Global Rates, FX & EM 2017 Year Ahead
Tectonic shifts
16 November 2016 Corrected
Our top 10 Rates, FX & EM trades for 2017
FX and Rates
Global
1. Short US 5y rates – Two and a half Fed hikes priced by the rates market for 2017-
18 are not consistent with aggressive fiscal easing promised by Trump.
2. Short US 10y real rates – After the violent repricing of inflation breakevens, we
believe real rates offer better risk-reward to position for higher rates.
3. Buy USD/JPY – With the BOJ pegging 10y JGB yields at zero, we expect this highly
interest rate sensitive USD cross will continue to be the biggest beneficiary of the
Trump win.
4. Sell a basket of Brazilian, Mexican, and Colombian long bonds – Positioning in
EM fixed income market remains crowded while liquidity is poor.
5. Sell BRL/MXN – MXN is oversold but BRL will likely be vulnerable to the divergent
paths between Brazil’s easing and the Fed’s tightening cycles.
David Woo
FX, Rates & EM Strategist
MLPF&S
david.woo@baml.com
See Team Page for Full List of Contributors
6. Buy USD call/CNH put – President Trump will need a weak USD, but President Xi
needs a weak CNY. We believe risk premium for a collision course is too low.
7. Sell EUR/GBP – Brexit and Trump could bolster the anti-globalization parties in
Europe ahead of key elections next year.
8. Sell Eurozone 30y inflation breakevens – We think investors should take
advantage of the recent rally to sell into the December ECB meeting, which could
disappoint.
9. Sell EUR/RUB – Likely OPEC production cuts on November 30 and possible
sanction relief for Russia are bullish for the RUB, in our view.
Unauthorized redistribution of this report is prohibited. This report is intended for kaasha.saini@baml.com
10. Buy NZD/USD put spread – Spot NZD/USD is forming a head and shoulders top
pattern that suggests a decline will follow in 2017.
Trading ideas and investment strategies discussed herein may give rise to significant risk and are not
suitable for all investors. Investors should have experience in FX markets and the financial resources to
absorb any losses arising from applying these ideas or strategies.
BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a
result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report. Investors should consider this report as only a single factor in making
their investment decision.
Refer to important disclosures on page 54 to 56. Analyst Certification on page 53. Valuation &
Risk on page 53. 11688515
Timestamp: 16 November 2016 05:30AM EST
Introduction
David Woo
MLPF&S
david.woo@baml.com
First came Brexit, then Donald Trump’s election as the president of the most powerful
country in the world. The world has changed. Possibly irrevocably so.
These ground shifts have been brought on by a backlash to globalization, increasingly
viewed as the culprit for wage stagnation (Chart 1), growing disparity of income and
wealth between the rich and the poor (Chart 2), and the loss of national identity. We
suspect the trend of anti-globalization is here to stay.
Chart 1: US real median household income
Chart 2: Income inequality and globalization
60,000
58,000
56,000
China entered
WTO
23
22
21
20
54,000
52,000
50,000
19
18
17
16
18
16
14
12
10
8
6
4
48,000
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
46,000
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
share of aggregate income going to top 5 percentile (%, LHS)
import/GDP (%, RHS)
Source: BofA Merrill Lynch Global Research
Source: BofA Merrill Lynch Global Research
Wide-ranging consequences for financial markets
In our view, the anti-globalization theme will have at least seven major consequences
for financial markets in 2017.
1. Monetary easing will give way to fiscal easing
The history of populism is one of fiscal largesse. Furthermore, with limited scope for
further monetary easing, fiscal easing is becoming the last and only resort for
policymakers. It seems reasonable to assume that the combination of these two factors
will soon usher in a period of easier fiscal policy.
Nowhere will the impact of fiscal easing be felt more than the US in 2017, in our view.
