Monetary

Highlights Rate Volatility: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Treasury Yields: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. MBS: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Feature Low interest rate volatility has been a constant feature of the investing landscape during the past few years. In fact, you need to go back to the 1970s to find another period when interest rate volatility was consistently at or below its current level (Chart 1). Not surprisingly, the implied volatility priced into Treasury options is also as low as it has been during the past 30 years, with the exception of the period just prior to the financial crisis in 2007 (Chart 2). Chart 1Yield Volatility: Lowest Since The 70s Chart 2Implied And Realized Yield Volatility Move Together This begs the question of whether the current low-vol environment can be sustained, or whether overly complacent investors are in for a shock. At the very least, we believe that rate volatility has already passed its cyclical trough and will start to move up this year. Investors should prepare themselves for higher volatility. In this week's report we examine the key macro drivers of interest rate volatility and discuss the implications of rising vol for both Treasury yields, and crucially, mortgage-backed securities. Macro Uncertainty & Rate Volatility Chart 3Macro Drivers Of Rate Volatility In a Special Report published in 2014,1 we posited that the long-term trends in volatility across all asset classes are largely driven by common macroeconomic factors. Specifically, investor uncertainty regarding the outlook for economic growth and monetary policy. A 2004 paper by Alexander David and Pietro Veronesi2 provides some theoretical justification for this view, as the authors observed that investors tend to overreact to new information when macro uncertainty is high, and underreact when uncertainty is low. To test the linkage between interest rate volatility and macro uncertainty we consider three measures of uncertainty. The first two measures, shown alongside the MOVE index of implied Treasury volatility in Chart 3, are measures of GDP growth and T-bill rate forecast dispersion. We measure dispersion - the disagreement among forecasters - by looking at individual forecasts of GDP growth and T-bill rates and calculating the difference between the 75th and 25th percentiles. The series shown in Chart 3 are equal-weighted averages of the forecast dispersion calculated for five different time horizons, ranging from the current quarter to four quarters ahead. As can be seen in the top two panels of Chart 3, implied interest rate volatility is higher when the disagreement among forecasters is greater, consistent with our thesis. The third measure of uncertainty we consider is the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index tracks uncertainty about the macro environment by counting the number of mentions of certain key words in major global newspapers. Elevated readings from this index have also coincided with high rate volatility in the past (Chart 3, bottom panel). GDP Growth Forecast Dispersion Chart 4Forecast Dispersion & Corporate Lending Disagreement among GDP growth forecasts reached an all-time low in the fourth quarter of 2016, but has since recovered to slightly more typical levels. Historically, we have found that C&I lending standards and corporate sector balance sheet health correlate most closely with GDP growth forecast dispersion (Chart 4) and both measures suggest that forecast dispersion is biased upward. T-Bill Rate Forecast Dispersion T-bill rate forecast dispersion was abnormally low between 2011 and 2014 for two reasons. The first reason is quite simply the zero-lower-bound on interest rates. A short rate bounded at zero necessarily trimmed the distribution of possible T-bill rate forecasts, since forecasters logically assumed that further interest rate cuts were not possible. This impact will gradually dissipate the further the fed funds rate moves off zero. Chart 5Fed Says March Meeting Is Live The second reason for extremely low T-bill rate forecast dispersion was the Fed's forward guidance. During this timeframe the Fed was actively trying to convince the public that interest rates would remain low. The most obvious example being the "Evans Rule", where the Fed promised not to lift interest rates at least until the unemployment rate had fallen below a specific threshold. This activist forward guidance limited the range of conceivable T-bill rate forecasts and crushed interest rate volatility. Nowadays, the Fed is engaged in a different sort of forward guidance, trying to convince markets that every FOMC meeting is live and that rate hikes could occur at any moment. Essentially, the Fed is trying to inject volatility into the rates market. Just a few weeks ago, when asked about the low probability markets are assigning to a March rate hike (Chart 5), San Francisco Fed President John Williams replied flatly: "I don't agree. All our meetings are live." Global Economic Policy Uncertainty We have written a lot about the policy uncertainty index in recent reports,4 focusing specifically on how it has diverged from its historical relationships with many asset prices. At the very least, we expect that sustained elevated policy uncertainty will place upward pressure on asset price volatility at the margin. Bottom Line: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Rate Volatility & Treasury Yields Long-dated nominal Treasury yields can be decomposed in a few different ways. In recent reports we have focused on the decomposition of the nominal 10-year Treasury yield into its real and inflation components. By identifying different macro drivers for each component we concluded that nominal Treasury yields will increase this year, driven by a rising inflation component and relatively stable real yields.5 Alternatively, we can think of the nominal 10-year Treasury yield as consisting of an expectations component equal to the market's expected path of short rates over the next ten years, and a term premium that reflects all of the other market imbalances and uncertainties associated with taking duration risk. This second approach is complicated by the fact that it requires a model of ex-ante interest rate expectations and every commonly used model is fraught with its own unique difficulties.6 Setting that aside, if we use the Kim & Wright (2005)7 estimate of the 10-year term premium we observe an expectations component that generally tracks the fed funds rate and a term premium component that is correlated with implied Treasury volatility (Chart 6), although the latter correlation is less than perfect. This decomposition also suggests that nominal Treasury yields should rise. The Fed is much more likely to hike rates than cut them and we have concluded that rate volatility is likely to trend higher from current depressed levels. However, the relationship between rate volatility and the term premium is complicated. The main reason for the complicated relationship between interest rate volatility and the term premium is the fact that elevated interest rate volatility also tends to be correlated with high equity volatility (Chart 7). So while higher rate volatility puts upward pressure on the term premium, the associated increase in equity volatility tends to raise investor risk aversion and increase the perceived value of bonds as a hedge against equity positions. This mitigates some (or often all) of the impact of rising rate volatility on the term premium. Chart 6Which Way For The ##br##Term Premium? Chart 7MOVE & VIX Have Opposing##br## Impacts On Bond Yields Bottom Line: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. Rate Volatility & MBS The relationship between rate volatility and MBS is much more straightforward than for Treasury yields. We observe a tight correlation between nominal MBS spreads and the MOVE implied volatility index (Chart 8). Chart 8 suggests that, even in the near-term, MBS spreads are too low for current levels of rate vol. The relationship between MBS spreads and rate volatility is easily explained. The defining characteristic of a negatively convex asset, such as MBS, is that its duration is positively correlated with the level of interest rates (Chart 9). This correlation leads to increased losses when yields rise and lower gains when yields fall. It's not surprising that negatively convex assets perform best in low volatility environments. Chart 8MBS Spreads Are Linked To Vol Chart 9MBS Duration Moves With Yields We maintain an underweight allocation to MBS given that spreads are already low and that the volatility environment is poised to become less favorable. Further, if the Fed continues along its planned normalization path it is likely to cease the reinvestment of its MBS portfolio at some point in 2018. There are two reasons why this poses a risk for MBS. The first reason is that the unwinding of the Fed's MBS portfolio is likely to place upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility is likely to increase. The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 10). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 11), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 10Annual MBS Excess Returns ##br## Vs. Net Supply Since 1989 Chart 11Net Issuance Will Turn##br## Positive In 2018 During the past three years the Fed has been buying between $20bn and $40bn MBS per month, just to keep its balance sheet stable. Net new MBS issuance will not be strong enough to overcome this hurdle in 2017, but net MBS issuance (adjusted for Fed purchases) will swing quickly into positive territory in 2018 if the Fed decides to let its MBS portfolio run down. Bottom Line: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "Volatility, Uncertainty And Government Bond Yields", dated May 13, 2014, available at usbs.bcaresearch.com 2 "Inflation and earnings uncertainty and volatility forecasts", Alexander David and Pietro Veronesi, Manuscript, Graduate School of Business, University of Chicago (2004). 3 Please see www.policyuncertainty.com for further details. 4 Please see Theme # 4 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Bond Volatility - The Unwelcome Guest That Will Not Leave", dated June 16, 2015, available at usbs.bcaresearch.com 7 Don H. Kim and Jonathan H. Wright, "An Arbitrage-Free Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates", FEDS 2005-33. https://www.federalreserve.gov/econresdata/feds/2005/index.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The divergence in political uncertainty measures and the VIX index suggests that equity prices are vulnerable to Washington disappointments. Longer term, a self-reinforcing, low-inflation recovery is in place, which sets a fundamentally positive cyclical backdrop for equities. Monetary policy is still in a sweet spot for risk assets. Fed policy decisions throughout the current cycle have been in line with the Taylor Rule, once the model is adjusted for regional growth disparities. The most recent Senior Loan Officer Survey runs counter to most other data on the consumer. Improved consumer confidence should lead to stronger consumer loan demand, while banks should be more willing to lend when their customers have jobs and rising incomes. Feature Equity market performance over the past few weeks has been impressive. Still, there are starting to be signs that investors are becoming nervous. Safe-haven assets have been undergoing a stealth recovery since mid-December: gold, the Japanese yen, and the Swiss franc have all appreciated (Chart 1). In relation to these trends, the equity market is the so-called "odd man out": even though several safe-haven assets bottomed out mid-December, the stock market continued to make new highs. A second worrying divergence is the behavior of two popular risk indexes: the VIX and the Global Policy Uncertainty Index. The former - a measure of the cost of equity insurance - remains very low, while political uncertainty is making record highs. In fact, Chart 2 shows that the gap between these two risk measures is at a historic extreme. This reinforces our view that the equity market is vulnerable to negative surprises. Chart 1A Message From Safe Havens? Chart 2Different Signals? One main risk is that investors will become disappointed with the timing and magnitude of market-friendly policies from Washington. Meanwhile, the possibility of less friendly policies being passed is rising. Our Geopolitical team believes that the Trump administration will ultimately accept the House GOP's Border Adjustment Tax (BAT) proposal, though the road between here and there will be tortuous, as past attempts at tax reform show.1 We would expect market volatility to rise as the BAT debate intensifies. Longer term, the economy is entering a self-reinforcing phase. And since it is premature to expect inflation to flare up to a point that would require aggressive monetary tightening,2 we expect that the cyclical bull market will be prolonged. Policy Sweet Spot We have shown on several occasions3 that equities perform well in the early phases of a rising interest environment, i.e. for as long as rates remain in accommodative territory. We have identified four phases of the fed funds rate cycle, which are defined by the policy rate relative to its equilibrium level (accommodative or restrictive) and the direction of its last move: Phase I = Policy is accommodative, but