currently hovering around the 2% target of the Bank of Korea (BoK), while core CPI growth is lower at 1.3%. The BoK has maintain the policy rate at 1.25% since June 2016, with a bias towards additional easing given the lack of sustained inflationary pressure amid weak domestic demand. The BoK did sound a slightly more upbeat tone on the economy at last week's monetary policy meeting, led by the spillover effects from improving global growth rather than a more bullish expectation on the Korean consumer. Importantly, the central bank still expects inflation pressures to remain subdued - no surprise given the large output gap. The BoK did note that it is monitoring several factors in judging future policy decisions: the pace of rate hikes by the Fed, trends in global trade, geopolitical tensions, the pace of household debt accumulation and "the directions of the new government's fiscal policies." The latter may end up being the most important factor, as President Moon is proposing an increase in government spending equal to 0.7% of GDP - an amount equal to ½ of the estimated output gap coming after a 2016 budget surplus of 1% of GDP. This increase in fiscal spending could directly drive up the longer-end of Korean yield curve, as this would result in a narrower budget surpluses and greater KGB issuance. At the same time, the lack of domestic inflation pressures, even with the fiscal stimulus, will keep the BoK on an easing bias that will keep short dated yields well anchored. Therefore, we see the potential for the Korean yield curve to eventually steepen and break the downward-sloping trendline in place since 2014 (Chart 14). We recommend positioning for this move by entering a 2-year/10-year steepening trade in the Korean yield curve. Admittedly, this trade is more structural than tactical in nature, as the Moon stimulus policies will take time to unfold. Importantly, a flattening of the 2-year/10-year KGB curve is currently priced into the forwards, meaning that positioning now for a steepener does not incur negative carry (Chart 15). Chart 14More Fiscal Stimulus =##BR##Steeper Korea Curve Chart 15Enter A 2Yr/10Yr##BR##Korean Bond Curve Steepener Also, Korean 10-year bond yields are currently exhibiting a strong correlation to similar maturity U.S. Treasuries with a yield beta around 1.0 (bottom panel). Given our view that longer-dated U.S. yields have upside risk from both additional Fed rate increases and higher U.S. inflation expectations, that high yield beta suggests that the Korean yield curve could suffer some of the same cyclical bear-steepening pressures that we expect for U.S. Treasuries in the next 3-6 months. Bottom Line: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end curve of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean bond curve. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 https://www.theguardian.com/technology/2017/jan/29/silicon-valley-new-zealand-apocalypse-escape 2 The central bank noted that its "suite" of output gap estimates, using varying methodologies, have an unusually wide range at the moment between -1.5% and +2%. 3 http://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement 4 These trades can be done using interest rate swaps as well (receiving NZD rates vs paying USD & EUR rates), as swap spreads are expected to remain broadly stable in all three regions. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Bloody Potomac", dated May 19 2017, available at fes.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 According to the OECD, Korea's college enrollment rate was a whopping 87% as recently as 2014. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Monetary Policy: The Fed will deliver two rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet. The market is only priced for 36 bps of rate hikes this year. Maintain below-benchmark duration. Economy: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. Inflation: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome. Financial Conditions: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Feature The market-implied probability of a June rate hike jumped sharply during the past two weeks (Chart 1), and stood at 81% as of last Friday's close. In all likelihood the fourth rate hike of the cycle, and the third in the past six months, will occur at the next FOMC meeting on June 14. In our view, the Fed will deliver two 25 basis point rate hikes between now and the end of the year and will also begin the process of winding down its balance sheet (see Box). With the market only priced for 36 bps of rate hikes during that timeframe, we continue to advocate a below-benchmark duration stance. Chart 1Still On For June The minutes from the May FOMC meeting, released last week, suggest that most Fed policymakers still maintain a forecast for two more hikes this year. The minutes also provide some useful insight about how FOMC participants think about the economy and what developments could cause their forecasts to change. This week we take a look at what the Fed believes, and consider whether those beliefs are well founded. Box Balance Sheet Strategy Revealed We wrote about the potential impact of the Fed’s balance sheet policy in last week’s report (please see U.S. Bond Strategy Weekly Report, “Two Challenges For U.S. Policymakers”, dated May 23, 2017, available at usbs.bcaresearch.com), but provide a brief update this week because of new information gained from the May FOMC minutes. Previously, it was unknown whether the Fed would cease the reinvestment of its securities holdings all at once, or whether it would “taper” the reinvestment by gradually increasing the amount of securities it allowed to run off. We now know that “nearly all policymakers expressed a favorable view” of a tapering strategy where the Fed will set a series of gradually increasing caps on the total amount of securities it allows to run off its balance sheet. The plan calls for the caps to be raised every three months, according to a schedule that will be set in advance. The only reason for this plan to not function smoothly would be if market participants start to view the reinvestment caps as an additional policy tool that the Fed will vary according to economic conditions. This would risk taking the focus off the fed funds rate as the main policy tool, and would make it difficult for the market to interpret the overall stance of monetary policy. The minutes show that the Fed plans to avoid this messy outcome by setting a fixed schedule for changing the reinvestment caps. If the market believes that the Fed will stick to this schedule, then the plan should work fine. The May minutes also showed that “nearly all policymakers” thought that it would be appropriate to begin the reinvestment process this year, as long as economic conditions do not deteriorate. While we still lack some important details, such as the Fed’s target for the ultimate level of reserves in the banking system, we now think it is very likely that these details will emerge at either the June or September FOMC meeting and that balance sheet run off will begin following either the September or December meeting. What The Fed Believes: Weak Q1 Growth Is Transitory Although the incoming data showed that aggregate spending in the first quarter had been weaker than participants had expected, they viewed the slowing as likely to be transitory.1 Even after last week's slight upward revision, at 1.2%, first quarter GDP growth came in well below its post-crisis average (Chart 2). However, a quick look at the major components of GDP reveals that the weakness was concentrated in consumer spending and the change in private inventories (Chart 2, bottom two panels). Growth contributions from residential and non-residential investment were actually considerably above their post-crisis averages, and the contributions from net exports and government spending were in-line with theirs (Chart 3). Chart 2The Consumer Was A Drag In Q1 Chart 3Investment Is A Bright Spot We know from history that large changes in inventories tend to mean-revert fairly quickly. In fact, we can model the inventory component of GDP growth based on the lagged change in inventories and the Backlog of Orders component of the ISM Manufacturing survey (Chart 4). Both of these factors suggest that inventories will bounce back strongly next quarter. In fact, the ISM survey shows the largest backlog of manufacturing orders since 2014. Likewise, weakness in consumer spending is unlikely to persist. The fundamental drivers of consumer spending all continue to paint a positive picture (Chart 5). Chart 4Big Backlog Of Orders Chart 5Consumer Spending Drivers: Part I Consumer confidence has hardly given back any of its post-election gains (Chart 5, panel 1). Personal income growth is already on the upswing, and income expectations point to further acceleration (Chart 5, panel 2). Employment is still growing at a reasonably robust pace, and the mild slowdown since early 2015 has been offset by stronger wage growth (Chart 5, bottom panel). Longer-run drivers of consumer spending are also solid. Households continue to accumulate wealth, and household leverage has returned to late 1990s levels. In other words, household balance sheets are the healthiest they have been since prior to the housing bubble (Chart 6). More broadly, indicators of overall GDP growth are also pointing toward an acceleration (Chart 7). The ISM Non-Manufacturing index increased to 57.5 in April from 55.2 in March, and the BCA Beige Book Monitor - an indicator based on the occurrence of certain keywords in the Fed's Beige Book2 - has gone vertical. It would be unusual for GDP growth to diverge from these two indicators for a prolonged period of time. Chart 6Consumer Spending Drivers: Part II Chart 7Overall Growth Indicators Bottom Line: Weakness in Q1 GDP was concentrated in consumer spending and inventories. Both of these components are likely to strengthen in the months ahead. The Fed is probably correct that weak Q1 growth will prove transitory. Recent Weak Inflation Readings Are Also Transitory Overall, most participants viewed the recent softer inflation data as primarily reflecting transitory factors, but a few expressed concern that progress toward the Committee's objective may have slowed.3 We dealt with the inflation outlook in last week's report,4 through the lens of our Phillips Curve inflation model. To recap, using our model we found it very difficult to craft a realistic set of economic assumptions that resulted in year-over-year core PCE inflation below 1.88% by the end of the year. In our base case economic scenario the model projects that core inflation will reach 2.11%. Because our model is based on one that Janet Yellen referred to in a 2015 speech,5 we assumed that the Fed would reach a similar conclusion with regards to the inflation outlook. Although it must be said that the May FOMC meeting occurred prior to the disappointing April CPI release, it is notable that the minutes from the May meeting say that only "one member view[ed] further progress of inflation toward the 2 percent objective as necessary before taking another step to remove policy accommodation." In other words, almost all Fed members are content to rely on Phillips Curve style inflation models, which suggest that inflation will rise in the near future, and are putting less weight on the current low level of actual inflation. Of course, that dynamic could change relatively quickly. Chart 8 shows the track record of our Phillips Curve model, and we can see that it is not unusual for large residuals - on the order of 0.5% - to persist for significant periods of time. This means that even if all of our forecasts of the independent variables in the model turn out to be correct, there is still a chance that actual inflation will not keep pace with the model. In light of current circumstances, one period in particular stands out. The period from late-1993 to mid-1994, denoted by the shaded region in Chart 8. Chart 8The Fed Still Believes In The Phillips Curve In that episode the fair value from our model suggested that inflation should trend higher. Instead, inflation fell quite sharply. Eventually the model's fair value also moved lower, driven by a declining contribution from the model's lagged inflation term,6 and also by falling inflation expectations. In our view, this latter point is particularly important. In 1993-94, the failure of inflation to keep pace with Phillips Curve forecasts eventually caused market participants to lose faith and revise their inflation expectations lower. In a worst case scenario, a large decline in inflation expectations can feed on itself, leading to a deflationary spiral from which the Fed would have difficulty escaping. Chart 9Inflation Expectations Are ##br##Tough To Measure The Fed is very worried about falling (or more specifically "un-anchored") inflation expectations. In her aforementioned 2015 speech,7 Chair Yellen cautioned that temporary fluctuations in import prices or resource utilization could lead to permanent changes in inflation if they also caused inflation expectations to shift. Also, the longer the Fed misses its inflation target, the more likely it is that inflation expectations will become un-tethered. This is a