The GOP has achieved a rare clean sweep in the latest elections. During the 18 years
that a single party controlled both the Presidency and Congress since 1965, US
structural budget balance as a share of potential GDP deteriorated by 0.4pp a year on
average (Chart 3). In other words, history tells us that a clean sweep is usually a recipe
for fiscal stimulus. The GOP has the additional incentive to use fiscal easing to boost
economic growth ahead of the mid-term elections in 2018. The Republicans will need to
pick up at least eight more seats in the Senate to accomplish their stated objectives of
repealing Obamacare and Dodd-Frank (Chart 4). We think the Republican controlled
Congress will use the reconciliation process (which has a deadline of 15 April) to pass
most of its fiscal agenda into law.
2. Fiscal easing not yet priced into the belly of the curve
Fiscal easing is unlikely to be kind to the Treasury market. For one thing, a bigger
budget deficit would increase risk premium. And, fiscal easing at this late stage of the
expansion would likely lead investors to demand higher inflation risk premium. Also,
2 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Chart 3: Change in structural budget balance /potential GDP (pp)
Chart 4: Number of Senate seats up for grab in 2018
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
Clean sweep
Divided government
25
20
15
10
5
0
Democrats Republicans Independent
Source: BofA Merrill Lynch Global Research
Source: BofA Merrill Lynch Global Research
fiscal easing will likely place pressure on the Fed to normalize rates more quickly when
internal dissent against near zero rates is growing.
US rates have backed up quickly after the election, driven largely by a repricing of
inflation expectations. With long-term inflation breakevens closing on their historical
averages (Chart 5), we think the next phase of the rates move will be led by the belly of
the curve. The market is only pricing in a one and a quarter rate hike in 2017, and
another one and a quarter hike in 2018, with Fed Funds futures implying that the Fed
Funds rates will be only at 1.25% at the end of 2018 (Chart 6). We think the 5y part of
the curve offers the best risk-reward trade-off for investors with a 3-6 month horizon to
position for a more aggressive Fed. As our leading indicator section suggests, global
growth momentum is set to pick up in Q1, also supporting this view.
For investors with a 1-3 month horizon, we would recommend shorting 10y real rates.
This trade would benefit from higher rates in general, but more importantly, would also
benefit from a sudden risk-off that could render vulnerable reflation trades that have
gone a very long way since 9 November. This trade would also benefit from a grand
bargaining that stabilizes long-term debt dynamics, cuts waste and supports investment
and growth.
3. USD/JPY will the main beneficiary of Trump win
While the US fixed income sell-off will likely continue to spill over to other bond
markets, yield differentials are likely to move in favor of the USD. This will be especially
Chart 5: US 10y inflation breakeven (%)
3
2.8
2.6
2.4
2.2
2
1.8
1.6
1.4
1.2
1
1/7/2010 7/7/2011 1/7/2013 7/7/2014 1/7/2016
Source: BofA Merrill Lynch Global Research
Chart 6: Implied Fed Funds rates in 24 months (%)
2.5
2
1.5
1
0.5
0
1/1/2010 7/1/2011 1/1/2013 7/1/2014 1/1/2016
Source: BofA Merrill Lynch Global Research
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 3
Chart 7: Cumulative Japanese purchases of foreign bonds since 2010
900
800
700
600
500
400
300
200
100
0
-100
1/1/2010 7/1/2011 1/1/2013 7/1/2014 1/1/2016
Source: BofA Merrill Lynch Global Research
Chart 8: USD/JPY 10y forward outright
100
95
90
85
80
75
70
65
60
55
50
1/1/2010 5/1/2011 9/1/2012 1/1/2014 5/1/2015 9/1/2016
Source: BofA Merrill Lynch Global Research
true against the JPY given the Bank of Japan is pegging 10y JGB yields at zero. We are
cognizant of the possibility that the willingness of Japanese investors – who have
already bought record amount of US bonds this year – to buy more is likely to be
constrained by their recent losses (Chart 7). However, with long-dated USD/JPY forward
outrights near their lowest levels in more than a year, further purchases are more likely
to be currency unhedged (Chart 8). This is why we would recommend buying USD/JPY
even after the big rally of the past week.