the Fed funds rate is rising. Phase II = Policy is tight and the Fed funds is still rising. Phase III = Policy is tight, but the Fed is cutting rates. Phase IV = Policy is easing and the Fed is cutting rates. As one would expect, the best equity market returns occur when the Fed funds rate is accommodative (below the equilibrium rate) and the Fed is still cutting and/or on extensive hold, i.e. Phase IV. The second best phase for equity performance is the current one: when policy is still accommodative, but rates are rising (Chart 3). Granted, the magnitude of returns in this phase depend markedly on earnings performance, but the general message is that risk assets will continue to eke out positive gains, so long as the Fed finds reason to stay accommodative. Chart 3Policy Sweet Spot Can Last A Long Time To this end, this week we examine the Taylor rule - which prescribes a value for the federal funds rate based on the values of inflation and economic slack - and its usefulness in the current economic (and political) environment. The Robotization Of The Fed In mid-January, FOMC Chair Janet Yellen gave a speech4 that outlined the merits of using statistical rules to guide monetary policy. Her speech served as a rebuttal to the FORM Act (Fed Oversight Reform and Modernization Act). The FORM Act - whose main feature is to have Fed officials determine a mathematical formula to guide their interest-rate decisions - is only one of several measures that have been proposed over the years to revamp the Fed to put it under greater Congressional scrutiny and limit its discretionary powers. The Senate has never voted on the FORM Act, but Yellen's speech on rule-based approaches to monetary policy suggest that this type of legislation should be on investors' radars. In the past, plenty of simple policy rules have been suggested to guide central banks' decisions.5 But in her speech, Yellen spoke about the relevance of the Taylor Rule. The Taylor rule calls for systematic adjustments in the federal funds rate relative to its expected longer-run neutral level in response to movements in inflation and the output gap, defined as the percentage difference between actual output and the economy's productive potential. The traditional Taylor Rule shows that the Fed is currently behind the curve and should be much more hawkish (Chart 4, top panel). Chair Yellen's preferred variant is to use a "balanced approach," which is twice as responsive to the movements in resources utilization (Chart 4, bottom panel). Simply put, it doubles the coefficient of the output gap, putting more emphasis on maintaining sustainable growth. But even with this methodological tweak, Yellen warned of the danger of using simple rules to conduct policy and quoted the uncertain footing of the global economic growth pattern. She also highlighted that the uncertainty related to upcoming fiscal policy: "simple rules ignore such important factors as fiscal policy, trends affecting global growth, structural developments influencing supply of credit, and overall financial conditions." For this reason, we created an Augmented Taylor rule that improves on the Traditional as well as Yellen's preferred modified Taylor rule. Our version of the Taylor rule has a better track record in explaining the Fed's policy decisions historically. Chart 4Taylor Vs. The Fed Chart 5Different Rates For Different States Augmenting The Taylor Rule One of the difficulties in conducting monetary policy in the U.S. is that growth is unevenly distributed. For example, according to the BEA, state level real GDP growth varied between -0.1% (In Alaska and New Mexico) and 7.1% (in South Dakota). Regulating interest rates over such an eclectic base has the potential to create distortions. Therefore, determining a mathematical formula for monetary policy should take into account these asymmetric patterns. By studying state-specific variables, we augment the Taylor Rule and come up with a more accurate reading of the Fed's behavior. The Augmented Taylor Rule is calculated using an average of 51 state-specific Taylor rules,6 using state GDP deflator and state unemployment rate as inputs. Please note that the following work does not make us advocates for the Fed following a mathematical formula. However, our model does better formulize the Fed's historical actions. To construct our Augmented Taylor rule we do the following: Step 1 - State Taylor Rules: NAIRU and the Fed's targets for interest rates and for inflation were used at the national level. As such, we used state-specific variables for the rest of the variables. Specifically, we used each states' GDP deflator and unemployment rate as inputs for inflation and resource utilization, respectively. With these variables, we calculated each states' Taylor Rule using Janet Yellen's preferred formula, the balanced approached. We then aggregated the data by calculating a simple average of the 51 Taylor Rules. As a reference, the top panel of Chart 5 shows that the averaged state Taylor Rules and Yellen's balanced approach are similar despite slightly different methods. Step 2 - Quantifying Asymmetry: As the middle panel of Chart 5 shows, there are large divergences between states' Taylor Rule-prescribed interest rates throughout time. Therefore, we calculated the standard deviations of the Taylor Rules across the 51 states Taylor Rules to come up with a value of asymmetry measure (Chart 5, bottom panel). Step 3 - Augmenting The Taylor Rule: We then deducted the asymmetry measure from the average Taylor Rule (Chart 6). The rationale for doing so is that it is much more difficult for the Fed to raise rates when outputs gaps vary greatly across states. Step 4 - Validating The Rule: Chart 7 shows the relationship between the national balanced Taylor rule (i.e. Yellen's preferred approach) and the Fed funds rate, and the augmented Taylor rule and the Fed funds rate. The main difference between our adjusted Taylor rule and Yellen's balanced approach is that we give equal weight to each state Taylor rule and then subtract the variance across states. Recall that both the Traditional and Balanced Taylor rules use national aggregate data, and do not account for state variances. The augmented Taylor Rule improves the R2 over the national rule, therefore providing more explanatory power of the Fed's decisions. Chart 6The Fed Is Constrained By Asymmetry Chart 7Validating The Augmented Taylor Rule The bottom line is that the Augmented Taylor Rule allows us to understand and quantify the economic asymmetry within the U.S. Further, it appears as though the Fed has been following this rule even if policymakers are not aware of it! Given the current message from our rule, investors should expect the Fed to remain gradual in raising rates. We do not foresee the Fed "catching up" with the Traditional Taylor (which currently calls for a policy rate of over 4%). The above Taylor Rule analysis corroborates our view that policy will stay in a sweet spot for equities. The bond market currently is priced for two rates in the next twelve months. If that is realized, interest rates would still be below the equilibrium rate, underscoring that monetary policy will be a benign factor for risk assets. Economy Update: Too Early To Worry About Rising Rates The most recent Fed Senior Loan Officer Opinion Survey, completed after most of the run up in interest rates, showed that banks' lending standards for loans to businesses remained largely unchanged, though lending standards for consumer loans stiffened, especially for auto loans and credit cards (Chart 8). There was also reportedly less demand for consumer credit. These results run counter to most other data on the U.S. consumer. As we highlighted in previous reports, consumer confidence has soared to its highest level in the cycle and the labor market is approaching full employment. These trends should lead to stronger consumer loan demand, while banks should be more willing to lend when their customers have jobs and rising incomes. This was not borne out in the Fed's Q1 lending survey, especially as it relates to auto and credit card loans: banks expect the asset quality of auto and credit card loans to further deteriorate this year. These survey results are difficult to ignore as they tend to correlate reasonably well with consumer spending patterns. We maintain an optimistic view on household spending for 2017, driven by the strong labor market, though the next survey (to be released in early May) will tell whether the Q1 results were an aberration or the start of a weaker trend. Importantly, recent work from our Bank Credit Analyst service7 concluded that household interest payment burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates increase immediately by 100bps for today's levels. According to their analysis, it would require a much more significant shock, i.e. 300bps or greater, to move interest payments as a share of GDP back toward historical averages. Projections are shown in Chart 9. Chart 8Banks Are Still Cautious On Lending Chart 9Rising Rates Are Not Problematic More broadly for the major economies, global debt has soared by over 40 percentage points since 2007. However, The BCA report uncovers that a doomsday scenario for global growth due to a rising interest rate environment (led chiefly by the Fed) is unlikely to unfold. First, the starting point for debt service burdens in the corporate, household and government sectors is low. These burdens have generally trended down since 2007 because falling interest rates have more than offset debt accumulation, with the major exception of China. Second, the maturity distribution of debt means that it takes time for interest rate shifts to filter into debt servicing costs. For example, the average maturity of corporate investment-grade bond indexes in the major economies is between 3 and 12 years. The average maturity of government indexes range from 7½ to 16 years. Moreover, the majority of household debt is related to fixed-rate mortgages. Even a significant portion of consumer debt is fixed for 5 years and more in some countries. Third, even following the backup in yield curves since the U.S. election, current interest rates on new loans are still significantly below average rates on outstanding household loans, corporate debt and government debt. The implication is that most older loans and bonds coming due over the next few years will be rolled over at a lower rate compared to the loans and bonds being replaced. This will even be true if current yield curves shift up by 100bps in many cases (except for the U.S. where current yields are closer to average coupon and loan rates). The bottom line is that a rising interest rate backdrop will only become problematic much later in the economic cycle. In the meantime, the strength of the consumer spending upcycle depends on (stronger) income trends and banks' willingness to spend. We are optimistic about the former and will continue to monitor the latter. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com David Boucher, Editor/Strategist davidb@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?," dated February 8, 2017, available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report "Inflation In 2017: An Idle Threat," dated January 9, 2017, available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "Lingering In The Policy Sweet Spot," dated September 26, 2016 and "Stocks And The Fed Funds Rate Cycle," dated December 23, 2013, available at usis.bcaresearch.com. 4 Please see a transcript of Janet Yellen's January 19, 2017 speech, https://www.federalreserve.gov/newsevents/speech/yellen20170119a.htm 5 Taylor, J. and Williams, J. "Simple and Robust Rules for Monetary Policy," Federal Reserve Bank Of San Francisco, Working Paper Series, Dated April 2010. 6 We used the 50 states and the District of Columbia. 7 Please see, The Bank Credit Analyst Special Report "Global Debt Titanic Collides With Fed Iceberg?," dated February 2017, available at bca,bcaresearch.com. Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommendation for cash has been upgraded to benchmark at the expense of bonds. The weightings for the major asset classes are: neutral equity exposure at 60% (benchmark 60%), neutral Treasury allocation at 30% (benchmark 30%) and cash at 10% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component retained its "buy" signal, with slight advances for both the breadth & trend and momentum indicators. The monetary component, which measures overall liquidity conditions, though still favorable for equities, is giving a less bullish signal. The earnings-driven component continues to give a cautious signal. Even as real operating earnings continue to gradually improve, they still remain at a significant distance from positive economic expectations which have moved higher yet again. Earnings momentum is also still sluggish, based on our earnings diffusion index. The model's recommendation for bonds is now at benchmark which fits with our neutral qualitative stance for Treasuries in balanced portfolios since November 7, 2016. Although the valuation and cyclical components of the bond model are still constructive, the deterioration of the technical component triggered a "sell" signal changing the allocation from overweight tot benchmark. Chart 10Portfolio Total Returns Chart 11Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report “Presenting Our U.S. Asset Allocation Model”, February 6, 2009.

Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move Chart I-11Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Fears that the Trump Administration will brow-beat America's trading partners into strengthening their currencies have pushed down the dollar in recent weeks. The likelihood of another Plaza-type accord remains extremely low, however. History suggests that such agreements only work when currency interventions are aligned with the underlying macroeconomic fundamentals. With the Fed eager to hike rates, that is not the case today. The only situation where a multilateral agreement to weaken the dollar could be reached is one where the dollar ascends so high that major financial stresses begin to form, particularly in emerging markets. We are not there yet. The real trade-weighted dollar is likely to rise 5%-to-10% by the end of the year. A stronger greenback will hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. Feature Dollar Under Pressure Chart 1The Recent Dollar Dip Is Not ##br##Reflected In Interest Rate Spreads After rallying sharply following the U.S. presidential election, the greenback has given up some of its gains. Since peaking in late December, the trade-weighted dollar has fallen by around 2.5%. Notably, the dollar's swoon has not been accompanied by a narrowing of 2-year real interest rate differentials between the U.S. and its trading partners (Chart 1). This suggests that shifts in relative growth expectations have played a relatively minor role during this latest dollar selloff. In our view, the more important factor has been the "weak dollar" rhetoric coming out of the Trump administration. Historically, U.S. officials have at least given lip service to America's "strong dollar policy." As with many other political customs, Trump has thrown this one out the window. Peter Navarro, head of Trump's National Trade Council, made headlines last week by calling Germany a "currency manipulator" - even though, strictly speaking, Germany does not have a currency to manipulate. This came on the heels of Trump's comments to The Wall Street Journal earlier in January where he lamented that "our currency is too strong... it's killing us." The President reiterated that sentiment last week, telling a group of pharmaceutical company executives: "You look at what China's doing, you look at what Japan has done over the years ... they play the devaluation market and we sit there like a bunch of dummies." A Deal That Worked The Trump administration's efforts to talk down the dollar have raised the question of whether another Plaza Accord is on the horizon. The original agreement was concluded at The Plaza Hotel in 1985. As fate would have it, Trump ended up buying the landmark property three years later. It would go on to be the setting for such historically momentous events as Trump's wedding to Marla Maples and his Oscar-worthy cameo in Home Alone 2: Lost In New York. The Plaza Accord prescribed that G5 nations - the U.S., Japan, Germany, the U.K., and France - intervene in currency markets with the aim of driving down the value of the dollar. At least in this respect, the Accord was a smashing success. Between early 1985 - when rumors of a deal began to swirl - and January 1987, the dollar fell by 54% against both the yen and the mark, 49% against the franc, and 44% against the pound. In fact, so effective was the Plaza Accord that it necessitated the Louvre Accord two years later, an agreement that was drawn up in order to halt the dollar's slide. Chart 2A Widening Current Account ##br##Deficit Sowed The Seeds For The Plaza Accord Then And Now: Some Similarities... There are some clear similarities between 1985 and the present. Just like today, the greenback strengthened significantly in the years leading up to the Accord. At first, the Reagan administration was content to let the dollar appreciate, seeing this as validation of its pro-growth policies. The Fed was also happy to go along with a stronger dollar since lower import prices helped to dampen inflation. As time wore on, however, the damage from an overvalued dollar became increasingly apparent: The current account balance swung from a modest surplus at the start of the 1980s to a deficit of 2.7% of GDP by the end of 1985 (Chart 2). The Big Three automakers, along with companies such as Caterpillar, IBM, and Motorola, began to lobby the U.S. government for trade sanctions against foreign competitors. With Reagan's appointment of James Baker to the post of Treasury Secretary in February 1985, U.S. trade policy moved away from being governed by a doctrinaire free market philosophy and took on a more pragmatic tone. Fearing further protectionist measures, the Japanese and Europeans agreed to take action to strengthen their currencies. ...But Some Notable Differences Despite the clear parallels between 1985 and the present, there are also a number of critical differences. First, there is the issue of magnitude. By early 1985, the greenback was entering the seventh year of a massive bull market - one that had lifted the real broad trade-weighted dollar up 53% from its lows in October 1978 (Chart 3). In contrast, the current dollar bull market is a mere 2.5 years old and has seen the dollar strengthen by "only" 20% since July 2014. Moreover, the current bull market began from a point where the dollar was highly undervalued. As a consequence, as of today, the real trade-weighted dollar remains 21% below its 1985 peak and 11% below its 2002 peak. Second, one of the reasons the Plaza Accord worked so well was because policymakers ensured that their currency interventions were consistent with the macroeconomic fundamentals. The combination of tight monetary policy and loose fiscal policy created a fertile backdrop for the dollar's ascent in the early 1980s. By 1984, however, those bullish dollar fundamentals started to break down. Chart 4 shows that the dollar continued to appreciate into 1985, even though U.S. interest rates were declining relative to other G5 economies. The dollar, in other words, had entered a full-fledged bubble - one that was ripe for a pricking. Chart 3The Dollar Is ##br##Below Past Peaks Chart 4A Full-Fledged Dollar ##br##Bubble Preceded The Plaza Accord Once the dollar bubble burst, monetary policy amplified the downward pressure on the greenback. Most notably, the Federal Reserve continued cutting interest rates, ultimately taking the effective Fed funds rate down from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year nominal interest rate differential shrank by 454 basis points against Japan over this period. For the U.K., the interest rate differential fell by 630 basis points, while for Germany it declined by 407 basis points. In contrast to the mid-1980s, the Fed is unlikely to lean into dollar weakness this time around. The output gap in the U.S. has been nearly eliminated and the economy continues to grow at an above-trend pace. This suggests that the Federal Reserve will keep raising rates. We expect the Fed to hike rates three times this year, one more than the market is pricing in. Most other central banks are nowhere near the point where they can start tightening monetary policy. As such, the interest rate differential between the U.S. and its trading partners is likely to widen further. In a world where foreign exchange trading now exceeds $5 trillion per day, any currency intervention - unless it is backed by an underlying shift in the economic fundamentals - is bound to backfire. A Political Reality Check Chart 5China's Weight Matters Political considerations also render another Plaza Accord highly improbable. In the 1980s, West Germany and Japan were politically subservient to the U.S. That is less the case today. China's role in the global economy has also expanded. The RMB now accounts for 22% of the Fed's broad trade-weighted dollar basket, the largest weight of any country (Chart 5). China's government will fiercely resist negotiating any agreement that is not in the country's best interests. The economic circumstances facing most of America's trading partners could also scuttle any hopes for a deal to weaken the dollar. Inflation expectations in Japan have risen over the past six months, but still remain well below the BoJ's 2% target. A stronger yen would undermine efforts to reflate the economy. The German economy is certainly benefiting from an undervalued exchange rate. However, a continued weak currency is necessary for Southern Europe, where unemployment is still very high. Moreover, it is not clear that Germany could stomach a much stronger euro. The German unemployment rate is at a 25-year low, but that is because the country is running a massive 9% of GDP current account surplus. Take away Germany's ability to export its excess savings abroad, and the German economy would look a lot like Japan's. The only scenario in which a new multilateral accord would be seriously entertained is if a rising dollar began to wreak havoc on the global economy. A modestly stronger dollar would boost global growth to the extent that it redistributed demand from the U.S. to economies such as Europe and Japan with greater levels of economic slack. However, if the greenback were to ascend into bubble territory, this could instigate a vicious circle where an appreciating dollar increases the local-currency value of EM dollar-denominated debt, leading to a wave of bankruptcies and defaults, and, in the process, generating even further selling pressure on EM currencies. That said, the dollar would probably need to appreciate by another 15% or so before a crisis occurred. And even if a meltdown seemed imminent, the bar for currency intervention would remain quite high. No emerging market wants to go cap-in-hand to the IMF or the U.S. Treasury. This is particularly true for China, which would likely shun any offers of assistance, even if capital were flooding out of the country. In any case, if a deal were reached, it would likely seek to prevent the dollar from rising further, rather than falling in value. That is a critical distinction. Trump, Trade, And The Fed The discussion above suggests that a new Plaza-style accord is not in the cards, at least not unless the dollar strengthens substantially from current levels. Where does that leave Trump's pledge to bring manufacturing jobs back to the U.S.? We see two possible ways that Trump could try to square this circle. First, Trump could lean on the Fed to maintain a highly accommodative monetary stance. Since inflation expectations are likely to rise further as the economy begins to overheat, it is possible that real rates would actually decline unless the Fed raised rates fast enough, pushing down the dollar in the process. The problem with this theory is that Trump's public pronouncements on monetary policy have generally been on the hawkish side. He criticized Janet Yellen on the campaign trail, accusing her of trying to goose the economy in order to help the Democrats at the polls. Granted, Trump's views on the hard money/easy money debate may have changed now that he is President and poised to benefit politically from a more stimulative monetary policy. Nevertheless, it will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans are likely to resist efforts to pack the FOMC with doves. As long as the economy is doing well, our guess is that Trump will accede to Republican demands that he nominate members to the FOMC with a somewhat hawkish disposition. This should keep the dollar uptrend intact. If a policy U-turn does occur, it will happen towards the end of the decade, by which time the economy will be due for another recession. With another presidential election looming at that point, Trump might end up taking a page out of the old Nixon playbook and browbeat the Fed chair into pursuing a massively expansionary monetary policy.1 This could set the stage for a stagflationary episode, a prediction we discussed at length in our latest Strategy Outlook.2 In the meantime, Trump will try to mitigate the effects of a stronger dollar on U.S. manufacturing by pursuing a more protectionist trade agenda. This is likely to entail expanding the use of countervailing duties which target foreign