very real risk. For now, the FOMC continues to view inflation expectations as well anchored, although the May minutes showed that "some participants" expressed concern that "the public's longer-term inflation expectations may have fallen somewhat." One problem is that there is no perfect way to measure inflation expectations (Chart 9). Market-based measures of inflation compensation are well below levels that have been consistent with the Fed's 2% inflation target in the past (Chart 9, panel 1), but these measures are volatile and are often driven by market-specific factors unrelated to inflation expectations. Meantime, the inflation expectations of professional forecasters have been quite stable (Chart 9, panel 2), while the message from consumer inflation expectations is mixed (Chart 9, bottom panel). The University of Michigan consumer survey shows inflation expectations near an all-time low, but the New York Fed's survey shows them in an uptrend. In any event, the strong correlation between consumer inflation expectations and gasoline prices makes them questionable at best. Bottom Line: The Fed is content to rely on Phillips Curve inflation forecasts, and does not need to see actual inflation rise in order to lift rates. However, if inflation does not rebound as expected, the Fed will become increasingly concerned about falling inflation expectations and could adopt a more dovish reaction function later this summer. We think inflation will be strong enough to avoid this outcome and that the Fed is still on track for two more rate hikes this year. Financial Conditions Are Crucial [Some participants] noted variously that the decline in longer-term interest rates and the modest depreciation of the dollar over the intermeeting period would provide some stimulus to aggregate demand, that the Committee's recent policy actions had not resulted in a tightening of financial conditions, or that some of the decline in longer-term yields reflected investors' perceptions of diminished odds of significant fiscal stimulus and an increase in some geopolitical and foreign political risks.8 The above passage shows that the Fed believes that financial conditions lead growth, a result we have also shown in prior reports (Chart 10).9 In this context, the Fed would expect financial conditions to tighten as it lifts rates, eventually causing economic growth to moderate. If financial conditions fail to tighten it would suggest that monetary policy needs to become more restrictive, and vice-versa. Financial conditions tightened dramatically following the December 2015 rate hike (Chart 11) and the ensuing growth slowdown caused the Fed to postpone the next rate hike for 12 months. Then, financial conditions were relatively unchanged following the December 2016 rate hike, and this allowed the Fed to deliver another hike in March. The large easing in financial conditions since the March hike is telling the Fed that it needs to step up its pace. Chart 10The Fed Believes That Financial Conditions Lead Growth Chart 11A Big Easing Since March Ultimately, the Fed still needs inflation to increase. This means that it does not want financial conditions to tighten too much, and would likely prefer to keep the Chicago Fed's Adjusted Financial Conditions index below the zero line (Chart 11, top panel). A negative reading from the adjusted index signals that financial conditions are easy relative to the strength of the economy. That is, they should be sufficiently accommodative to allow the economic recovery to continue and cause inflation to rise. At the same time, levels that are deep in accommodative territory signal that the Fed can move more rapidly. Bottom Line: The Fed strongly believes that financial conditions lead economic growth. Absent any major changes in the economic data, the pace of rate hikes will be determined by the Fed's targeting of financial conditions. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 2 For further details on the BCA Beige Book Monitor please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com 3 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 4 Please see U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 23, 2017, available at usbs.bcaresearch.com 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 One of the independent variables in our model is a 12-month lag of the year-over-year change in core PCE inflation. The lagged inflation variable pressures the model's fair value toward the level of actual inflation. If no other variables change, then over time the lagged inflation variable will ensure that the model fair value converges toward actual inflation. 7 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 8 Minutes of the Federal Open Market Committee May 2-3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf 9 Please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Downgrade communications equipment stocks to underweight. All three end-markets are weak and signal that profits will continue to surprise to the downside. Continue to avoid the electrical components & equipment index. Deficient demand warns that the profit down cycle is far from over. Recent Changes S&P Communications Equipment - Downgrade to underweight. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs last week. The minutes from the latest FOMC meeting implied that it would take considerable economic strength for the Fed to tighten more than markets currently forecast. A reactive rather than proactive Fed raises the odds that the equity overshoot will persist, because it means monetary conditions will still support profits. A good part of this year's market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery. Net analyst earnings revisions have hit their highest level since the initial post-GFC surge. The number of S&P industry groups with rising earnings estimates has climbed above 80%, reflecting broad-based earnings upgrades. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates (Chart 1). Evidence of a healthy earnings recovery is supported by our own Indicators. Of our ten sector pricing power gauges, seven are in positive territory. On a more granular basis, the majority of our 64 industry group pricing power proxies is also rising. This reflects increased global business activity and U.S. dollar depreciation. In terms of costs, six out of ten wage inflation proxies are decelerating, and more than 50% of our industry labor expense gauges are falling. As a result, seven out of ten of our broad sector profit margin proxies are in positive territory, i.e. pricing power is rising at a faster pace than wage inflation. Of the three in negative territory, two are easing in intensity, i.e. margin pressures are diminishing. These profit trends will support stocks, at least until they generate economic overheating and by extension, a more restrictive Fed. Thus, the good news for bulls is that financial conditions will remain sufficiently easy to sustain a durable profit recovery (see Chart 1 from last week's Report), so much so that investors are lengthening their time horizons. Evidence of the first synchronized global expansion in years and the ability of regional economies to bounce back from a headline risk, such as Brexit, have boosted conviction in the sustainability and strength of long-term earnings growth: analyst 5-year earnings growth forecasts are being steadily upgraded. History shows that as long as economic tail risk remains on the back burner, then valuations can camp out in overshoot territory, as occurred in the second half of the 1990s (Chart 2). To be sure, nosebleed valuation levels underscore that the rally is in a high risk phase and virtually guarantee paltry long-term returns. Still, timing pullbacks is notoriously difficult. We follow a checklist of five reliable indicators that should provide a helpful timing tool. Emerging market currencies have weakened prior to or coincident with U.S. stock market corrections (Chart 3). Exchange rate depreciation in these high beta economies is emblematic of growth disappointment, fears of capital flight and/or risk aversion. At the moment, our proxy of EM currencies is accelerating. Chart 1Buoyant Breadth Bodes Well Chart 2Long-Term Profit Conviction Is Driving Multiples Chart 34/5 Lights Flash Green Corporate bond spreads, both in the U.S. and emerging markets, have also widened coincident with, or in advance of, meaningful equity setbacks (Chart 3). So far, spreads remain tight in both regions, suggesting minimal concerns about debt servicing capabilities. In addition, bullish individual investor sentiment has also eclipsed the 60% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, but are not yet frothing bulls, according to the latest survey data (Chart 3). Of the five checklist items, the behavior of the yield curve is the most disconcerting. The curve has narrowed considerably in recent weeks, and is closing in on the pre-U.S. election lows as inflation expectations recede (Chart 3). If real long-term yields do not soon advance and confirm the profit/economic recovery narrative, then the odds of an imminent corrective phase will ratchet higher. In sum, the overshoot should remain intact for a while longer. But we continue to recommend a barbell portfolio rather than one with excessive beta, favoring select defensives and early cyclical sectors such as consumer discretionary and financials given the lack of economic confirmation from the bond market. This week we highlight two exceptions to the generally bullish profit backdrop, which reinforces that selectivity remains critical to portfolio construction. A Weak Signal From Communications Equipment: Downgrade To Underweight Communications equipment stocks have diverged negatively from the broad tech sector and have also trailed the broad market. Instead, this small corner of the tech industry moves with the ebb and flow of telecom carrier stocks - a key end-market, with a slight lag (top panel, Chart 4). The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While the share price ratio has lost ground and valuations look compelling (Chart 4), the risks of further near-term losses and a longer-term value trap remain high. Technical conditions are still far from previously extreme washed out levels. In fact, the overbought conditions' unwind is recent and there is ample downside left before a full capitulation materializes (middle panel, Chart 4). Worryingly, all three key communications equipment end-markets point to additional weakness in the coming months. Telecom carrier outlays have hit a wall. Telecom providers are at each other's throats and a full blown price war has engulfed the industry. This is outright deflationary, and telecom services pricing power has contracted at a double-digit rate during the past three months (bottom panel, Chart 5). In the absence of revenue growth, telecom capex is unlikely to reaccelerate. U.S. telecom facilities construction and communications equipment new order growth move in lockstep (second panel, Chart 5). Both have collapsed on a short-term rate of change basis, warning that communications equipment demand is soggy. Tack on the quickest industry inventory accumulation since 2011 (third panel, Chart 5), a soft order backlog (not shown), and the industry sales growth outlook has darkened even further. Overall corporate outlays are also soft. While a capex upcycle looms and some capital will inevitably flow to the communication equipment industry (middle panel, Chart 6), anemic C&I loan growth (an excellent proxy for broad corporate health, not shown) is a yellow flag. Chart 4Value Trap Chart 5Weak Telecom Segment Capex... Chart 6...Aggravates The Sales Risk Moreover, enterprise spending has not been concentrated on communications equipment gear for years, as the industry has been unable to gain any share of total corporate investment. The implication is that any business sector uptick is unlikely to match the pressure stemming from the telecom services sector. The government segment represents another source of drag. True, a global move away from austerity is a plus, but delays/uncertainty with regard to U.S. fiscal policy is a sizeable offset. In fact, U.S. government spending as a percentage of output is in decline (not shown) and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time. Finally, export markets are unlikely to offset domestic cooling. While the cheapened U.S. dollar should boost U.S. communication equipment manufacturers' competitiveness, China's global networking ascendancy and Europe's recent V-shaped export recovery suggest that U.S. gear providers are losing market share (Chart 7). All of this paints a grim picture for communications equipment sales. As such, cyclically stretched operating margins are at risk (Chart 8). Industry productivity growth has crested, and is likely to recede because slowing new orders and rising inventories imply reduced output. The implication will be profit margin pressure and a return on equity squeeze (middle panel, Chart 8). While the industry constantly realigns headcount to the challenging operating environment, a sustainable profit turnaround requires a demand driven rebound. Chart 7U.S. Manufacturers Are Losing Market Share Chart 8Beware A Margin Squeeze Meanwhile, industry specific forces will also contribute to margin pressure. Five years ago, Cisco's CEO dismissed the nascent virtual networking threat. However, today, virtual networking is a deflationary reality. Such intense deflationary pressure is a clear profit negative and warns that relative EPS are headed south (Chart 8). Bottom Line: The S&P communications equipment index is breaking down. Trim exposure to below benchmark. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV. Electrical Components & Equipment Are Out Of Power The niche S&P electrical components & equipment (ECE) industrials sub-index has marked time since our late-November downgrade to underweight. Our bearish thesis remains intact. Cyclical momentum has sputtered after the relative share price ratio failed to sustain its post-U.S. election euphoria. Valuations remain dear, with the forward P/E ratio trading at a 15% premium to the broad market (bottom panel, Chart 9). If profits continue to disappoint, as we expect, then a de-rating phase is inevitable. ECE companies garner roughly half of their sales from abroad. Thus, the U.S. dollar's fluctuations are inversely correlated with relative share prices. Delayed translation effects from the U.S. dollar's large run-up last year should continue to weigh on profits, and offset the European and emerging market economic recoveries. Worrisomely, there is a wide gap between relative performance and the greenback. If history rhymes, then a convergence phase is likely with the relative share price ratio deflating closer to the level predicted by the U.S. dollar (currency shown inverted, top panel, Chart 9). Domestically, news is equally grim. Investment spending on electrical equipment remains moribund: outlays are contracting in absolute terms and continue to trail overall investment. Historically, the industry's new orders-to-inventories ratio has been closely correlated with relative outlays and the current message is bleak (bottom panel, Chart 10). Chart 9No Reasons To Pay For Premium Valuations Chart 10No Reasons To Pay For Premium Valuations Importantly, the surge in ECE inventory growth and deceleration in backlog growth point to pricing power pressure in the coming months. Chart 11 shows that a rising wage bill and anemic pricing power have squeezed our industry margin proxy. In terms of industry productivity, gains have given way to losses, according to our gauge. This suggests that profits will continue to languish (middle panel, Chart 10). Tack on the slump in weekly hours worked, and there is cause to doubt recent sell side analyst optimism (bottom panel, Chart 11). A demand-driven increase in revenues/backlogs is needed to reverse the industry's profit fortunes. However, our relative EPS model is forecasting the opposite: profits will continue to underwhelm and trail the broad market into the back half of the year (Chart 12). Chart 11Lean Against Analysts' Exuberance Chart 12EPS Model Says Sell Against this backdrop, we remain reluctant to pay a premium valuation to own an industry with an uncertain, at best, earnings profile. Bottom Line: While we are neutral on the broad industrials sector, we continue to recommend underweight exposure in the S&P electrical components & equipment index. The ticker symbols for the stocks in this index are: BLBG: S5ELCO - EMR, ETN, ROK, AME, AYI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights On the European side, the key risk to our bullish DXY stance is that European growth is strong, the labor market seems to be tightening, and core CPI has perked up. These risks are real but mitigated by budding signs that European growth is at its best, by the abundance of hidden labor market slack, and by the high chance that the CPI spike was transitory. On the U.S. side of the ledger, the key risks are that wages do not pick up, that credit growth continues to act as a break on activity, and that political risks hamper fiscal dynamics. All would mean a more dovish Fed than we anticipate. These risks are mitigated by the fact that hidden U.S. labor market slack is only now low enough for wages to improve, credit looks set to turn around as financial conditions are supportive, and fiscal policy should surprise to the upside. USD/NOK has upside as Norway experiences declining inflation. Go long CAD/NOK. Feature Last week, we augmented our cyclically dollar bullish view by removing our tactical bearish bias on the USD. In our eyes, the market is underestimating the capacity of the Fed to increase rates and is also overestimating the economic impact of the fiasco surrounding Trump's alleged relationship with Russia. Despite our high conviction view that the dollar can rally 10% or more from current levels, we cannot be blind to the key risks surrounding it. This week, we explore where our stance on Europe and the Fed can go wrong. ECB Tapering = Upcoming Tightening Campaign? The key risk to our negative euro stance is the ECB. The market has moved to discount the first rate hike in Europe to happen in barely two years, an event we judge highly unlikely. However, if the market is right that a tapering of asset purchases in 2018 and a potential increase in the rates on deposit facilities to 0% are the opening salvos of an imminent campaign to push up the repo rate, the EUR/USD rally is only in its early days. Here are the key factors that would support this bullish euro view: The European economy is in a major economic upswing. Not only have PMIs surged, the IFO has hit an all-time high (Chart I-1). If this pace of growth can be maintained for an extended period of time, the European output gap will close faster than we anticipate, providing a stronger basis for the ECB to nudge all rates higher. The euro area labor market is tightening. Euro area unemployment rate is at 9.5%, only 0.7% above the OECD's estimate for NAIRU (Chart I-2). Thus, it would paint a picture where there is little slack in the economy at large and in the labor market in particular. In this environment, a continuation of the elevated growth currently experienced by the euro area could boost wages. Core inflation has picked up to 1.2% (Chart I-3). The ECB has historically displayed a tight reaction function to inflation. In the past, headline CPI mattered, but since Mario Draghi took the helm of this institution, the focus has switched to underlying pricing pressures. Thus, if euro area core inflation continues to move up, especially as U.S. core PCE inflation has weakened to 1.6%, the market will be vindicated and the euro could rebound on a more hawkish ECB. Chart I-1Europe Is Booming Chart I-2Low Labor Market Slack In Europe Chart I-3That Should Help The ECB To Hike Why Are These Factors Risks And Not Base Cases? To begin with, these factors have been discounted by the markets, a fact highlighted by the 42-month fall in the month-to-hike for the ECB since July 2016 to 24 months today. Also, as the European surprise index has outperformed the U.S. one, EUR/USD has rallied by 6%. In the process, investors have switched from being massively short the euro to being the most aggressively long in three years (Chart I-4). Risk-reversals in EUR/USD options are also at elevated levels, highlighting the potentially too-bullish disposition of investors toward the euro. On the growth front, some factors suggest that European growth may soon peak. The large improvement in the amount of industrial activity and capacity utilization in Europe relative to the U.S. was reflective of the big easing in monetary conditions that followed the collapse of the euro after 2014. But, as Chart I-5 illustrates, European industrial production needed a falling euro to beat that of the U.S., soon after the euro stabilized, the growth outperformance began to recede and is now near inexistent based on this metric. Thus, the euro rebound removes one of the key factors that supported the European economy in the first place. Chart I-4Investors Have Discounted##br## The Good News In Europe Chart I-5Europe's Growth Outperformance ##br##Was Because Of Policy Additionally, some economic data are showing disturbing signs. While Germany's IFO stands at a record high, Belgian business confidence has rolled over. In fact, export orders have been particularly weak (Chart I-6). This is of importance as Belgium has long been a logistical center for the euro area, and is a small open economy deeply integrated in the European economic infrastructure. This, therefore, portends to emerging risks to the whole euro area. Monetary dynamics too raise questions. European business confidence, a key piece of soft data that has underpinned investors increased bullishness on the euro is led by dynamics in M1 money supply. The roll over in M1 implies that business conditions in Europe are slowly passing their best period (Chart I-7). If euro area growth peaks, this also raises concerns about the state of the labor market. This is especially worrisome as we think the unemployment gap based on the OECD's estimate of NAIRU misses key elements of the European labor market slack. As we wrote last week, the key problem in Europe is labor underutilization; hidden labor market slack remains a serious concern.1 With workers in irregular contracts being a key source of job creation since the end of the 2013 recession, there are plenty of workers willing to change jobs without the incentive of a higher pay, limiting the upside in wages. Without wage growth, it will be difficult for European core inflation to continue its uptrend, especially as there are many signs that the rebound that has excited investors' imagination may have been a transitory event. Worryingly for euro bulls, our Core CPI A/D line for Europe, which tends to lead core CPI itself, rolled over last year and points to lower core CPI.2 Industrial good prices excluding energy have also been weakening for 15 months now, suggesting this inflation rebound may be an aberration (Chart I-8). Chart I-6Where Belgium Goes, ##br##So Does Europe Chart I-7Money Trends Point To A Deceleration##br## In European Soft Data Chart I-8Europe Core CPI ##br##Will Roll Over Bottom Line: Investors have become very bullish of the euro based on the fact that the economy has been very strong, the European headline unemployment rate is moving closer to NAIRU, and core inflation has perked up; raising the specter of high rates sooner than we anticipate. These economic developments need to be monitored closely, but the growth impulse in Europe is likely to soon deteriorate, broader measures of labor market slack in the euro area are far from being at full employment, and the tick up in core inflation is likely to prove to have been only a temporary blip. These forces should weigh on the euro for the rest of 2017. Maybe The Fed Will Not Tighten That Much? Meanwhile, in the U.S., investors only expect three rate hikes over the next 24 months. Markets have begun doubting the fed's capacity or resolve to hike interest rates as aggressively as we envision. A slew of disappointing data and political developments have cemented this opinion among investors. Among the most crucial factors are the following: Chart I-9Disappointing U.S. Wages Wage growth in the U.S. remains poor, especially as per average hourly earnings which are still only growing at a disappointing 2.3% rate (Chart I-9). This raises the specter that consumption will remain tepid and that inflationary dynamics will never take hold in the U.S. This risk is perceived as especially salient as core inflation and core PCE have slowed below the 2% objective of the FOMC. Slowing credit growth has also garnered a lot of attention among the public. Credit is the life blood of the economy, and this slowdown has prompted many investors to begin questioning whether or not the U.S. economy would ever be able to take off. This compounded worries around the perennially weak Q1 GDP growth. Finally, the myriad of scandals surrounding Trump and his dealings with Russia have raised much questions about his ability to ever implement fiscal stimulus. Moreover, the punitive terms associated with the repeal of Obamacare and the implementation of the American Health Care Act (AHCA) - which according to the CBO could leave as many as 23 million individuals without health insurance by 2023 and cause sharp increases in insurance premia - may dull any growth boosting impact of potential tax cuts. Thus, the political backdrop may prompt the Fed to be easier than was anticipated as recently as December 2016. Why Are These Factors Risks And Not Base Cases? To begin with, BCA still hold the view that wages in the U.S. are set to accelerate in the coming quarters. The Phillips Curve continues to be a reality, as the Atlanta Fed Wage Tracker still display a tight relationship with the unemployment gap (Chart I-10). Moreover, it is often argued that the problem with today's labor market is that much of the job creation is happening in low-skilled positions. This is true, but historically, low-skilled jobs have tended to experience the most upward pressures when the job market tightens significantly. Instead, the key anchor on average hourly earnings has been the hidden labor market slack. However, today, the U-6 unemployment rate is finally ticking at 8.6%, levels where in previous cycles wage growth accelerated (Chart I-11). A