More generally, the USD is likely to benefit from repatriation of overseas US corporate
earnings, which is highly likely, in our view, given that it is the lowest hanging fruit in
Washington for the new administration.
4. MXN is oversold but BRL faces more headwinds
Until the US election, EM fixed income was the best performing asset class in 2016,
benefiting from the decline in rates in core markets as well as the rebound in global
growth. The combination of higher US rates and higher USD over the past week has
nearly wiped out its YTD gains. However, long positions remain crowded (Chart 9) and
liquidity conditions are poor. For these reasons, we think downside risk remains and
would recommend selling a basket of Brazilian, Mexican, and Colombian long bonds.
Some EM markets have already seen brutal capitulation. In particular, MXN has priced in
a lot of bad news, even though it is not clear that the net impact of Trump policy is
negative for Mexico. In contrast, the BRL remains one of the most crowded EM
Chart 9: EM fixed income performance vs. positioning
Source: BofA Merrill Lynch Global Research, EPFR Global
Chart 10: BRL/MXN
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
1/3/2011 1/3/2012 1/3/2013 1/3/2014 1/3/2015 1/3/2016
Source: BofA Merrill Lynch Global Research
4 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
currencies. The fact that the Central Bank of Brazil will be looking to cut rates in the
face of a Fed tightening cycle makes the BRL especially vulnerable in 2017. We would
recommend buying MXN against BRL as a relative value trade.
5. The best hedge against escalation of trade friction
The rise of populism means that policies will become less predictable and less market
friendly. This should be especially true in the area of international trade. Even though a
trade war is not our central scenario, the risk of trade friction will likely be much greater
than anything we have seen in recent years.
For Donald Trump’s trade policy to work he needs a weak USD. Meanwhile, with
increased concerns about the long-term ill effect of debt-fuelled expansion, Beijing
seems to have become resigned that China needs a weaker RMB (Chart 11). This could
set the US and China on a collision course in 2017. To hedge against the possibility of
an escalation of trade tension between China and the US, we would recommend buying
a 10 delta USD call/CNH put that would benefit from either an increase in risk premium
or an acceleration of renminbi depreciation between now and the inauguration of the
new US president on January 20 (Chart 12).
6. Contagious populism will benefit the GBP
Brexit and the election of Donald Trump could help bolster nationalistic and antiglobalization
parties elsewhere by lending legitimacy to their causes. With major
elections coming up in France, Holland and Germany next year and the possibility of
early elections in Italy, investors will be on tenterhooks, as anti-globalization movements
could further undermine public support for the European project at a time that the
Eurozone is still recovering from the peripheral crisis.
It is not our central scenario that right wing parties will take power in any of these
countries next year. However, after the surprise victories of the Brexit camp and Trump,
investors are likely to demand greater risk premium ahead of these votes. We think this
could lead to further reversal of the rally in EUR/GBP this year and would recommend
selling the cross at the current level.
7. Not all reflation trades are born equal
Reflation trades have skyrocketed since the US election. Commodities, mining stocks,
commodity currencies, and inflation indexed bonds generally have outperformed.
However, we would caution against the indiscriminate buying of inflation-linked assets,
as the general theme is not supported by fundamentals in all inflation-linked markets.
Eurozone 10y20y inflation breakeven has jumped over the past week to 1.96%, near the
year’s high, but more importantly, approaching the ECB’s “below but close to 2%”
Chart 11: RMB trade weighted basket
106
104
102
100
98
96
94
10/1/2015 1/1/2016 4/1/2016 7/1/2016 10/1/2016
Source: BofA Merrill Lynch Global Research
Chart 12: EUR/GBP spot
0.95
0.9
0.85
0.8
0.75
0.7
0.65
1/1/2010 7/1/2011 1/1/2013 7/1/2014 1/1/2016
Source: BofA Merrill Lynch Global Research
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 5
target. It is possible that Trump’s election could weaken fiscal discipline in the Eurozone
over the medium term, but we are more concerned by the non-trivial risk that the ECB
may disappoint in the December meeting by either not extending quantitative easing
(QE) beyond next March or announcing tapering prematurely. We like selling 30y
breakeven.