industries that are alleged to be engaging in unfair trade practices - similar to what Obama did when he slapped an extra 35% duty onto Chinese tires in 2009. Trump is also likely to continue "twitter shaming" companies that have moved, or are contemplating moving, production abroad. On the whole, however, a radical departure from existing trade policy is unlikely as long as the economy continues to expand. Nevertheless, as with his approach to Fed policy, Trump could break with all established traditions if unemployment starts rising and his poll numbers begin tumbling. In other words, a major trade war is coming, just not yet. Investment Conclusions Chart 6The Dollar Can Climb Amid ##br##Bullish Sentiment In politics, as in life, preferences are not the only things that matter. Constraints are as important, if not more so. Just as in the early 1980s, the U.S. is pursing a policy of fiscal easing and monetary tightening. As was the case back then, this has led to a stronger dollar. It would be easy to say that Trump could badger other countries into tightening monetary policy in order to keep the dollar from appreciating. Even if we ignore the political implausibility of such a strategy, it still would not work. If a country needs a low interest rate to keep growth from stalling, then raising rates is unlikely to boost that country's currency. The market will realize in short order that the central bank will eventually have to reverse course and cut rates to keep deflationary forces from setting in. The point is that trying to influence exchange rates without changing the economic fundamentals is destined to fail. We expect the real trade-weighted dollar to rise 5%-to-10% by the end of the year. Granted, bullish dollar sentiment is widespread these days (Chart 6). However, dollar bulls were around in even greater numbers in the second half of the 1990s, and this did not prevent the greenback from scaling to new highs. If the dollar resumes its ascent, as we expect, this could hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. A stronger greenback would also weigh on commodity prices, with metals being the most vulnerable. The risks to our dollar view are fairly symmetric. On the downside, the failure of the Trump administration to loosen fiscal policy could prevent the Fed from hiking rates as much as planned. The risk here is not so much that the tax cuts will be scuttled, but rather that Congressional Republicans succeed in pushing through big spending cuts as part of any budget deal. On the upside, the passage of a Border Adjustment Tax - something to which we assign 50% odds - would lift the dollar.3 Rising stress in emerging markets could also push money into safe haven markets such as U.S. Treasurys, similar to what happened during the late 1990s. This could cause the dollar to appreciate more than our baseline forecast implies. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Burton A. Abrams, "How Richard Nixon Pressured Arthur Burns: Evidence From The Nixon Tapes," The Journal of Economic Perspectives, Vol. 20, no. 4 (2006), pp.177-188. 2 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The latest adjustment of the interest rates of some PBoC lending facilities reflects China's ongoing moves toward market-driven interest rate reforms. Domestic growth improvement calls for higher interest rates, but it is too soon to conclude whether the latest interest rate adjustment is the beginning of a new tightening cycle or a temporary pause in a broad reflation process. The PBoC will remain data dependent and policy will remain accommodative. The interest rate increases in the PBoC lending facilities will likely lead to higher cost of funding for the corporate sector as well as mortgage borrowers The economic impact of the rising cost of funding should not be significant. Feature In the past three weeks, the People's Bank of China (PBoC) has raised the interest rates it charges financial institutions through various lending facilities. Questions abound over how the PBoC's latest maneuvers differ from their traditional monetary policy tools, and more importantly how these changes impact the economy and financial markets. What? In a slew of actions since late January, the PBoC has increased interest rates on several liquidity management facilities. On January 25th interest rates on the Medium-Term Lending facility (MLF) were raised, the first increase since the MLF debuted in 2014. Last week interest rates on reverse repurchase agreements (repos) were also hiked by 10 basis points. Meanwhile, interest rates on the Standing Lending Facility (SLF) were also lifted. Overall, these actions have increased financial institutions' funding costs on borrowing from the central bank. Table 1The PBoC's Tool Box There have been important changes in how the PBoC conducts monetary policy in recent years. While conventional measures such as the benchmark lending rate and reserve requirement ratio (RRR) have not been abandoned, the PBoC has been increasingly focusing on utilizing various new tools (Table 1).1 The RRR has been left unchanged, while the central bank has been actively dealing with financial institutions directly to manage interbank liquidity. The latest move shows a further departure from conventional monetary operations: instead of directly adjusting benchmark policy rates on lending and deposits of commercial banks, the PBoC has targeted interest rates on its claims to financial institutions. These changes reflect China's ongoing moves toward market-driven interest rate reforms, which at this stage have become quite advanced. Commercial banks are no longer under the administrative constraints on interest rates they pay to depositors and charge borrowers, and therefore their marginal cost of funding has become increasingly important for setting their own loan rates. Meanwhile, targeting interest rates of these lending facilities rather than benchmark interest rates or the RRR provides some important advantages from the PBoC's point of view. The newly created alphabet soup of various lending facilities gives the PBoC much more flexibility to "fine-tune" interbank liquidity in terms of both magnitude and timing, and can be quickly reversed if necessary. The RRR adjustment, on the other hand, is inherently much more blunt and harder to turn. These lending facilities can aid the central bank's macro-prudential policy. For example, banks that fail to meet certain conditions of the macro-prudential assessment (MPA) will have to pay punitive interest rates to borrow from the PBoC. Similarly, the PBoC can offer subsidized loans to policy lenders for certain prioritized projects. Direct adjustment on commercial banks' loan and deposit rates is not only against the broad trend of the country's interest rate reform, but also requires coordination of various government departments under the State Council. The PBoC has much higher discretion in changing its own interest rates that it charges commercial banks. Chart 1Policy Rates Catch Up To The Market Why? The PBoC's latest adjustments on interest rates of various lending facilities and open market operations should not be surprising, given the significant increase in interbank interest rates and domestic bond yields since late last year. For example, both the seven-day interbank rate and one-year government bond yields have increased from about 2.3% to 2.6% (Chart 1). If the PBoC left its short-term lending rates unchanged, it would potentially create arbitrage opportunities in which commercial banks could borrow from the central bank and lend out to other institutions. In other words, the PBoC has already begun to tighten by allowing market interest rates to inch higher since late last year, and the recent policy rate adjustment is in fact a "catch-up." A few reasons may be behind the central bank's tightening bias. The economy has recovered considerably, with both quickening activity and easing deflation. Nominal GDP growth accelerated to 9.6% in the last quarter, up from a bottom of 6.5% in late 2015 when benchmark interest rates were cut to current levels2 (Chart 2). The January macro numbers are likely distorted by the Chinese New Year effect, but holiday sales have been quite strong compared with a year ago, and the latest PMI numbers suggest continued acceleration in both the industrial and service sectors. All of this naturally calls for higher interest rates. It is possible that the January credit numbers are uncomfortably high for the PBoC, which may have pushed the authorities to send a signal to lenders to cool things off to prevent overheating and damp further property price gains. The central bank has been concerned about leverage and overtrading in the interbank market as well as local bond markets by financial institutions, and the latest tightening moves have also been designed to reduce financial excess (Chart 3). Repo transactions in the interbank market have already dropped sharply since late year when the PBoC began to push interest rates higher. This, together with regulators' latest administrative overhaul on commercial banks' wealth management products and off-balance-sheet items, all underscore the determination to rein in excesses in the banking sector. Chart 2Growth Rebound Generates Upward Pressure ##br##On Interest Rates Chart 3The PBoC Aims To Tame##br## Financial Excess So What? Whatever the reason, the PBoC will likely continue to shift away from "conventional" tools and increasingly focus on the new framework that has emerged in recent years in conducting monetary policy. Benchmark loan and deposits rates are already on the way out, and the RRR will also be gradually faded. The problem is that the RRR is still at 17% for large banks and 15% for smaller lenders - both of which are still elevated compared with historical norms. As a result, commercial banks have been putting ever rising reserve deposits with the central bank, while at the same time their borrowings from the PBoC have also skyrocketed - leading to an ever-expanding balance sheet at the PBoC (Chart 4). Technically, it is likely that the RRR will be lowered to a more reasonable level, cutting the central bank's liability, while at the same time the PBoC can reduce its claims to commercial banks on the asset side. This operation will shrink the PBoC's balance sheet, but does not necessarily change the liquidity situation in the banking system. It is too soon to conclude whether the latest interest rate adjustment is the beginning of a new tightening cycle or a temporary pause in a broad reflation process. We expect the PBoC will remain data dependent, and that the Federal Reserve's actions will also be taken into consideration. In the near term, a few observations can be made. First, the interest rate increases in the PBoC lending facilities, together with the increase in market-driven interest rates, will likely lead to higher cost of funding for the corporate sector as well as mortgage borrowers (Chart 5). Already, discount rates of bank acceptance bills, a proxy for short-term funding costs of the corporate sector tightly linked with interbank rates, have surged in recent months. The expected returns of Wealth Management Products (WMPs), an alternative to conventional bank deposits that set banks' marginal funding costs, have also picked up notably since October. This means the average interest rate on commercial banks' loans likely have already been rising. Chart 4The PBoC's Liquidity Operation Chart 5Corporate Cost Of Borrowing Will Likely Rise The economic impact of the rising cost of funding should not be meaningful, in our view, as it is accompanied by a strengthening economy and easing deflation. The overall monetary conditions index, which takes into consideration both real interest rates and the exchange rate, has continued to ease, thanks largely to the rapid increase in producer prices. Furthermore, there is still massive scope for the Chinese authorities to reform the financial sector and reduce the funding costs of the country's dynamic smaller private enterprises - although falling sharply in recent years, the Wenzhou private loan rate, a proxy for private enterprises' borrowing costs, still stands