rebound in GDP growth, as highlighted by the Atlanta Fed growth forecast of 4.1% in Q2, would accentuate pressures on the labor market and help realized the underlying wage pressures resulting from the current readings of the U6 unemployment rate. Chart I-10The Phillips Curve: It's Alive Chart I-11U.S. Wages Will Pick Up What could support growth? Let's begin with the credit dynamics. As we have argued, credit growth is a lagging indicator of economic activity. The improvement in the ISM through 2016 and early 2017 continues to point to a rebound in C&I loans in the U.S. (Chart I-12). Moreover, aggregate bank credit in the U.S. is already re-accelerating, suggesting that credit will once again add to economic activity, and will stop subtracting from it (Chart I-13). Chart I-12Credit Lags, And It Will Pick Up Chart I-13Momentum In U.S. Loans Is Turning Up Another positive for the U.S. economy has been the substantial easing in financial conditions resulting from the fall in the dollar and bond yields since the beginning of 2017. This easing should help economic activity over the course of the next quarters (Chart I-14). In its most recent minutes, the Fed has alluded to these forces. The fall in the dollar is already showing signs of helping. The ISM export orders index is currently ticking near 60, suggesting that the fall in the USD has had a stimulative impact on the U.S economy (Chart I-15). This is especially salient when contrasted with the euro area industrial production dynamics described above. Chart I-14U.S. Financial Conditions Will Help Growth Chart I-15The Dollar's Easing Is Evident Finally, when it comes to fiscal policy, our Geopolitical Strategy team remains adamant that tax cuts will materialize in the coming quarters. It is becoming imperative for congressional Republicans to achieve this as Trump's popularity remains dismal at the national level, which could prompt a serious electoral rout in the 2018 mid-term elections (Chart I-16). This means that fiscal easing is likely to come through, which should have an impact on asset prices and the dollar: The DXY is back to pre-election levels and the relative performance of stocks most sensitive to changes in tax policy is back to January 2016 levels. These price trends indicate that investors have massively curtailed their expectations for governmental support to growth. Chart I-16If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 Moreover, the current format of the AHCA is unlikely to make it through the more moderate U.S. Senate. The loss of coverage and the insurance premia increases implied by the current plan are likely to be electoral poison in 2018, something well understood by key GOP policymakers. An AHCA still up in the air does not preclude tax cuts either. The budget deficit hole created by unfunded tax cuts will likely be patched through aggressive growth assumptions, the magic of dynamic scoring. The recently revealed Trump budget proposal itself is also unlikely to see the light of day in its current form and will evolve toward something more supportive of growth as time and negotiations pass. Bottom Line: Investors have massively curtailed their expectations of Fed tightening over the next two years. This view has been based on the lack of wage acceleration in the U.S., the poor credit growth numbers, and the uncertainty surrounding fiscal policy. These are still important risks to our bullish stance. However, we remain optimist because wage growth is only set to increase now, credit is a lagging indicator that looks about to pick up anew, financial conditions should help future U.S. economic activity, and the potential for tax cuts is far from dead. Stay long DXY. Norway's Passing Inflation Problem It was not long ago when the Norges Bank was facing the daunting task of kick starting a Norwegian economy ravaged by the collapse in oil prices while trying to contain the high inflation brought upon by the sell-off in the krone. However, following the stabilization of the NOK, this dilemma has dissipated as multiple measures of inflation have plunged. The Norges Bank is now free to maintain its dovish bias as the economy remains tired and will require easy monetary to recover going forward. Based on the effect of currency moves, inflation might reach a bottom at the beginning of next year, but it will likely stay below the central bank's target of 2.5 % for the foreseeable future (Chart I-17). Indeed, in spite of the rebound in oil prices, employment is contracting, the output gap is large, and wage growth remains deeply negative (Chart I-18). The Norges Bank is sympathetic to this view, acknowledging in its most recent monetary policy statement that inflation will hover in a 1-2% range in the coming years. Chart I-17A Stable NOK Will Keep Inflation Subdued Chart I-18No Domestic Inflationary Pressures In Norway Lastly, Norway's bubbly real estate market, the last obstacle to the Norges Bank dovish bias, is finally slowing down. Thanks to changes in regulation on residential mortgage lending at the start of the year, banks are tightening lending standards to households, a precursor to a cooling housing market (Chart I-19). With a Fed looking to increase rates, the real rate differential between the U.S. and Norway should move in favor of USD/NOK. Yet, could rising oil prices deepen the USD/NOK weakness? This seems doubtful as USD/NOK continues to be more correlated with real rate differentials than with the price of oil (Chart I-20). Nevertheless, the outlook of the krone against the AUD and the NZD is much more promising: Chart I-19No Need To Raise Rates To Curb Housing Prices Chart I-20Real Rates Matter More Than Oil Yesterday, OPEC Russia agreed to maintain their production cuts in place for the next nine months. This deal should keep the oil market in a deficit, pushing oil prices up and providing a tailwind to the NOK against non-oil commodity currencies. Chart I-21CAD/NOK: A Call On The U.S. Dollar On the other hand, the outlook for industrial metals and other commodities, which are more sensitive to the Chinese economy, continues to be worrying. Monetary conditions are still tightening in China and multiple economic activity indicators have disappointed to the downside. While base metals have already fallen considerably, we believe that additional weakness in the Chinese economy will trigger a selloff in EM assets, bringing the NZD and the AUD down with them. Finally, it may be time to sell the NOK against the CAD. The Bank of Canada struck a hawkish tone on Wednesday, stating that the Canadian economy's adjustment to lower oil prices is largely complete and that consumer spending should be supported by an improving labor market. This change in rhetoric should set the stage for a rally in CAD/NOK. Moreover, our Intermediate-Term Timing Model shows that this cross is 7% cheap, and our bullish USD view implies an outperformance of the loonie versus the krone given the tight correlation between CAD/NOK and the DXY (Chart I-21). Bottom Line: Outperformance of oil in the commodity space will help the krone outpace non-oil commodity currencies. However, the Norges Bank is likely to keep a dovish bias, which should make it difficult for the NOK to rally durably against a cheap U.S. dollar. Go long CAD/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "The Achilles Heel Of Commodity Currencies", dated May 5, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback suffered some losses following the release of Fed minutes. Puzzlingly, the rhetoric was not dovish, as markets and news outlets confirmed the prospect for a June rate hike. The result was a dollar selloff and a drop in yields. This easing in financial conditions created an additional fillip for the S&P as it traded at a record high, the opposite of what is expected with a looming rate hike. As new home sales contracted on a monthly basis and the manufacturing PMI disappointed, the U.S. soft patch continues. Nevertheless, our base case remains on par with the Fed's: the weakness in data is temporary and the Fed will hike more than the markets expect. We are already seeing this as continuing and initial jobless claims beat expectations at 1.923 million, and 234,000 respectively, and the greenback has found a footing at the 97.1 level. As this scenario further unfolds, gold will retreat as real returns increase, and the greenback will gain upward momentum. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro area continues to surprise with better than expected data: German IFO: Overall Business Climate came in at 114.6 - levels last seen in 1970; Expectations came in better than expected at 106.5; and the Current Assessment also beat expectations of 121.2, coming in at 123.2. Euro area Manufacturing PMI is at 57 for May, beating expectations of 56.5, and the Composite measure also recorded an outperformance, coming in at 56.8. On the consumer side, German Gfk Consumer Confidence Survey came in at 10.4, beating expectations of 10.2. While the euro to be overvalued on short-term metrics, and the euro area is structurally weaker than the U.S., weaker data needs to be seen for the markets to see a correction. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been negative in Japan: Manufacturing PMI decreased to 52 in May from 52.7 in April. Exports growth decreased to 7.5%, from 12% the month before and underperforming expectations. Japan's all industry activity Index also underperformed expectations, contracting by 0.6% MoM. We continue to believe that Japanese economic activity will ultimately be determined by the exchange rate. The yen has appreciated since this the start of the year, therefore it is understandable that inflation and economic activity have been subdued. Taking this into account, the BoJ will continue to target a yield of 0% in JGB's, and thus the yen should suffer on a cyclical basis given that real rates differentials with the U.S. will continue to widen. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent British data has been mixed: GDP growth underperformed, coming in at 2%, decreasing from last quarter and underperforming expectations, mostly reflecting poor trade numbers. Meanwhile total business investment grew by 0.8%, outperforming expectations. We are not positive on the pound against the dollar, given that near 1.3 the pound is no longer a bargain tactically. On the other hand we expect more upside against the euro. Powerful inflationary pressures are building in the U.K., and governor Carney, previously concerned about the effects of Brexit in the economy, might be more inclined now to deal with inflation as the U.K. has proved resilient. This will put upward pressure in British rates vis-à-vis European rates. Additionally EUR/GBP has reached overbought levels, indicating it might be a good time to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As the greenback's descent slowed down, so did the Aussie's ascent. The underlying motives for strength in the antipodean currency are misplaced. As data remains unpromising, this week followed through with further disappointments as overall construction work done contracted by 7.2% on an annual basis, with the engineering component contracting by 13%. Research by the RBA illustrates that construction work has a very close relationship with the national accounts of Australia. This could result in a slowdown in the economy - something which the RBA cannot afford amidst flailing inflationary pressures. On a more optimistic note, the commodity selloff is taking a breather. Most crucially for the AUD, iron ore futures have remained flat for almost a month after a 30% depreciation, and natural gas has been flat for almost a month. These developments have limited the AUD's downside for now. However, looming EM risks and the potential resumption of the dollar bull market represent very real risks for the AUD going forward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has appreciated by about 1.5% against the dollar this week. Additionally, recent data has been positive: Visitor Arrivals yearly growth skyrocketed to 21.5% on April. The trade balance outperformed expectations coming in at -3.48 Billion The kiwi economy continues to surge, with 7% growth in nominal GDP and retail sales growth at decade-highs. Additionally, dairy prices continue to surge, and are now growing at a 60% YoY pace. For this reason we are bearish on AUD/NZD, as the Australian economy is not only in a more precarious state, but is also more sensitive to the Chinese industrial cycle. Meanwhile, we continue to be bearish on NZD/USD, as a negative view on EM assets necessarily entails a bearish view on the kiwi. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following on from the dollar's weakness, the CAD displayed further strength after the BoC's decision statement. While keeping rates unchanged, the bank highlighted that "recent economic data have been encouraging" and that "consumer spending and the housing sector continue to be robust on the back of an improving labor market". Furthermore, the Bank more or less expects these supports to growth to "strengthen and broaden over the projection horizon". While wholesale sales increased by less than expected at 0.9%, the BoC also expects that the "very strong growth in the first quarter will be followed by some moderation in the second quarter". This is likely to keep market expectations anchored and the CAD's value intact. Additionally, oil should pare recent weaknesses as OPEC follows through on its cuts. The CAD is therefore likely to see some strength against other commodity currencies. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has continued to depreciate after coming close to reaching 1.1. We continue to be negative on this cross, as the Euro is likely to have limited upside from current levels. The ECB is unlikely to hike rates any time soon, as wage pressures outside of Germany continue to be muted. Furthermore, this is not likely to change any time soon, as the labor market of the periphery continues to be very rigid. Meanwhile, the SNB is likely to take off the floor from this cross next year, as core inflation and retail sales growth have both returned to positive territory. We will continue to monitor the rhetoric by the SNB to have a more clear understanding of when the removal of the floor might occur. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone has rallied this week, thanks to the rise in oil prices. However real rate differentials should continue to move in favor of USD/NOK. While the fed is likely to hike more than what is currently anticipated in the OIS curve, the Norges Bank will stay dovish, given that the Norwegian economy is still too weak to sustain a rise in interest rates. Furthermore, macro prudential measures seem to be helping the Norges bank to slow down the housing market. The NOK is also likely to have downside against the CAD. The dollar bull market should help this cross rally, given the tight correlation between CAD/NOK and the DXY. Furthermore the BoC has struck a more hawkish tone as of late, which should further increase the difference between interest rate expectations in these two countries. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Positive data emerged from Sweden this week as consumer confidence picked up to 105.9 from 103.7, beating expectation of a decline to 103.6. The seasonally-adjusted unemployment rate remains on a structural downtrend, coming in at 6.6% according to Statistics Sweden. In terms of crosses, USD/SEK continues to weaken due to the greenback's instability. EUR/SEK has topped out and is also showing some weakness. Against commodity currencies, the movement is mixed. The SEK has shown the most strength against the AUD, while CAD/SEK and NZD/SEK have been flat, and NOK/SEK has seen considerable strength on the back of robust oil prices. We can see the SEK being weak against oil-based currencies as we expect OPEC to remain focused on cutting global oil inventories, while AUD/SEK could see further downside due to poor fundamentals in Australia. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The equity risk premium (ERP) is distorted: too low. The Eurostoxx600 uptrend is reaching a technical limit according to its 130-day (6-month) fractal dimension. The U.S.-Euro area bond yield spread is distorted: too high. The Spain-France bond yield spread is distorted: too high. The Italy-Germany bond yield spread is not distorted. Feature Central banks' massive interventions in markets have left many investors wondering: has the market's price discovery mechanism become dysfunctional - and if so, where most severely? It is a good question because clearly, the prices that are most distorted are also the ones most likely to dislocate, and generate lucrative opportunities. This week's report assesses the distortion in three important relative pricings: the Italy-Germany sovereign yield spread; the U.S.-euro area sovereign yield spread; and the prospective excess return from equities over bonds, otherwise known as the equity risk premium. The Italy-Germany Bond Yield Spread Is Not Distorted We often hear the claim that the ECB's bond purchase program has compressed periphery bond yields relative to core yields. But we find no evidence for such a distortion. For example, relative to the ECB's capital key1 and other guidelines for bond purchase volumes, there is a larger ongoing supply of Italian BTPs than German bunds.2 So from a technical perspective, the ECB's interventions should have depressed German bund yields more than Italian BTP yields, thereby expanding the spread. Chart Of The WeekLow Volatility: We've Been Here Before... And It Didn't Last In fact, the technical distortion seems quite small because the Italy-Germany yield spread can be fully justified by its two underlying fundamentals: relative competitiveness (Chart I-2) and euro breakup probability (Chart I-3). Chart I-2Euro Area Yield Spreads Depend On Relative Competitiveness ... Chart I-3... And The Probability Of Euro Break-Up The premium on Italian BTP yields exists as a compensation for the expected redenomination loss in the tail-event of euro breakup. Assuming this currency depreciation would neutralize Italy's current 25% under-competitiveness versus Germany, we can infer that the 125 bps yield premium on 5-year BTPs is pricing a 5% annual probability of euro breakup (because 125 bps = 25% loss times 5% probability). The probability should account for an Italian election that is due within the next year, and Italian public support for the euro hovering at an unconvincing majority of around 55%. In this context, the probability should be somewhat elevated, though not alarming. So a 5% annual probability of euro breakup through the next five years seems reasonable within its post-crisis 2%-20% range. On this basis, the Italian-Germany yield spread is not distorted (Chart I-4). Instead, the real anomaly is the Spain-France (5-year) yield spread which stands at 50 bps (Chart I-5). There is now no difference in competitiveness between Spain and France, so there should be no redenomination premium on Spanish Bonos over French OATs, irrespective of the probability of euro break up. Stay structurally overweight Spanish Bonos versus French OATs. Chart I-4The Italy-Germany Yield Spread At 150 Bps Is Fair Chart I-5The Spain-France Yield Spread At 50 Bps Is Too High The U.S.-Euro Area Bond Yield Spread Is Distorted: Too High If bond price discovery were based solely on economic fundamentals, the U.S.-euro area yield spread would not be at a multi-decade extreme today. Such an extreme spread exists because the difference between Fed and ECB policy is much more polarized than is justified by the economic fundamentals. In this sense, the relative pricing is distorted. Consider the hard data. The percentages of the working age population in employment are at the same respective pre-crisis highs in both economies; the difference in wage inflation is closing; and the gap between core inflation in the U.S. and euro area has narrowed very sharply to just 0.6%. Indeed, excluding the cost of shelter - which is not represented in the euro area CPI - core inflation in the U.S. is now lower than in the euro area. Agreed, Fed policy should be tighter than ECB policy. But the expected difference should not be at a multi-decade extreme. Given the self-proclaimed 'data-dependency' of both the Fed and the ECB, the polarization of monetary policy expectations (Chart I-6) has to converge to the rapidly narrowing gap in the hard economic data, one way or another (Chart I-7). Chart I-6The U.S.-Euro Area Yield ##br##Spread Is Too High ... Chart I-7... And Will Gravitate To The Narrowing ##br##Gap In The Economic Data I conclude that: the U.S.-euro area (and U.S.-Germany) yield spread can close much further; euro/dollar can rise structurally; and the market neutral equity pair-trade long euro area Financials/short U.S. Financials can continue to outperform. The caveat is that these positions are just one big correlated trade (Chart I-8 and Chart I-9). Chart I-8Expected Monetary Policy Difference ##br##Is Driving The U.S.-Germany Yield Spread ... Chart I-9... And Therefore The Relative ##br##Performance Of Financials The Equity Risk Premium Is Distorted: Too Low Equity market behaviour is starkly asymmetric; market ascents tend to be gentle and drawn out, while descents tend to be violent and abrupt. By contrast, bond market behaviour is more symmetric; both upward and downward moves can be gentle or violent. The upshot is that when the equity market is ascending, its observed volatility declines. And the longer and more established the ascent becomes, the lower the observed volatility goes, both in absolute terms and relative to bonds. Crucially, this is just an observation of the inherent behaviour of equities: a low observed volatility simply tells us that equity ascents are gentle and drawn out (Chart I-10); it does not tell us that equity risk has diminished. Chart I-10Low Volatility Just Tells Us That Equity Ascents Are Gentle And Drawn Out. ##br##It Does Not Tell Us That Equity Risk Has Diminished! Unfortunately, the decline in the observed volatility may create the illusion that equity risk has diminished. In response, investors might demand a smaller (or no) equity risk premium (ERP) - the excess prospective long-term return over bonds - because they have falsely concluded that the risk of a large intermediate loss is vanishing. In turn, the shrinking ERP and lower required return justifies an even higher price today, allowing the market to continue its gentle ascent. So observed volatility falls even further, and the process feeds on itself in a self-reinforcing spiral. Readers might recognise this as the setup of the Minsky hypothesis in which the illusion of systemic stability breeds systemic instability and an eventual tipping point - a so-called 'Minsky Moment'. The Minsky hypothesis is an explanation for the boom bust cycle in the economy. It proposes that a credit boom initially generates strong and steady growth with low observed volatility. But the associated hubris - "no more boom and bust" - eventually encourages reckless lending and thereby sows the seeds of its destruction. When the misallocated loans cannot be repaid, the inevitable nemesis arrives. Likewise, in the case of the equity market, today's low observed volatility is absolutely not a reason for hubris. Yet as demonstrated in Markets Suspended In Disbelief,3 the low observed volatility has seduced investors into accepting a wafer-thin ERP. Today's low observed volatility is at the lower end of a range that has existed for at least 50 years (Chart of the Week). We have been here many times before. In each case, the low observed volatility did not last. And when it rose, so too did the ERP. As supporting evidence, observe that the 130-day (6-month) fractal dimension of the Eurostoxx600 is suggesting that the current uptrend is reaching its technical limit (Chart I-11). As a reminder, when an investment's fractal dimension approaches its natural lower bound, it signals that excessive trend following and groupthink have reached a natural point of instability. At which point the established trend is likely to break down with or without an external catalyst. Chart I-11The Current Uptrend In The Eurostoxx600 ##br##Is Reaching Its Technical Limit Before making a large absolute commitment to the equity asset class on a 6-12 month or longer horizon, I would first like to see both of these trustworthy signals stop flashing red. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The capital key refers to the proportion of the ECB's capital owned by each of the euro area member states, and it is broadly pro-rata to the member state's GDP. 2 German GDP is 2 times the size of Italian GDP, but the stock of German sovereign debt is only 1.1 times the size of Italian sovereign debt. 3 Published on April 13 2017 and available at eis.bcaresearch.com Fractal Trading Model* The 65-day fractal dimension of nickel versus tin is approaching a level which has previously signaled an imminent trend-reversal. Go long nickel/short tin as this week's trade. Chart I-12 For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Feature Chart 1 Senior officials at the Federal Reserve have begun preparing the market for the eventual run down of the central bank's balance sheet. After several rounds of quantitative easing (QE), total assets held by the Fed currently stand at US$4.5 trillion - a dramatic increase from US$900 billion before the global financial crisis. Indeed, efforts to shrink the Fed's balance sheet are essentially reverse QE. As the 2013 'Taper Tantrum" suggests, such a profound change in U.S. monetary policy can have a significant impact on interest rates and broader financial assets, and Fed officials are working hard to properly anchor market expectations. In comparison, how the People's Bank of China manages its balance sheet is much less transparent and less understood by market participants, even though the PBoC has the biggest balance sheet among the world's major central banks (Chart 1). Currently, the PBoC's total assets amount to US$4.9 trillion, compared with about US$4.5 trillion for both the Fed and the European Central Bank (ECB). Moreover, its balance sheet has stopped growing since 2015 in local currency terms and has been shrinking in dollar terms, but the impact on the economy and financial markets has so far not been material. Generally speaking, a central bank uses its balance sheet to