Our commodity team expects OPEC to agree on production cuts on November 30. This
should help support oil prices and the currencies of oil producers like Russia. With the
election of Trump, the probability has increased that there could be some sanction relief
for Russia under the new US administration. RUB has the additional advantage of
offering the highest real rates in EM right now. Given our bullish view on the USD, we
would recommend selling EUR/RUB.
Top 10 Rates, EM & FX trades for 2017
1. Short US 5y rates – Two and a half Fed hikes priced by the rates market for
2017-18 are not consistent with aggressive fiscal easing promised by Trump.
2. Short US 10y real rates – After the violent repricing of inflation breakevens,
real rates offer better risk-reward to position for higher rates.
3. Buy USD/JPY – With the BOJ pegging 10y JGB yields at zero, we expect this
highly interest rate sensitive USD cross will continue to be the biggest
beneficiary of the Trump win.
4. Sell a basket of Brazilian, Mexican, and Colombian long bonds – Positioning
in EM fixed income market remains crowded while liquidity is poor.
5. Sell BRL/MXN – MXN is oversold but BRL will be vulnerable to the divergent
paths between Brazil’s easing and the Fed’s tightening cycles.
6. Buy USD call/CNH put – President Trump will need a weak USD, but President
Xi needs a weak CNY. We believe risk premium for a collision course is too low.
7. Sell EUR/GBP – Brexit and Trump could bolster the anti-globalization parties in
Europe ahead of key elections next year.
8. Sell Eurozone 30y inflation breakevens – We think investors should take
advantage of the recent rally to sell into the December ECB meeting, which
could disappoint.
9. Sell EUR/RUB – Likely OPEC production cuts on November 30 and possible
sanction relief for Russia are bullish for the RUB, in our view.
10. Buy NZD/USD put spread – Spot NZD/USD is forming a head and shoulders
top pattern that suggests a decline will follow in 2017.
The rationale and risks to the trades are detailed below. For a complete list of open and
closed trades see the Global Liquid Markets Weekly.
6 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Best Directional Trades
David Woo
MLPF&S
david.woo@baml.com
Shyam S.Rajan
MLPF&S
shyam.rajan@baml.com
Jane Brauer
MLPF&S
jane.brauer@baml.com
Ian Gordon
MLPF&S
ian.gordon@baml.com
Stay hungry, stay bearish (not foolish)
• For the year ahead, we recommend being bearish 5y US rates, long USDJPY and
short a basket of LatAm long bonds (Mexico, Brazil and Colombia).
• But in the near term, we urge caution with the reflation trade. Short 10y US real
rates offers the best risk-reward after recent moves.
US rates back in the driver seat
After three years of being the sideshow, US rates are back. The US rate outlook in no
small part will drive the FX and EM outlook for 2017. Our strongest medium-term
conviction on a Republican sweep was higher US rates (Mind the Sweep, 31 Aug 16).
That conviction remains steadfast: US rates are headed higher to start 2017. But, this is
not the time to be foolish – 5y and 10y rates have seen a 5 standard deviation move
over the last week. So we recommend a near-term trade (bearish 10y real rates) that
has the least to lose if the reflation theme unwinds while capturing most of the upside
from a bearish move. Our medium-term directional view goes with the flow of recent
price action: short 5y rates, long USDJPY and short basket of LatAm long bonds. Here
we make the compelling case that recent moves have a lot further to go.