at 16% (Chart 6). This will likely continue to drift lower as the country's financial reforms continue to deepen. In short, the latest policy tightening does not change our cyclical assessment on the broader economy. In this vein, higher interest rates may introduce some near-term turbulence in stocks, but will not change the cyclical profile. The marginal increase in interest rates will not derail the growth improvement, profit growth should continue to recover and policymakers are unlikely to overkill. Meanwhile, strategically we continue to favor Chinese equities in global and EM portfolios. Finally, rising interest rates in China should lend some support to the RMB, due to the close link between China-U.S. interest rate differentials and the USD/CNY exchange rate (Chart 7). The interest rate gap between Chinese government bonds and U.S. Treasurys has widened notably since late last year, which should marginally make RMB assets more attractive in the near term. Nonetheless, the broad trend of the dollar against other majors will remain the dominant force setting the USD/CNY cross rate. The PBoC still faces challenges to contain capital outflows and maintain exchange rate stability. Chart 6Private Loan Rate Needs ##br##To Drop Further Chart 7China - U.S. Interest Rate Gap And##br## USD/CNY Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "A Closer Look At The PBoC's Balance Sheet," dated September 23, 2015, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Growth Watch," dated January 19, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global competitiveness equalisation occurs: For Germany, at EUR/USD = 1.35 For the Euro area, at EUR/USD = 1.20 For Spain, at EUR/USD = 1.17 For France, at EUR/USD = 1.15 For Italy, at EUR/USD = 1.10 But today EUR/USD = 1.07. The main culprit for the over-competitive euro is the ECB. Feature President Trump is right about one thing. The ECB's own analysis - available at https://www.ecb.europa.eu/stats - shows that the trade-weighted euro needs to appreciate by 10% to cancel the euro area's competitive advantage versus its major trading partners including the United States. To cancel Germany's competitive advantage, the ECB calculates that the euro needs to appreciate by 25% (Chart I-1). Chart I-1ECB Analysis Supports President Trump: ##br##The Euro Is Over-Competitive Even more controversially, the central bank's own analysis shows that the ECB itself is to blame for the euro area's significant competitive advantage. Prior to the ECB's extreme and unprecedented policy easing, the euro area's competitiveness was exactly in line with its trading partners (Chart I-2). The ECB says that it does not target the exchange rate, but it is fully aware that negative interest rates and trillions of euros of asset purchases carry major ramifications for the euro's value. Chart I-2The ECB Caused The Over-Competitive Euro The ECB's Ultra-Looseness Is Counterproductive The ECB could be forgiven for its ultra-looseness if the euro area were on the edge of a deflationary abyss. But as we showed in Fake News In Europe1 euro area inflation and inflation expectations are little different to those in other major economies when compared on an apples for apples basis. Chart I-3Emergency Monetary Policy##br## Not Needed Furthermore, the euro area is among the world's top-performing major economies through the past three years (well before ECB easing started), and the percentage of the working age population in employment is at an all-time high. These are hardly the hallmarks of an imminent deflationary threat which warrants emergency monetary policy (Chart I-3). Perhaps the ECB's ultra-looseness is trying to quell a flare-up of ever-present political risk. If so, the strategy is becoming counterproductive. As well as irking President Trump, the extreme policy is riling Germany's Finance Minister, Wolfgang Schäuble, who has blamed Mario Draghi for "50 per cent" of the success of the populist right-wing Alternativ Für Deutschland. And by frustrating voters worried about the low interest rates on their hard-earned savings, the ECB is also playing right into the hands of Marine Le Pen's Front Nationale. Admittedly, the euro area's current economic 'mini-upswing' is likely approaching its end. But as we showed last week in Slowdown: How And When?,2 a deceleration is likely to be even more pronounced outside the euro area. Even the ECB acknowledges that "the risks surrounding the euro area growth outlook relate predominantly to global factors" rather than domestic factors. If the ECB is right, the extent of anticipated monetary tightening outside the euro area is overdone. If the ECB is wrong, then the extent of anticipated monetary tightening inside the euro area is underdone (Chart I-4 and Chart I-5). Either way, the investment conclusion is the same. Chart I-4Expected Divergence In Monetary Policy Drives##br## Relative Bond Market Performance... Chart I-5... And ##br##The Euro Stay underweight German bunds versus U.S. Treasuries. Stay long the euro, with our preferred crosses being euro/pound in the near term and euro/yuan in the long term. And given that euro/pound (inversely) drives relative stock market performance, stay underweight Eurostoxx600 versus FTSE100. The Great Currency Manipulation Manipulation: (noun) - the controlling or influencing of a situation cleverly. The creation of the euro in 1999 was arguably the greatest currency manipulation of modern times. To be absolutely clear, this is not a criticism, just a statement of fact. In 1999, when European policymakers killed national currencies such as the deutschemark, franc, lira and peseta and replaced them with the new-born euro, the action clearly fitted the dictionary definition of manipulation. Our preceding analysis about the euro area's competitive advantage today assumes that the euro started its life at the right value. The evidence suggests that this assumption is correct. In 1999, the euro area' external trade was in balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. Likewise the evidence suggests that national currencies such as the deutschemark, franc, lira and peseta converted to the euro at the right exchange rates. The euro area's constituent economies had much in common in 1999 and were broadly in balance with each other. Surprising as it now seems, in 1999 Germany and Italy scored identically on exports as a share of GDP (Chart I-6) and on total debt as a share of GDP (Chart I-7). And German wages had been rising in lockstep with productivity (Chart I-8). Chart I-6After The Euro, Germany's ##br##Exports Soared Chart I-7After The Euro,##br## Italy's Debt Soared Chart I-8After The Euro, German Wages##br## Lagged Productivity It was only in the decade after 1999 that the euro area developed its major internal imbalances. Germany depressed its wages relative to productivity and used the resulting ultra-competitiveness to build an export-driven business model. In the seven years before 1999, net exports had made zero contribution to Germany's economic growth (Chart I-9), but in the seven years after 1999, net exports accounted for all of Germany's economic growth (Chart I-10). Chart I-9Germany Pre Euro: Net Exports ##br##Contributed Nothing To Growth Chart I-10Germany Post Euro: Net Exports Contributed ##br##Everything To Growth Prior to the one-size-fits-all exchange rate, a rising deutschemark would have largely snuffed out the increased competitiveness from wage depression and thereby thwarted the export-driven business model. However, once locked in the euro, Germany's exchange rate could no longer rise sufficiently to choke off external demand. Meanwhile, Italy and Spain could suddenly rely on a debt-driven business model - especially given that their strong national cultures of homeownership provided the perfect collateral for borrowing. Prior to the one-size-fits-all interest rate, higher domestic interest rates would have thwarted this business model. But once locked in the monetary union, their interest rates could no longer rise sufficiently to choke off borrowing. By 2010, the imbalances had become monsters. Germany, through its wage depression, had become 20% over-competitive versus its major trading partners. Spain and Italy, through their reliance on debt-fuelled growth, had become 20% under-competitive. Understand that this is not a morality tale of good versus bad, as many commentators portray. The mirror-image imbalances were just the opposite sides of the same (euro) coin. Spain Is The Star-Performer Today, the good news is that the euro area's internal imbalances have narrowed sharply, as the under-competitive economies have taken draconian corrective measures. External competitiveness has also been boosted by a substantially weaker euro. The bad news is that Germany's over-competitiveness versus the world remains excessive. But as Wolfgang Schäuble correctly argues, it is extremely difficult for Germany to rebalance its global competitiveness when it is swimming against the tide of the ECB's extreme easing and resulting depression of the euro. The award for the most spectacular rebalancing goes to Spain. Eight years ago, Spain was 15% less competitive than France on the ECB's harmonised competitiveness indicator based on unit labour costs. Today, on the same measure Spain is 2% more competitive than France. This makes it very difficult to justify any yield premium on Spanish Bonos versus French OATs. The yield premium is a compensation for perceived redenomination risk. The expected annual loss of owning a Bono versus an OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. But if Spain is now as competitive as France, a new peseta ultimately should be as valuable as a new franc. The second item of the multiplication would be zero (Chart I-11). So irrespective of the probability of euro breakup, the yield premium should also be zero. Yet today, Spanish 10-year Bonos are still trading at a substantial 65 bps yield premium over French 10-year OATs (Chart I-12). Chart I-11Spain Is As Competitive ##br##As France... Chart I-12... Bonos Should Not Have A ##br##Yield Premium Over OATs Stay long Spanish Bonos versus French OATs. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 and available at eis.bcaresearch.com 2 Published on February 2, 2017 and available at eis.bcaresearch.com Fractal Trading Model* A tactically short position in equities is warranted. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 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##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Special Report