aid monetary policy. It controls the size and composition of its assets to affect interest rates, and in turn the economy. Through "operation twist" and QE, the Fed significantly increased its holdings of longer-dated Treasury securities and mortgage backed securities (MBS), which currently account for 95% of its assets (Table 1). Therefore, shrinkage of the Fed balance sheet means that the Fed's holdings of long-term securities will gradually be reduced - likely by allowing them to run off at maturity rather than selling them in the open market. This should nonetheless put some upward pressure on long-term risk-free rates going forward. Table 1The Fed's Balance Sheet In a Special Report we published six years ago, we pointed out the explosion in the PBoC's balance sheet and its unique features compared with other central banks.1 In a nutshell, the PBoC's biggest holdings on its asset side were U.S. Treasurys rather than domestic risk-free assets. The Chinese central bank was essentially engaging in a massive "currency swap" in which it accumulated U.S. Treasurys while dramatically increasing the country's monetary base. Meanwhile, it was also working hard to "sterilize" by forcing commercial banks to maintain an increasingly massive sum of required reserves with the central bank. These policy tools, however, were inherently crude and clumsy, with huge volatility in monetary market rates and overall financial volatility being a key after-effect. This week we are revisiting the PBoC's balance sheet to highlight some major shifts in recent years. Some developments are worth highlighting. Dynamics have completely reversed since 2015, when Chinese official reserves began to fall, leading to a shrinking in the PBoC's balance sheet by about US$500 billion since the all-time peak. The "sterilization" process has also been reversed, as the PBoC has been releasing liquidity back into the domestic financial system. The overall liquidity situation has been largely stable. Normally a decline in the PBoC's foreign asset holdings would lead to a decline in the reserve requirement ratio (RRR) to offset the liquidity outflows, leading to a simultaneous decline in both sides of the central bank's balance sheet. The PBoC, however, has been resisting shrinking its balance sheet. As its foreign asset holdings (U.S. Treasurys) have been declining, the PBoC has significantly ramped up domestic asset holdings by increasing direct claims on commercial banks through repos and other lending facilities. The central bank appears to be concerned that a lowered RRR will stoke more domestic capital outflows, which risks creating a vicious circle. How the PBoC manages domestic liquidity has seen major shifts in recent history, and will likely continue to evolve going forward. The RRR, as a monetary policy tool, will likely be gradually phased out.2 Over the long run, this will lead to important changes in the PBoC's balance sheet and the way it conducts monetary policy. In the short term, commercial banks' excess reserves are at close to record low levels. The odds are rising that the RRR will be lowered in the coming months, especially if the RMB stabilizes against the dollar, as we expect.3 Finally, it is worth noting that the most aggressive phase of the Fed's QE efforts coincided with the most rapid phase of the PBoC's balance sheet expansion. This means that both central banks were aggressive buyers of U.S. Treasurys and risk-free assets in previous years. Looking forward, if a shrinking Fed balance sheet leads to a sharp increase in U.S. interest rates and a dollar rally, it could force the PBoC to also liquidate its holdings of U.S. Treasurys to stabilize the RMB exchange rate. This means both the Fed and the PBoC could become marginal sellers of Treasurys, which would have a much more profound impact on U.S. interest rates and the growth outlook. Monitoring the PBoC's balance sheet will become increasingly important for Fed watchers. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Delving Into the PBoC'S Balance Sheet," dated July 27, 2011, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "More On The Chinese Debt Debate," dated April 20, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Can The RMB Appreciate Against The Dollar, Again?" dated May 11, 2017, available at cis.bcaresearch.com. Table 2 offers a simplified balance sheet of the People's Bank of China. Foreign assets still account for 65.6% of its total assets, down from a peak of 83% in 2014. In comparison, most other major central banks' assets are predominantly domestic government bonds. The explosive growth of the PBoC's holding of foreign assets had been the only source of its balance sheet expansion before 2015. In the past two years the PBoC's domestic assets have increased sharply. Overall the PBoC's balance sheet has stayed flat in the RMB terms. PBoC's holding of foreign and domestic assets has been matched by expansion of reserve money (monetary base) on the liability side of the PBoC's balance sheet, including currency issuances (M0 and cash in the vaults of depository institutions) and deposits of commercial banks in the central bank. Commercial banks' reserve deposits at the PBoC have continued to grow even though the PBoC balance sheet expansion has stalled. (Chart 2) Table 2The PBoC's Balance Sheet Chart 2 PBoC holdings of foreign assets include foreign exchange reserves and gold. Foreign reserves currently account for 63% of PBoC total assets, compared with a peak of 84% in 2014. Official record shows that gold is still a negligible share of its total assets. Other major items on the asset side of the PBoC's balance sheet include claims on the government, commercial banks and other financial corporations. The PBoC's claims on the government (entirely on the central government) account for 4.5% of its total assets. In 2007 the government set up a sovereign wealth management fund to manage part of the country's reserves. The government issued bonds to the PBoC in exchange for foreign exchange reserves, which was used as capital of the investment firm. Legally the PBoC is forbidden to directly hold government bonds. The PBoC's claims on other depository corporations (commercial banks) include loans and rediscounts to commercial banks and the net amount of repurchase agreements, which has increased sharply since 2016. The PBoC claims on other commercial banks were a major policy tool to control liquidity in the early 2000s. The central bank's claims on other financial corporations mainly include loans to the asset management firms that the government set up in the late 1990s to deal with bad loans spun off from commercial banks. There has been no change in this item in recent years. (Chart 3 and Chart 4) Chart 3 Chart 4 On the liability side of the PBoC's balance sheet, the dominant item is reserve money, which includes currency issuances and deposits of depository corporations. Taken together these items account for almost 90% of banks' total liabilities. However, currency issuances (M0 and cash in vault) have been hovering around 20% of the PBoC balance sheet in recent years. Deposits of depository corporations account for about 66%. Deposits of commercial banks in the central bank include required and free reserves. Currency issuance and free reserves make up China's "high power money" that can result in a much larger increase in money supply through the money multiplier. Therefore, adjusting the reserve requirement ratio (RRR) on banks has been a key policy tool for the PBoC to control "loanable" funds and liquidity. The central bank, however, been reluctant to adjust RRR since 2016 despite continued liquidity outflow. Commercial banks used to hold large amounts of free reserves with the central bank, which however have declined sharply in recent years. The massive reserves of commercial banks in the PBoC offer a critical liquidity buffer for banks at times of crisis. As banks' free reserves have been running thin, there is a building case for an RRR reduction in coming months. (Chart 5 and Chart 6) Chart 5 Chart 6 Other major items on the liability side of the PBoC's balance sheet include bond issues, government deposits and foreign liabilities. The central bank started to issue bonds (notes) in 2002 as a way to sterilize foreign capital inflows, a tool that has essentially been phased out. Currently, total outstanding bonds amount to RMB 50 billion, a mere 0.1% of the PBoC total liability, compared with almost 30% in 2007. The PBoC's foreign liabilities are deposits of international financial institutions, which account for a negligible share of its total assets. Government deposits account for 8.4% of the central bank's total liabilities, or RMB 2.88 trillion at the end of April 2017. The PBoC regularly auctions off fiscal deposits to commercial banks as a way to adjust interbank liquidity. (Chart 7 and Chart 8) Chart 7 Chart 8 There are four main items on the PBoC's balance sheet that the central bank uses at its discretion to manage domestic liquidity: claims on depository corporations (banks), deposits of depository corporations, liabilities to the government (fiscal deposits) and bond issues. Claims on depository corporations are on the asset side, and include loans and rediscounts to commercial banks and the net amount of repurchase agreements. The PBoC has significantly expanded some new liquidity tools, such as various lending facilities and open market operations. These assets are mostly short term, allowing the central bank flexibility to adjust the quantity quickly. Reserve deposits of commercial banks, central bank bond issues and fiscal deposits are on the liability side of the PBoC's balance sheet, but reserve deposits play by far the largest role in the central bank's sterilization efforts. Commercial banks reserve deposits are still hovering around record high levels. (Chart 9 and Chart 10) Chart 9 Chart10 Taken together, the ebbs and flows of the PBoC's sterilization operations coincide with the pace of country's foreign reserve accumulation. The PBoC was able to "sterilize" about 80% of foreign capital inflow before 2015, and it has been quickly adjusting its balance sheet to offset domestic capital outflows in the past two years. All these items on the PBoC's balance sheet should be cross-checked to assess its liquidity operations, rather than focusing on one item. Looking forward, the PBoC's liquidity operations will remain contingent on the situation of cross-border capital flows in the near term, and its monetary independence will remain compromised. Over the long run, a free-floating RMB exchange rate will diminish the purpose of PBoC's precautionary holdings of foreign reserves, which will in turn impact how the central bank manages its balance sheet for domestic considerations. (Chart 11 and Chart 12) Chart 11 Chart 12 Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: The bond market is not providing adequate compensation for the inflationary economic back-drop. Remain below-benchmark duration on a 6-12 month investment horizon. The Fed & Inflation: Even in the most deflationary of the four scenarios we consider, inflation is still projected to be very close to the Fed's median forecast by year end. The Fed is still on track for two more rate hikes this year. The Fed's Balance Sheet: The run-down of the Fed's balance sheet will lead to a substantial increase in gross Treasury issuance next year. Most, if not all, of this extra issuance will be met by greater demand from the banking sector. Feature Chart 1Inflationary Pressures Are Building No, the title of this report does not refer to the challenge of getting a tax reform bill through Congress when betting markets say there is a 44% chance that the President won't keep his job through 2018.1 Although bond markets are clearly sending the message that progress on tax reform is less likely with the White House embroiled in controversy. The 10-year Treasury yield fell to 2.22% last week after having briefly broken above 2.4% earlier in the month (Chart 1). For the record, our Geopolitical Strategy service thinks that even a growing scandal within the Trump administration won't be enough to prevent tax cuts,2 and from our point of view, we worry that bond markets might be distracted by the political soap opera and are missing the underlying economic picture. As the nominal 10-year yield fell last week, the 10-year TIPS breakeven inflation rate also declined to 1.78%, its lowest level since prior to the election. Meanwhile, the base case scenario from our Phillips Curve model of core PCE inflation, which closely tracks the 10-year TIPS breakeven rate (Chart 1, bottom panel), is sending the message that inflationary pressures are building in the economy, tax reform or no tax reform. Chart 2The Fed's 2017 Forecasts The next section of this report provides more detail on the assumptions underlying our Phillips Curve model, but suffice it to say that the bond market is not providing adequate compensation for the inflationary economic back-drop. Remain below-benchmark duration on a 6-12 month investment horizon. The remainder of this report focuses on two key challenges that U.S. policymakers will face this year. The first is the Fed's challenge of whether to focus on Phillips