Bearish 5y yields for the medium term
Our bearish energy in US rates for 2017 will largely be focused on the 5y point of the
curve. Despite the recent move, we see three clear reasons why the market still has to
play catch-up from now, at least until inauguration day:
1. Comeback chart of 2017: market vs dots
We prefer short 5y rates over the widely held view of short 30y rates given we think
that fiscal stimulus will move the Fed before it shows up in fundamentals. We believe
the Fed’s current dot projections will move from being a ceiling to a floor on the market.
In this case, intermediate forwards like the 3y1 and 4y1y have the most room to sell off,
leaving the 5y point most vulnerable, (Chart 13). Our fair value framework indicates that
if the market were to revert to the dots, 2y rates can move higher by 26bp, 3y rates by
45bp, 5y rates by 57bp and 10y rates by 48bp.
Chart 13: After three years of treating the dots as a ceiling, they will
soon act as a floor for the market, in our view
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19
OIS implied FF target
FOMC median
Source: BofA Merrill Lynch Global Research
Chart 14: Additional deficit needs are likely to be financed by increasing
front-end auction sizes
0
-5
-10
-15
-20
2y 3y 5y 7y 10y 30y
Change in auction szies from the peak in 2010 ($bn)
Source: BofA Merrill Lynch Global Research
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 7
2. Learning from Japanese fiscal stimulus
Ultimately, fiscal stimulus is not the long-term answer to flat curves or low neutral rates
(Japan being the prime example). Fiscal stimulus merely captures some low-hanging fruit
that extends the business cycle by a couple of years and provides the central bank an
opportunity to get further away from the ZLB. Said simply, fiscal stimulus raises the
terminal rate in the current business cycle while doing little for the long-run neutral rate
– this by definition should be more bearish for intermediate rates than 30y rates.
3. Additional deficit issuance
With the average maturity of UST debt already standing at record highs (70months),
Treasury showing an inclination to cut long-end issue sizes in 2016, and the supply
shortfall in the front end of the UST curve post MMF reform, we also believe that the
US Treasury will finance the increased deficit using the belly of the UST curve as
opposed to the long end
Trade: We recommend a 3m5y OTM payer 25 delta, strike = 2.05% for a gross
payoff ratio of 3.4: 1. See the Best Vol Trades section for more details and risks.
But focus on being short real rates now
After spending much of 2016 successfully being long real rates, we recommend
switching to a real rate short for 2017. We think the consensus was too slow to get on
the real rate train and is now too long relative to benchmark. As described in the detail
here, fiscal stimulus is likely to leave government and private companies competing for
a shrinking pool of savings, driving the real cost of debt higher. We highlight three
reasons why short real rates provides better risk-reward now (Chart 15).
• Anti-globalization = higher real rates: Few appreciate that one of the biggest
beneficiaries of globalization has been US real rates. Globalization was undoubtedly
good for EM growth and reserves. As these reserves found their way back into the
US, US real interest rates were held lower. As the global savings glut unwinds, real
rates have the most room to re-price. Chart 16 offers compelling proof.
• Risk parity unwind = higher real rates: Exposure to any heightened concern about
a risk parity deleveraging trade in a high vol environment is best found in asset
classes where their footprint is large relative to market liquidity. TIPS is a prime
example of one such asset class. The influence of a multi-asset strategy on real
rates is clear from Chart 17.
• Lower rates = lower breakevens: If the recent euphoria unwinds, it is likely due to
a 1) RMB deval; 2) commodity collapse post OPEC; or 3) equity market correction.
Chart 15: Real rates vs. breakevens: A real
short offers better risk reward than nominal
short
2
1.8
1.6
1.4
1.2
1
Jan-15
Apr-15
Jul-15
Oct-15
Jan-16
Apr-16
Source: BofA Merrill Lynch Global Research
Jul-16
Oct-16
5y5y breakevens (LHS)
5y5y real rates
0.8
0.3
-0.2
-0.7
-1.2
Chart 16: Foreign official holdings of UST vs.