Highlights Brazilian growth will recover modestly in 2017, but it will be insufficient to stabilize the public debt-to-GDP ratio. With interest rates still at double digits, public debt dynamics will become unsustainable as the ratio reaches or surpasses 85-90% of GDP over the next couple of years. The central bank has been financing the government by buying local currency bonds. Going forward, the path of least resistance, and most likely scenario, is direct or indirect public debt monetization by the central bank of Brazil. This will allow the nation to avoid fiscal stress/crisis but the price for it will be large exchange rate depreciation. In the end, investors will lose capital in Brazilian financial markets in U.S. dollar terms. Feature Brazil's financial markets have rallied sharply over the past 12 months, even as the economy has continued to disappoint. Growth has fallen short of even our downbeat expectations, yet the tremendous rally in its financial markets had sent our bearish strategy wide of the mark. In the past year, we have argued that even if the Brazilian economy recovers, it is likely headed towards a public debt trap because the recovery will be muted and the starting point of fiscal accounts/government debt is already quite poor. So, has Brazil achieved escape velocity - i.e., has growth gained enough momentum to thwart concerns about public debt sustainability? Escape Velocity Chart I-1Despite A Strengthening Global Economy, ##br##Brazilian Growth Is Relapsing It is tempting to conclude that the rally in Brazilian markets has been so powerful that the country has broken away from its five-year bear market, and hence that public debt sustainability is not an issue at all. In other words, financial markets seem confident that Brazil has achieved escape velocity. We do not think so. Notably, in recent months Brazil's economy has surprised to the downside, despite the ongoing improvement in global growth: Brazil's manufacturing PMI overall index has rolled over decisively, despite broad-based strength in the global business cycle (Chart I-1). More importantly, export prices in general, and iron ore and soybean prices in particular, have rallied a lot in the past year. Hence, the external sector has been a positive force for the economy, yet the latter has failed to revive. Having appreciated dramatically, the currency is no longer cheap. This is confirmed within Brazil's trade dynamics since export volumes are slipping relative to import volumes. As fiscal spending growth has until now been decent, the epicenter of the retrenchment has clearly been household consumption and business investment (Chart I-2 and Chart I-3). Chart I-2Brazilian Households Are ##br##Still Feeling Massive Pain... Chart I-3...As Is The ##br##Business Sector Household debt-service costs remain elevated at 22% of disposable income (Chart I-4). This, and ongoing job losses, are keeping a lid on consumer spending. Manufacturing production is still collapsing, and capacity utilization is at a 20-year low (Chart I-3, bottom panel). This is not a sign of a competitive exchange rate or vibrant manufacturing sector. Due to the economic contraction, Brazil's primary and overall fiscal deficits have reached 2.5% and 8.9% of GDP (Chart I-5), respectively, despite the authorities' attempts to secure considerable one-off revenues. Chart I-4Brazil: Elevated Household Indebtedness ##br##Will Prevent A Consumption Rebound Chart I-5Brazil's Fiscal Accounts Remarkably, the level of Brazil's real GDP has already contracted by 7.6% from its peak in 2014, producing the worst depression in more than 116 years (Chart I-6). Bottom Line: Not only has Brazil failed to achieve escape velocity, but also its growth dynamics have underwhelmed even the most pessimistic of forecasts. As a result, public debt dynamics have become unsustainable. Fiscal And Credit Impulses In 2017 Going forward the outlook for Brazil's economy will hinge on credit and fiscal impulses: If government spending rises by 6.3% in 2017, which is equivalent to the 2016 IPCA inflation rate as mandated by the fiscal spending cap (known as PEC 55), the federal fiscal spending impulse in 2017 will be 79 billion BRL, or 1.23% of GDP (calculated using our 2017 nominal GDP estimate) (Chart I-7, top panel). Chart I-6Brazil's Worst Recession In 116 Years Chart I-7Fiscal And Credit Impulses The impact of fiscal policy on growth is defined by government spending and taxes. Odds are that taxes need to be hiked to achieve the 2017 budget targets. Unless growth recovers strongly, doubtful in our view, there are non-trivial odds of impending tax hikes. The latter will counteract the positive fiscal impulse from government expenditures. The credit impulse is calculated as an annual change in credit growth, or the second derivative of the outstanding stock of credit. If we assume private and public banks' credit growth will be 0% and -5%, respectively, in 2017 overall loan growth will contract by 2.5%, and the credit impulse will be 0.54% of GDP (Chart I-7, middle panel). Even though interest rates are declining, real (inflation-adjusted) rates remain high at 5.4%, and banks' balance sheets are impaired by mushrooming NPLs following the credit boom years. This will preclude a revival in loan growth in the banking system. Aggregating the fiscal spending and credit impulses together, there will be about a 2% boost to nominal GDP growth in 2017 (Chart I-7, bottom panel). However, as it is likely that taxes will rise, the overall combined effect on the economy will be less than that. Bottom Line: Odds are that the aggregate fiscal and credit impulse will be only mildly positive in 2017 - assuming no tax hikes. This portends only moderate nominal GDP growth in 2017. Government Debt Simulation Revisited The Brazilian economy will probably recover and our baseline view assumes real GDP growth will be modestly positive for 2017. However, the recovery will not be vigorous enough to halt the exponential rise in the public debt-to-GDP ratio. Table I-1 presents a scenario analysis for Brazil's public debt. Table I-1Brazil: Public Debt Sustainability Scenarios 2016-2019 We considered three scenarios: base case, optimistic and pessimistic. For each scenario, we have made assumptions for nominal GDP growth, nominal government revenue growth, nominal government expenditure growth (based on the fiscal spending cap), and on the average (or blended) interest rate on all local currency public debt. Chart I-8Brazil's Is Headed Towards ##br##A Public Debt Crisis In our base case scenario, the public debt-to-GDP ratio reaches 84% in 2018 and 91% in 2019 (Chart I-8). With double-digit interest rates, the 91% public debt load spirals out of control. In short, even in our base case scenario, which assumes a return to modest growth in 2017 and a decent recovery in economic activity in 2018 and 2019, Brazil is unlikely to avoid a debt trap. For the base case, we use the following assumptions For nominal GDP growth in 2017 we use the most recent Brazilian Central Bank Survey year-end forecast of real GDP growth of 0.5% plus our estimate of 5% inflation to arrive at 5.5%. In 2018, we assume real GDP growth of 2.5% plus 4.5% inflation to arrive at 7%. And in 2019 we also assume growth of 7%. For nominal government revenue growth, we use 5% in 2017 and 8% for both 2018 and 2019, as we assume government revenue reasonably tracks nominal GDP growth. A caveat: the actual 2016 federal government revenue growth number of 4.3% was heavily boosted by non-recurring revenues such as privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL, tax amnesty/repatriation programs, and so on. In brief, the government used all means at its disposal to boost its revenue via one-off items. As these are non-recurring and impossible to predict, we did not attempt to account for them. Yet, in future, these non-recurring sources of fiscal revenue will be harder to come by. To be consistent, we do not incorporate one-off expenditures, such as financial support for local governments, or recapitalization of public banks and state-owned companies. In a nutshell, we assume potential one-off public sector revenues will offset one-off expenditures. With the dire state of the economy, and likely need for bailouts and financial assistance from the federal government, this is a reasonable assumption. Besides, with most states and local governments near bankruptcy, staving off insolvency remains a much more urgent matter that will likely drain central government coffers in the near term. As to nominal government expenditures, since these are capped by the previous year's inflation rate due to the fiscal spending cap (or PEC 55), we use 6.3% growth in 2017 (i.e. 2016 IPCA inflation), and 5% in both 2018 and 2019, respectively. Investors, however, should keep in mind that the spending cap only applies to primary expenditures. Critically, it does not include interest on public debt, spending on education and health in 2017, and nonrecurring expenditures. If anything, federal government spending will likely exceed the 2017 cap as the government may spend more on healthcare and education to offset overall fiscal austerity. Table I-2Composition Of Brazilian Federal Debt For the average, or blended, interest rate on public debt, we used calculations by Dr. Jose Carlos Faria, Chief Brazil Economist at Deutsche Bank.1 We use Dr. Faria's assumptions for local currency average interest rate on public debt in 2017, 2018 and 2019, for our pessimistic scenario. The impact of lower policy interest rates (i.e. the central bank's SELIC rate) on the public debt service is a drawn out process because not all debt is rolled/re-priced over every year. Table I-2 illustrates the breakdown of Brazil's public debt by type. Therefore, the impact of declining interest rates on public debt dynamics will be slow. Bottom Line: With interest rates still in the double digits, Brazil's public debt dynamics will become unsustainable if the ratio reaches or surpasses 85-90% of GDP. The odds are substantial that this limit will be breached in the next few years. The best cure for debt sustainability is growth. So far, however, Brazil has failed to achieve growth strong enough to stabilize its public debt trajectory. A Word On Social Security Reform It is widely accepted that pension (social security) reform is desperately needed to help keep Brazil's public debt on a sustainable path. It does appear that reforms will be passed this year, as they have good momentum in Congress. That said, it will take many years for the positives of pension reforms to kick in and help the fiscal accounts, and in turn improve Brazil's public debt profile. According to the IMF,2 it will take roughly until 2020-2025 to see any decrease in social security expenses as a percentage of GDP, even if the reforms involve an increase in the retirement age, a benefits freeze, and a removal or change of the indexation of pensions to the minimum wage (and/or a change to the minimum wage formula). Bottom Line: The benefits of social security reform will only come into effect after 2020-30 or so, if passed in full. Therefore, they will not prevent Brazil's public debt-to-GDP ratio from surpassing the 85-90% mark in 2019. A Way Out: Debt Monetization? Chart I-9Brazil's Central Bank Has Been ##br##Expanding Its Local Currency Assets Being strangled by economic contraction, high debt/fiscal deficits, and a lack of political capital to embark on painful fiscal austerity, the path of least resistance for any country in general and Brazil in particular is debt monetization. That would lead to a considerable exchange rate depreciation. There are already hints that the central bank has been funding the government since 2014. In particular: The Brazilian central bank's domestic currency assets have expanded dramatically - by 640 BRL billion, or 10% of GDP - since January 2015 (Chart I-9). Most of this balance sheet expansion - 460 BRL billion or 7% GDP has been due to the rise in the central bank's holdings of federal government securities (Chart I-10). On the liability side of the central bank's balance sheet, a considerable rise has occurred in Banco Central do Brasil repos with commercial banks and deposits received from financial institutions. The amount of outstanding repos and these deposits has risen by 220 BRL billion since January 2015 (Chart I-11). Chart I-10The Central Bank Has Been ##br##Accumulating A Lot Of Public Debt... Chart I-11....But Withdrawing Liquidity Via ##br##Repos & Deposits Received Essentially, the central bank has purchased 460 BRL billion of government securities since January 2015 and, hence, injected a lot of liquidity into the banking system. Then, Banco Central do Brasil simultaneously withdrew liquidity via repo agreements and deposits received from financial institutions. This has basically sterilized half of the central bank's government bond purchases, i.e. the operation withdrew half of the liquidity expansion that was first made. Without the central bank intervention to buy 460 BRL billion of government securities in the past two years, the 626 BRL billion and 557 BRL billion overall fiscal deficits in 2015 and 2016, respectively, would not have been financed and local bond yields would have risen. Chart I-12The BRL Is Expensive Again Looking ahead, as the fiscal accounts continue bleeding, public debt burden will rise to around 85% of GDP and the banking system - wounded by non-performing loans - will struggle to expand its balance sheet further. In turn, the central bank might be tempted to continue monetizing the government's debt without, however, sterilizing its operations. In such a scenario, the currency will depreciate meaningfully. Markedly, Brazil's real effective exchange rate has risen above its historical mean and is somewhat