Curve derived forecasts of inflation or the actual core inflation data. The second challenge relates to how the Treasury department will deal with the run-off of the Fed's balance sheet. The Fed's Phillips Curve Challenge As of the March FOMC meeting, the Fed's median projection called for two more 25 basis point rate hikes before the end of the year, and also for core PCE inflation to reach 1.9% (Chart 2). It would be logical to assume that if inflation were no longer expected to reach 1.9%, that the anticipated pace of rate hikes would also decline. On that note, a cursory glance at recent inflation data makes 1.9% look a tad aspirational. Core PCE inflation is running at only 1.56% year-over-year through March, and will probably stay low in April given that year-over-year core CPI fell from 2% in March to 1.89% in April (see Box). BOX A Note On The Divergence Between CPI And PCE While weak core CPI probably does indicate that core PCE will stay low, we would not expect the entirety of April's CPI drop to translate into the PCE data. A key driver of last month's disappointing core CPI was a 0.2% month-over-month decline in medical care prices, and the treatment of medical care costs is an important difference between CPI and PCE. The weight of medical care in core PCE is more than double the 10% weighting of medical care in core CPI, because the PCE deflator also factors in the medical care spending of government agencies on behalf of consumers while CPI only tracks the amount spent by consumers directly. For this reason, we see that the medical care components of CPI and PCE are not closely correlated (Chart 3). In fact, CPI medical care inflation has been decelerating for some time while PCE medical care inflation has been grinding higher alongside the health care component of the Producer Price Index (PPI). The health care component of PPI was flat in April, but the underlying uptrend remains unbroken. We would expect the spread between core CPI and core PCE to tighten in the months ahead as relative medical care costs continue to converge (Chart 3, bottom panel). Chart 3Expect CPI and PCE To Converge Meanwhile, a forecast based on trends in the labor market would suggest that inflation is set to accelerate. This, in a nutshell, is the Fed's conundrum. It can rely on Phillips Curve-type inflation forecasts and risk tightening too quickly if inflation does not respond as expected. Or, it can rely on the actual inflation data and risk staying easy for too long. For now, we believe the Fed will cling firmly to the Phillips Curve option. In a speech from September 2015,3 Chair Yellen outlined her model for inflation forecasting. In Yellen's model, core inflation tends to fluctuate around a long-run trend that is determined by inflation expectations. Changes in resource utilization (aka the employment gap) and relative import prices can cause inflation to deviate from this trend but, as long as these shocks prove transitory, inflation should gradually move back toward the level determined by expectations. Inspired by this approach, we created a Phillips Curve model of core PCE - the output of which was shown in Chart 1 on page 1. Specifically, we model core PCE as a function of: 12-month lag of core PCE Long-run inflation expectations from the Survey of Professional Forecasters Resource utilization (proxied by the difference between the unemployment rate and the Congressional Budget Office's (CBO) estimate of the long-run natural unemployment rate) Non-oil import prices relative to overall core PCE The value of this approach is that we can assess how core inflation is likely to react to varying assumptions about inflation expectations, the unemployment rate, the natural unemployment rate (NAIRU), and the trade-weighted U.S. dollar. We use the trend in the dollar to forecast relative import prices. A stronger dollar leads to lower import prices, and vice-versa. Charts 4-7 show the results of running this model under four different scenarios. We conclude that it is very difficult to create a set of reasonable assumptions where core PCE inflation does not approach the Fed's 1.9% forecast by year end. Given that Fed policymakers are very likely using a similar framework, we would expect them to arrive at the same conclusion. Scenario 1: The Base Case. In the first scenario we assume that the unemployment rate stays at its current level (4.4%) and also that the trade-weighted dollar remains flat. We also use the CBO's NAIRU estimate and assume no change in inflation expectations. In this environment, our model projects that year-over-year core PCE inflation will reach 2.11% by the end of December (Chart 4). Scenario 2: Strong Dollar. In this scenario we make the same assumptions as in Scenario 1, except that we allow the dollar to appreciate at a pace of 10% per year. The result is that import price deflation is more pronounced, but year-over-year core PCE inflation is still projected to reach 1.95% by year end (Chart 5). Chart 4Phillips Curve Model: Base Case Scenario Chart 5Phillips Curve Model: Strong Dollar Scenario Scenario 3: Bad NAIRU. In this scenario we consider that the CBO's NAIRU assumption might be too high. Specifically, we allow NAIRU to decline linearly from 5.07% at the end of 2012 to 4% by the end of 2013, we then hold it constant at 4%. Currently, the CBO's NAIRU estimate is 4.74%. In this scenario we also hold the unemployment rate, inflation expectations and the dollar flat. The result is that year-over-year core PCE inflation is projected to reach 2.03% by the end of the year (Chart 6). Scenario 4: The Deflation Case. In this scenario we make the same NAIRU assumption as in Scenario 3, but also incorporate 10% per year dollar appreciation. In this most deflationary scenario, the model still projects 1.88% core PCE inflation at year end (Chart 7). Chart 6Phillips Curve Model: Bad NAIRU Scenario Chart 7Phillips Curve Model: The Deflation Case Bottom Line: Even in the most deflationary of our four scenarios we still project inflation that is very close to the Fed's median forecast. We expect the Fed will arrive at a similar conclusion and will stay on track for two more rate hikes this year. However, if the actual core inflation data do not respond by moving higher during the next 3-4 months, then the Fed's hawkish stance will increasingly come into question. The Fed's Balance Sheet Is The Treasury's Problem Janet Yellen is sure to face some questions about how the Fed plans to unwind its balance sheet at next month's FOMC press conference, but the truth is that we already have a lot of information about how the Fed intends to proceed. The more challenging questions should be asked to the Treasury department, since it is the Treasury that will decide in what form the Fed's balance sheet run-off ultimately finds its way back into private hands. We have written about this topic twice in recent months. First, we published a detailed Special Report on how we expect monetary policy to evolve from an operational perspective in February.4 Then, we updated our expectations based on information contained in the March FOMC minutes.5 This week, we provide some additional observations based on what we learned from the recent meeting of the Treasury Borrowing Advisory Committee (TBAC). Chart 8Fed's Balance Sheet Will Still Be Large First, a brief recap. The Fed has told us that it plans to: Start shrinking its balance sheet later this year (assuming its growth forecasts remain intact) Shrink its balance sheet by ceasing the reinvestment of both MBS and Treasury securities at the same time The Fed has still not decided whether it will simply cease reinvestment all at once, or whether reinvestment will be phased out gradually (i.e. "tapered"). It has also not provided any guidance on what level of reserve balances it intends to maintain going forward. In Chart 8 we show that even if the Fed decides to drain reserves all the way down to zero, this process is likely to be complete by mid-2021. In fact, it might not even take that long since we have assumed a relatively slow pace of $15 billion MBS run-off per month. What is notable is that the Fed's balance sheet will still be sizeable even after reserves have fallen to zero. The reason is that the Fed's balance sheet needs to increase over time to keep pace with the growth of currency in circulation. Our calculations show that by the time reserve balances reach zero in mid-2021, the Fed will still be holding $1.3 trillion of Treasury securities and $1.1 trillion of MBS. After 2021, the Fed would likely continue to allow MBS to run off, but would once again start reinvesting the proceeds into Treasuries. Where Does The Treasury Department Come In? At present, the Fed reinvests the proceeds from its maturing securities by purchasing Treasury notes and bonds at regularly scheduled auctions. This means that when the Fed ceases the reinvestment of the securities running off its balance sheet, the Treasury department will have to increase the amount of issuance that is made available to the public. The Treasury is therefore tasked with determining whether the extra issuance will take the form of T-bills, short-dated notes or long-dated bonds. At the most recent TBAC meeting, committee members seemed to favor a strategy where the extra issuance is spread evenly across all maturities in proportion to current auction sizes, and where the proportion of T-bills in the overall funding mix is held constant. In Chart 9 and Chart 10 we show what this will mean for gross Treasury issuance of 2-year, 5-year, 10-year and 30-year securities, both in dollar terms and as a percentage of GDP. Chart 9Gross Coupon Issuance: In Dollar Terms Chart 10Gross Coupon Issuance: % Of GDP Interestingly, the Treasury department decided against placing a larger portion of the extra issuance in T-bills, as we had thought they might, and we remain concerned about the lack of short-term low-risk debt instruments in the market. The demand for short-term, low-risk instruments - largely from non-financial corporations, asset managers and foreign exchange reserve funds - is in a secular uptrend. Prior to the financial crisis this demand was met by broker/dealers in the repo market. Then, when regulations killed the repo market, the Fed increased the supply of bank reserves to make up for the shortfall (Chart 11). If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We would not be surprised to see the Treasury increase the proportion of T-bills in its funding mix, from historically low levels (Chart 12), if stresses in short-term rates markets start to appear at some point down the road. Chart 11A Shortage Of Cash-Like Instruments Chart 12Bill Issuance Has Room To Rise Can The Treasury Market Absorb All The Extra Issuance? Obviously, the most important question is whether the Treasury market will be able to absorb the substantial extra issuance shown in Charts 9 & 10. There are two reasons why we don't think the extra issuance will have a material impact on yields. First, the path of inflation and the expected pace of rate hikes will continue to drive the movement in long-dated yields. While the inflation component of nominal yields is tied to realized inflation, the real component of yields is closely linked to the expected number of rate hikes during the next 12 months (Chart 13). From this perspective, it is difficult to see how shrinkage of the Fed's balance sheet can have a material impact on yields unless it influences inflation or the expected pace of hikes. Second, the draining of reserves from the banking system will increase banks' demand for Treasury securities, providing a powerful offset to the increased supply of Treasuries. The newly implemented Liquidity Coverage Ratio (LCR) mandates that banks must hold High-Quality Liquid Assets (HQLA) that are at least sufficient to cover net cash outflows over a stressed 30-day period. HQLAs are divided into tiers, with Treasury securities and reserves at the Fed qualifying as Tier 1 assets. Agency MBS are considered Tier 2A assets, this means that a 15% haircut must be applied to MBS balances for the purposes of the HQLA calculation. An even larger haircut is applied to riskier assets such as corporate bonds. Chart 14 shows the aggregate balances of reserves, Treasury securities and Agency MBS for all private depository institutions, as well as a proxy for banking sector HQLAs that we calculated to include only: reserves, Treasury securities, and agency MBS with a 15% haircut. Chart 13Focus On Rate Expectations Chart 14Banks Need Safe Assets As the Fed's balance sheet shrinks and reserves are drained from the banking system, banks will be forced to buy Treasuries in numbers that are at least sufficient to maintain mandated HQLA balances. At the moment, it is difficult to calculate how much Treasury buying will be necessary. The regulation only forces banks to start reporting their LCRs on a quarterly basis starting on April 1 of this year. Citigroup did report an LCR of 121% in its 2016 annual report, and we suspect that the ratios for other banks are in the same neighborhood. The mandated LCR is 100%. If Citigroup's reported LCR is a reasonable guide, this means that banks are just barely above mandated LCR levels. In other words, banks will need to replace almost all of the decline in bank reserves with purchases of Treasury securities. This surge in demand will offset a good chunk, if not all, of the extra Treasury issuance that is on its way. Bottom Line: The run-down of the Fed's balance sheet will lead to a substantial increase in gross Treasury issuance next year. Most, if not all, of this extra issuance will be met by increased demand from the banking sector. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.predictit.org/Contract/5367/Will-Donald-Trump-be-president-at-year-end-2018#data 2 Please see Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17, 2017, available at gps.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Politics will inject further volatility into risk assets, but stocks will outperform bonds and cash on a 6-12 month horizon. The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. The combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. Feature The Economy Matters More Than Politics The health of the economy and earnings matter more than Trump's political woes for investors and the Fed. When the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s, the equity markets performed well. In the early 70s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 1). Today, the backdrop for the economy and earnings - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, two more Fed rate hikes and higher Treasury bond yields. Trump's political woes may slow, but not completely halt the GOP's legislative agenda1. Support for Trump among his GOP base remains high at 85%, making impeachment a long shot until after the November 2018 mid-term elections (Chart 2). If the Democrats take the House, they are likely to impeach Trump in 2019. For the Trump and the Republicans in Congress, this means the impetus is even greater to make progress now on tax cuts, tax reform and infrastructure. However, the embattled White House will slow the process as the president's staff often acts as a coordinator among the various factions in Congress. With Trump's team preoccupied with political woes, they will not be effective in this role. Chart 1Economy Will Trump Politics ##br## For Financial Markets Chart 2GOP Base Not Yet Willing To ##br## Impeach Trump The Fed will look through the politics and focus on the health of the economy and will continue to raise rates gradually this year, with the next hike coming in June. Financial conditions have eased since the Fed's 25 basis point rate hike in December, and that alone should be enough to keep the Fed on track to tighten next month. As we have noted in recent reports, even without fiscal stimulus, the U.S. economy will still grow near its long-term potential, tighten the labor market and push up wages and inflation. The Fed has been reticent to include any impact from fiscal stimulus into their policy deliberations thus far. The minutes of the March FOMC meeting noted that "members continued to judge that there was significant uncertainty about the effects of possible changes in fiscal and other government policies". Bottom Line: The lack of progress on legislation may result in a pullback in U.S. equity prices, but absent a material weakening of the U.S. economy or profit picture, the pullback will not turn into a bear market. Checking In On The Consumer The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This backdrop will allow the Fed to pursue two rate hikes this year. The weakness in several indicators has worried some investors that the economy may be on the verge of a slowdown or even a collapse. However, a firming economy should sustain corporate earnings growth and, ultimately, higher stock prices. Consumer spending's share of GDP is 68% and increasing (Chart 3). GDP growth excluding consumer spending is more volatile than overall GDP growth. The household sector has contributed 75% to growth since the end of the recession, which is the best performance of any sector. The key drivers of spending point to further gains in the sector, and the imbalances that were present ahead of prior downturns are not evident today. Chart 3Household Share Of GDP Is At An All Time High And Rising Chart 4Consumer Spending Remains In An Uptrend Household spending growth has softened but remains in an uptrend. Broad measures of consumer spending tend to peak two to four years prior to the start of a recession. The lead time is even longer in a long-cycle expansion.2 Investors should not dismiss the weakness altogether, but position portfolios for the late-cycle environment. Personal consumption expenditure growth peaked at 4% year-over-year in Q1 2015. Auto sales, a timelier measure of spending although not as comprehensive, peaked in December 2016 (Chart 4). Applying the 2 to 4 year lead time noted above - and making the assumption that spending has indeed peaked - this points to a recession commencing in the middle of 2019 at the earliest. Household net worth is at an all-time high, and the overall wealth effect on consumer spending has been positive for some time. Our forecast for financial markets and the housing market, though modest, imply that the positive wealth effect will continue. Debt-financed spending remains a viable option for consumers, which was not the case in late 2007 before the onset of the recession. Banks have not changed their lending standards for most consumer loans and demand for these loans will stay solid despite the Fed rate increases that we expect. The Bank Credit Analyst's March 2017 report showed that even a 100-basis point rate rise from the current levels would not lift the interest payments to burdensome levels by historical standards. Incomes will continue to climb and importantly, consumer income expectations have also hit new highs. With the economy at the Fed's assessment of full employment, wage growth is accelerating, albeit more modestly than in previous recoveries. Our recent report3 found that wages tend to rise about two years after the output gap has formed a bottom. A narrowing output gap leads to a tighter labor market and higher incomes. As measured by the quit rate, job security is at a fresh cycle high (not shown). Many consumer indicators are in better shape today than they were in 2007 or at similar points in the other long cycles4 (Charts 5 and 6). We define the long cycle economic expansions as those lasting 8-10 years. The two expansions that meet the definition are 1981-1990 and 1992-2001.5 Consumer spending is running in line with incomes, unlike in the mid-2000s. Chart 5Key Consumer Metrics ##br## Remain Favorable Chart 6There Is Still Plenty Of Support ##br## For Solid Consumer Spending Mortgage equity withdrawal, a crucial source of debt-fueled consumer spending prior to 2007, has been non-existent in this cycle. Spending on essentials are close to all-time lows. In 2007 they were at record highs and had moved up dramatically in the prior half-decade amid escalating debt levels, rising energy prices and consumer interest rates. We are concerned by the historically high percentage of household incomes (17%) dedicated to medical care. An aging population, ever rising healthcare costs and uncertainty surrounding the future of Obamacare may drive medical spending even higher. Household debt levels as a percentage of disposable income peaked in 2008 at over 120%, but are back under 100%, i.e. at the level that existed prior to the 2007-2009 recession. The level of household debt compares favorably to similar points in the long cycles of the 1980s and 1990s. Financial obligations are at multi-decade lows (Chart 6, bottom panel). Bottom Line: The fundamentals supporting consumer spending remain solid. A healthy consumer means the economy can meet the Fed's modest GDP forecast for 2017, keeping the central bank on track to tighten twice more in 2017. This outlook supports our view for stocks over bonds in the next 6-12 months. The Fed's Balance Sheet: It's Diet Time Chart 7Fed Set To Begin Tapering In Early 2018 The minutes from the March FOMC meeting indicated that a change in the Fed's reinvestment policy will likely be appropriate "later this year". The minutes suggested that the FOMC is split on whether to simply terminate all reinvestment for both Treasurys and MBS, or to "taper" reinvestment over time. Our base case is that the Fed will follow up a June rate hike with another one in September, at which point policymakers will provide some details on their plans for balance sheet runoff to begin in January of 2018. Investors are rightly concerned about the potential impact of the runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" (i.e. that QE implied that short-rates will be held at a low level for a very long time). Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables, including inflation expectations, demographics, growth, current accounts and budget balances. The model also includes the stock of assets held by the Fed as a share of GDP. If the Fed were to begin running off its holdings of both Treasurys and MBS at the beginning of 2018 by terminating all reinvestment, then the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a fall of roughly 10 percentage points of GDP (Chart 7). Given the IMF interest rate model's coefficient of -0.9, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. However, it is more complicated than that. The impact on yields is likely to be tempered by three factors: The Fed may opt to avoid going "cold turkey" on reinvestment, choosing instead to scale back gradually. Fed President William Dudley recently commented that the Fed wants balance sheet reduction to "run in the background", such that it is not a major event for markets. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. The implication is that the balance sheet may never fully revert to historic norms relative to GDP. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions get too tight, too quickly (i.e. the term premium would rise, but would be partly offset by a lower expected path for the fed funds rate). Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).6 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than is currently discounted in the market. We could also see some upward pressure on global term premia when the ECB announces the next tapering of its QE purchase program, possibly this autumn. However, it will be years before the ECB will be in a position to reduce the size of its balance sheet. As for the Bank of Japan, we doubt that the central bank will ever shed its JGB holdings. What about the shape of the Treasury curve? Our fixed-income strategists believe that the shape of the curve will be determined by the normal cyclical dynamics we have seen in the past. We are still in a window in which the Treasury curve will steepen as yields rise. A little later in the Fed cycle, the curve will bear-flatten as the long-end begins to rise at a slower pace than the front end. We do not see balance sheet adjustment as changing these dynamics much. Similarly, with respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. It is a different story for the mortgage market, where spreads will be biased to widen during Fed runoff. While spreads have already widened a bit, in our view they still do not adequately compensate for the additional MBS supply that will hit the market when the Fed takes a step back. Historically, there is a reasonably tight correlation between MBS spreads and the spread between mortgage rates and Treasury yields (Chart 8). Thus, it is reasonable to expect mortgage rates to rise by more than Treasury yields. Chart 8MBS Spreads Set To Widen As Fed Tapers While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten for a long time, outside of removing negative short rates and tapering QE purchases a bit further in 2018. Meanwhile, we think the Fed will tighten by more than is currently discounted. Admittedly, the economic data have disappointed so far in 2017 and CPI inflation has softened which, at the margin, would cause some FOMC members to back away from rate hikes. Nonetheless, policymakers are focused more on the labor market than GDP to gauge the health of the expansion and the amount of economic slack. Despite the dismal Q1 GDP figures, following unimpressive growth in 2016, the unemployment rate has already fallen below what the FOMC expected the rate will be at the end of this year! A tightening labor market means that the economy is still growing above a trend pace. Unless there is a clear deceleration in wage growth as measured by the ECI or the Productivity and Cost report, the FOMC will likely hike rates by more than the 38 basis points currently discounted over the next 12 months. 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 See Geopolitical Strategy Report, "Break Glass In Case Of Impeachment," May 17, 2017. Available at gps.bcaresearch.com 2 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 3 See U.S. Investment Strategy Weekly Report, "Still Awaiting the Next Pullback", May 15, 2017. Available at usis.bcaresearch.com 4 See The Bank Credit Analyst, March 2017. Available at bca.bcaresearch.com 5 We did not include the 1960s in this analysis because the Fed waited too long to tighten and allowed inflation to get out of hand. 6 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017.