expensive (Chart I-12). Brazil needs lower interest rates, more abundant banking system liquidity and a cheaper currency to embark on a sustainable recovery. The latter is required to avoid the fiscal debt trap. The exchange rate depreciation is an important relieve valve. Given that only 4% of government debt is denominated in foreign currency, a deprecation of the Brazilian real is the least painful solution. Bottom Line: Going forward, the only way for Brazil to stabilize the public debt-to-GDP ratio is to boost nominal GDP growth. This can be achieved by reducing interest rates aggressively, injecting large amounts of liquidity into the wounded banking system and devaluing the currency. Unless financial markets in Brazil sell off, there is a non-trivial probability that the authorities will embark on outright or covered public debt monetization. This would allow the country to avoid fiscal stress/crisis. Yet, the price will be large exchange rate depreciation. Chart I-13Stay Underweight Brazil ##br##Versus The EM Equity Benchmark Investment Implications We have been wrong on Brazilian markets in the past 12 months, but we do not see a reason to alter our view. The currency will plunge due to the ongoing debt monetization, and foreigners will not make money in Brazilian financial markets in U.S. dollar terms. We reiterate our short positions in the BRL versus the U.S. dollar, ARS and MXN. Stay long CDS and underweight Brazilian credit within EM sovereign and corporate credit portfolios. Continue underweighting this bourse within an EM equity portfolio (Chart I-13). Interest rate cuts will continue, but with the BRL set to depreciate considerably versus the U.S. dollar in the next 12 months - as we expect - buying local bonds for the U.S. dollar based investors is not the best strategy. Santiago E. Gomez, Associate Vice President santiago@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These figures come from the appendix on page 9 of the Deutsche Bank report titled, "Brazil at a Debt Crossroad - Again", dated January 23, 2017. 2 Please refer to the following IMF report on Brazil, available at http://www.imf.org/external/pubs/ft/scr/2016/cr16349.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Signing executive orders and memoranda post-Inauguration is a common tactic for new presidents. Unfortunately for investors, political rhetoric has caused uncertainty to surge, while actions affecting profitability have been minimal. The potential for radical changes to trade policy changes should not be underestimated. However, details about timing and contours are too vague to be of any support to potential industry-specific beneficiaries. Fed policymakers will focus primarily now on wage and price inflation to guide them on the appropriate pace of rate hikes. Policymakers increasingly believe the economy is operating at full employment. Feature Chart 1Policy Uncertainty Surge It has been a confusing two weeks in Washington. Since taking oath, President Trump has signed eighteen executive orders and presidential memoranda.1 This is not uncommon: Barack Obama signed an equal amount during his first week of his first presidential term, and executive orders are a frequent tactic used by new presidents to quickly deliver on campaign promises. Unfortunately for investors, Trump's signature has not yet found its way to policies that alter the profitability of U.S. businesses and/or clearly lower the risk premium for financial assets (although at the time of writing, there are rumors about an order that will affect Dodd-Frank). Instead, there has been a tremendous amount of rhetoric that has caused political uncertainty to spike higher (Chart 1). We have warned in past weekly reports that it would be difficult for equity prices to sustain gains built on the premise that a new American government will succeed in implementing a pro-business strategy while simultaneously avoiding any negative shocks from trade reform and foreign policy blunders. Actions under the new administration so far support this view. On Trade: Trade is the area of most confusion thus far in the Trump presidency. As our Geopolitical team highlighted in a recent report,2 the new White House seems focused on bringing the U.S. current account deficit down and will attempt to do so by using three primary tools: Protectionism, possibly in the form of a "destination-based border adjustment tax," as discussed in our Special Report two weeks ago.3 Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. and has insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption, though details are scant. Structural Demands: Trump and team appear ready to lob threats at other countries with trade surpluses, such as China - by charging the country with currency manipulation. Note that the above tools are in the White House's toolbox, but are yet to be employed. In terms of concrete action to date, President Trump has signed orders to pull out of the Trans Pacific Partnership (TPP). But this was a non-event since the TPP was never ratified by Congress. Takeaway: The potential for radical changes to trade policy should not be underestimated. However, details about timing and contours are too vague to be of any support to potential industry-specific beneficiaries. On the flipside, confusing and vague rhetoric should not (yet) form the basis of a negative economic and profit outlook. On Infrastructure: Trump signed an executive order to expedite environmental reviews for high-profile infrastructure projects. This executive order may expedite already approved projects, but any new spending requires approval from Congress. The budget will be announced only in mid- to late- April. Moreover, it is still an open question as to whether Congressional Republicans will try to axe government spending. Senior members of Trump's transition team have proposed a plan to cut federal spending by $10.5 trillion over the next 10 years! That would amount to a severe fiscal drag, rather than the much hoped-for fiscal thrust expected from infrastructure spending and tax cuts. Takeaway: As we have argued in the past, infrastructure spending could provide a fillip to U.S. growth, but at minimum, investors should not expect that to occur until late 2017 or 2018. On Taxes: None of the executive orders or memoranda directly address taxes. However, a majority of pundits believe that Trump's executive order on January 25 to Build The Wall with Mexico will be funded by U.S. taxpayers. Takeaway: Tax reform requires congressional approval. There has been no step forward as yet for a more market-friendly tax backdrop. On Regulation: On January 30, President Trump signed an executive order stating that for every new regulation proposed, two existing ones would be repealed. On the surface, this seems like excellent news for businesses, especially smaller ones that consistently argue that "red tape" is a major problem for their companies (Chart 2). After all, the U.S. ranks very poorly among global peers on how easy it is to start a business (Table 1). Note that the World Bank assigns the U.S. a much higher overall score for ease of doing business (8th), but this is due to high scores in only two areas: access to credit and bankruptcy protection laws! Chart 2(Part II) Regulation Is A Problem Table 1(Part I) Regulation Is A Problem Unfortunately, the language of the executive order is sufficiently vague that it is not clear what impact there will actually be. First, it is impossible to know which agencies and branches of government the order applies to. Second, it is not clear that a President has the legal authority to mandate the number of regulations, i.e. this executive order may be impossible to uphold. The President also signed a memorandum to streamline and reduce the regulatory burden for manufacturers. Though there is no immediate impact on businesses, the memorandum opens a 60 day window for the secretary of commerce to consult stakeholders. Takeaway: The President is serious about deregulation, but if anything, the 2-for-1 regulation order only serves to underscore that unwinding the regulatory burden is a complicated process that is unlikely to be achieved in the first 100 days of office. The bottom line is that the new administration has been busy, but little of their work thus far has been of direct concern to financial markets and underlying profitability. Instead, policy uncertainty has risen: protectionism, de-regulation and tax reform are all high on their agenda, but details are scant. This has left investors with little visibility. Our view is that the underpinnings of a self-reinforcing recovery are in place and thus will fuel outperformance of stocks relative to bonds on an intermediate time horizon (see last week's Special Report and also below).4 However, the rise in policy uncertainty serves to solidify our conviction that at current prices, risk assets are vulnerable to a near-term correction. Indeed, although not uniformly bearish, equity technical readings are beginning to herald a more treacherous phase ahead. Equity Technicals: Mixed Messages We are monitoring technical indicators for warning of a near-term equity pullback within the context of a longer term bull market. So far, the message is mixed. For example, our composite technical indicator is in the middle of its range and is not heralding danger. However, sentiment readings are at a bullish extreme. Our composite sentiment indicator remains near historic highs, which tends to be a good contrarian indicator (Chart 3). Meanwhile, the number of stocks above their 30 week and 10 week averages has also shot higher. Importantly, insiders are taking advantage of the price rally to sell their stock. The insider sell/buy ratio has soared to levels that typically herald corrections. Somewhat curiously, the VIX index - a measure of the cost of insurance - remains at bargain basement levels. This suggests that investors may be complacent to a near-term correction. Overall, sentiment readings have become extreme as has price momentum. As highlighted above, we expect that the near term catalyst for a pullback will likely center around policy disappointment. A more encouraging intermediate term outlook is supported by stronger economic fundamentals and, at least for now, a go-slow Fed. Fed & Economy Last week's FOMC policy statement included only minor tweaks from the previous one. Policymakers were silent as to how they view the impact on growth and inflation from the new Administration. Data released since the December minutes - when it appeared that the committee was shifting to a less dovish stance - have supported the Fed's more optimistic outlook. For example, the ISM manufacturing is trending higher, while the non-manufacturing index continues to be strong (Chart 4). On the manufacturing side, the composite index rose again in January, as the sector recovers from an energy-led recession. New orders held onto earlier impressive gains. The new orders-to-inventories ratio ticked down, but remains elevated, suggesting that there is more upside for industrial production in the coming months. Chart 3Equity Technicals: Mixed Message Chart 4Positive Economic Momentum In addition, as highlighted in our January 16 Weekly Report, conditions are ripe for a rebound in consumer spending.5 As confidence in the employment backdrop rises, the likelihood for a lower savings rate improves. Indeed, the January employment report, released on Friday, surprised to the upside, as non-farm payrolls grew by 227 000 (Chart 5). Despite the strong payrolls growth, the unemployment rate ticked higher to 4.8% due to an increase in the participation rate and average hourly earnings increased by a meager 0.1% m/m. Still, we expect that wages will rise as the labor market steadily tightens and Fed policymakers will focus primarily now on wage and price inflation to guide them on the appropriate pace of rate hikes. To this end, more policymakers are making the case that the economy is at full employment. In a speech in mid-January, San Francisco Fed president Williams argued that the economy has achieved full employment and that the economy only needs to create about 80 000 jobs to keep up with labor force growth.6 The implication is that with an average monthly payroll of 180 000, job creation will quickly put downward pressure on the unemployment rate. The San Francisco Fed has introduced a new, "Non Employment Index"7 which attempts to correct for the structural decline in participation (Chart 6). To construct the index, researchers treat everybody in the population as potentially in the labor force and construct a broader unemployment rate-a "non-employment index." This measure incorporates the unemployed and nonparticipants alike, based on their respective tendency to find jobs. They argue that when one carefully accounts for the availability of nonparticipants this way, the resulting broad non-employment index is consistent with a labor market at full strength. As the top panel of Chart 6 shows, even accounting for participation in this way, the non-employment index gives a very similar message to the standard unemployment rate. Chart 5Solid Employment Fundamentals Chart 6Full Employment = Wage Pressures The bond market is currently priced for two rate hikes later this year. We agree with this assessment, though view any surprises to the upside. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The latter have less legal weight than an executive order but serve as guidelines for the priorities of government. 2 Please see BCA Geopolitical Strategy Weekly Report "The 'What Can You Do For Me' World?," dated January 25, 2017, available at gps.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 23, 2017, available at usis.bcaresearch.com 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017, available at usis.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report "U.S. Consumer: The Comeback Kid," dated January 16, 2017, available at usis.bcaresearch.com 6 http://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2017/january/looking-back-looking-ahead economic-forecast/?utm_source=frbsf-home-president-speeches&utm_medium=frbsf&utm_campaign=president-speeches 7 https://www.richmondfed.org/research/national_economy/non_employment_index

Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In line with our House view, we expect the USD will weaken near term, and are recommending a tactical long gold position if the metal trades to $1,180/oz. Longer term, the Trump administration's presumed fiscal-policy goals - e.g., lighter regulation, lower taxes - will be hitting an economy at or near full employment, and will run smack up against deflationary pressures if a border-adjusted tax (BAT) scheme is implemented. Expect higher volatility. Energy: Overweight. Fundamentals continue to point toward global oil storage drawing by ~ 300mm bbl by 3Q17. Brent was backwardated going to press in the Dec/17 vs. Dec/18 spread, while WTI is in contango.1 Our WTI backwardation trade (long Dec/17 vs. short Dec/18) stopped out at -$0.05/bbl. Markets appear reluctant to take 2018 prices below 2017 levels, but we still like the position and will look to put it on again. Base Metals: Neutral. A weaker USD and marginally softer real rates will support base metals short term. We remain neutral. Precious Metals: Neutral. We are going tactically long gold, and are bracing for more ambiguity in U.S. fiscal-policy. This will keep the Fed on hold till 2H17. Ags/Softs: Underweight. Grains and beans will remain under pressure with Argentine growing conditions improving. High stocks-to-use levels will remain a headwind. Feature Gold prices will get a short-term bounce from financial markets' recalibration of when fiscal stimulus in the U.S. actually will start contributing to growth. With nothing for the Fed to react to in terms of fiscal policy other than sundry indications the Trump administration favors lighter regulation, lower taxes and higher infrastructure spending, we believe the U.S. central bank will remain on the sidelines until mid-year before it starts guiding toward a rate hike. In the meantime, synchronized global growth (Chart of the Week) will continue to fan medium-term inflation expectations (Chart 2). Chart of the WeekSynchronized Global Growth... Chart 2...Is Lifting Inflation Expectations At this point in the cycle, it is unlikely the Fed or other systematically important central banks will tighten policy to arrest the emerging growth. Besides, the U.S. central bank is, for all intents and purposes, on hold until it sees the outlines of the fiscal policy to be proposed by the Trump administration, which has indicated strong preferences for lighter regulation, lower taxes and infrastructure spending. The market is putting the odds of a Fed rate hike by March at just over 20% (Chart 3). The odds of seeing a hike by June, on the other hand, increase to 64%. Chart 3Fed Most Likely On Hold Until June Given the constraints on the Fed for now, and indications of synchronized global growth, we expect some inflation pickup near term. This will lower real rates and weaken the USD over the short term, which will, in turn, support gold prices. Given this expectation, we are recommending a tactical long gold position if the spot contract trades to $1,180/oz. Because this is a tactical position, we will use a 5% stop-loss. Ambiguous Inflation Signals For 1H17, we expect inflation and inflation expectations to remain buoyant, given the synchronized global upturn we are seeing and the prospect - and so far it is only a prospect - for stimulative fiscal policy in the U.S. All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation. The top candidates here would be gold and oil (WTI, in particular). But all else is not equal. President Trump and officials within the administration have floated the idea of a border-adjusted tax (BAT) scheme, which would tax imports into the U.S. and subsidize U.S. exports, and replace the existing corporate income tax. Our House view on the BAT is it has a 50% chance of becoming law. Even so, we believe there is a greater-than-50% chance apparel and energy products would be exempt from a BAT, if it became the law of the land, but we obviously cannot be sure this will occur. The first-round effects of a BAT would be felt domestically. U.S. inflation and inflation expectations would increase after it is rolled out, as prices on taxed imports rose by the inverse of (1 - Tax Rate). As an indication, a 10% BAT would lift domestic prices of taxed items by ~ 11%. If the BAT were extended to oil, the domestic price lift there would incentivize higher domestic oil production, which also would find its way to export markets. Taken together, these domestic effects arising from the imposition of a BAT would cause the U.S. trade deficit to contract, which would rally the USD, in addition to lifting domestic inflation. As we noted last week, even under the assumption a somewhat watered down version of a BAT is passed, our colleagues at BCA's Global Investment Strategy service anticipate the USD would rally another 10%.2 The second-round effects on the back of such an increase in the USD would be felt globally, particularly in oil markets and EM economies. In addition to the broad trade-weighted dollar rallying by 10%, we expected a 5% rise in the greenback prior to the discussion of the BAT. So, overall, we'd expect a 15% appreciation in toto following the implementation of a BAT in the U.S. This would stifle EM commodity demand, particularly for oil and base metals, given the stronger USD would make these commodities more expensive in local-currency terms ex U.S. In addition, it would encourage higher commodity production in the U.S. (if a BAT were to be imposed on oil imports) and ex U.S., where local-currency drilling costs once again would fall, leading to increased supplies at the margin. The possibility of deflationary blowback to the U.S. is high in this scenario. Positioning In Ambiguous Markets Investors seeking to profit from rising inflation, which we would expect in the U.S. in the first round of adjustment to a BAT, or to hedge against it often turn to commodities expecting they will rally as inflation increases. They typically do this via index exposure or individual commodity exposure, e.g., going long gold or oil. In the current environment, we believe gold offers the best commodity alternative for participating in a rising inflation environment, or hedging against it, which is why we recommend a tactical long position if the market corrects to $1,180/oz. We compared the one-year return performance of gold and oil as inflation hedges by regressing annual returns of both commodities against annual core PCE and the broad trade-weighted USD returns (Chart 4).3 The R2 goodness-of-fit statistics for both were extremely close - 0.88 (oil) vs. 0.85 (gold), indicating core PCE and USD returns do a good job of explaining oil and gold returns. However, the volatility of the gold regression (its standard error) was half that of the oil regression (0.06 vs. 0.12), indicating gold's relationship is more stable vis-à-vis core PCE inflation and the USD (i.e., subject to less dispersion). This would indicate returns for an inflation hedge using gold would be less volatile than a hedge employing oil futures.4 These tests indicate both gold and oil are well suited to hedging inflation, and that gold hedges will perform as well as an oil hedge with far less volatility in the returns. Longer term, we're concerned with the second-round effects attending a stronger USD on the back of the BAT discussed above - i.e., lower commodity demand and higher commodity supply. Over the medium to longer term, the above dynamic suggests oil and gold volatility will increase (Chart 5). Chart 4Gold Hedges Inflation And USD Risk ##br##As Well As Oil, With Lower Volatility Chart 5Oil And Gold Vol Likely Rise Besides being an inflation hedge, gold, unlike oil, also functions as a store of value. In the event of deflationary blowback arising from the imposition of a BAT, we believe gold also would hedge investor portfolios against the possibility of currency debasement. That is to say, it would hold its value while central banks and governments rolled out fiscal and monetary policy responses to deflation. It is worthwhile recalling nominal gold prices held fairly steady during the Great Depression, while real gold prices appreciated. We believe the optimal vehicle for such a hedge would be call options, but we await clarity the likelihood of a BAT and its provisions before recommending such a position. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Backwardation and contango are terms describing the shape of commodity forward curves. When a curve is backwardated, prompt-delivery prices (e.g., oil delivered next week) exceed deferred-delivery prices (e.g., oil delivered next year), indicating supplies are tight. A contango curve describes a market in which deferred-delivery prices exceed prompt-delivery prices, which indicates supplies are relatively more abundant. 2 We discussed the implications of a possible border-adjusted tax scheme in last week's Commodity & Energy Strategy Weekly Report, in an article entitled "Taking A Bat To Commodities", dated January 26, 2017, available at ces.bcaresearch.com. See also BCA Research's Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" dated January 20, 2017, which examined the BAT in depth, available at gis.bcaresearch.com. 3 We ran a simple regression of the percent returns of gold and oil against core PCE and USD annual returns over the 2001 - 2016 interval to assess the performance of each as inflation hedges. By using one-year returns, we were able to regress stationary variables and use an AR(1) model. 4 Along similar lines, the sum of squared residuals for the oil returns was almost 4x that of the gold returns, indicating far less dispersion in the errors and a tighter fit with gold vs. core PCE once again. The Durbin-Watson statistic measuring the degree of autocorrelation in the errors is was slightly > 2.0 for the gold regression, for the oil regression the DW statistic was < 2.0. This suggests the gold regression is better behaved in that the error terms more closely conform to the assumptions for them in the type of regression we're running. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017