real rates
600
400
200
0
-200
-400
10 11 12 13 14 15 16
-1.25
-0.75
-0.25
0.25
0.75
1.25
6m change in foreign official holdings of USTs
(LHS, $bn)
6m change in 30y real rates (RHS, inverted
scale, %)
Source: BofA Merrill Lynch Global Research, US Treasury
Chart 17: BAML multi asset strategy index vs
real rates
590
580
570
560
550
540
530
Jun-13
Dec-13
Jun-14
Dec-14
Jun-15
Dec-15
Jun-16
MLMAST1 Index (L1)
USGGT10Y Index (R1)
Dec-16
-0.2
0
0.2
0.4
0.6
0.8
1
The BAML multi asset strategy index is not representative of all
risk-parity funds. Source: BofA Merrill Lynch Global Research
8 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
All three would argue for the decline in rates to be led by breakevens leaving a real
rate short with little downside (real rates moved higher by 50bp post China deval in
Aug-15).
Trade: We recommend selling 10y real rates at 35bp with a target of 1% and a
stop loss of 0bp. Risk: A reflationary sell-off without re-pricing the Fed is a risk to
the trade.
FX: GOP sweep emboldens core USD/JPY view
Higher US real rates, higher intermediate (5-10y) nominal rates combined with a
potential USD tailwind from a second Homeland Investment Act (HIA), leave USD/JPY as
our top directional FX trade for 2017. We have maintained a core view that USD/JPY
would move higher in 2017, as the factors weighing on the pair this year, namely
speculative JPY buying and increased FX hedging by domestic investors ($/¥’s eventual
surge), would subside. We like the trade for the following reasons.
• USD/JPY most sensitive to fiscal-stimulus-driven rise in US yields: Of all G10
FX pairs, JPY is most vulnerable (versus the USD) to a fiscal-driven rise in US yields.
First, the pair’s correlation with rate differentials is the highest in G10 at 60%. But,
more importantly, USD/JPY is also the most sensitive to the shape of the US 2s10s
curve (Chart 18). The shift from loose monetary/tight fiscal to a tight monetary/
loose fiscal policy regime will support such a steepening as supply is concentrated
in the intermediate part of the curve, and the positive growth shock allows the Fed
to hike faster, supporting an increase in real yields, also a key 2017 call.
• BOJ yield target is bearish for JPY: The BOJ’s implementation of a yield target at
its September meeting has caused a break in the correlation between 10Y JGBs and
USTs (Chart 19). First, given USD/JPY’s significant correlation with 10Y yield
differentials (>60%), the anchoring of 10Y yields will further weigh on the Yen as
US Treasury yields rise. Second, further Japanese fiscal stimulus will successfully
lower real yields through higher breakeven rates of inflation while nominal yields
will remain unchanged. As our JPY strategist argues, to the extent that a Trump
victory has weakened Abe’s diplomatic success, not least from likely TPP failure,
and residual macro uncertainty makes it increasingly likely the government will seek
to draft a supplementary budget sooner than anticipated.
• HIA and domestic flow picture a JPY-negative: The flow picture also turns JPYnegative
in 2017. USD/JPY’s underperformance during Asia trading hours in 2016
highlights that domestics used any rally in the pair to hedge (by selling USD/JPY)
existing investments. This flow will likely subside in 2017. The compression in FXhedge-adjusted
yield pickup from a Japanese investor’s standpoint will likely shift
Chart 18: USD/JPY and Japanese equities
perform well in US 2s-10s curve steepening
5
3
1
-1
-3
-5
Bear Steep Bear Flat Bull Steep Bull Flat
Source: BofA Merrill Lynch Global Research, Bloomberg
Note: curve and average cross-market reaction (past 40 quarter
simple average)
Chart 19: Correlation breakdown
2.5
2.3
2.1
1.9
1.7
1.5
1.3
1.1
Nov-15
Jan-16
Mar-16
10Y UST
10Y JBG (RHS)
May-16
BOJ yield target
Jul-16
Sep-16
Nov-16
Source: BofA Merrill Lynch Global Research, Bloomberg
0.4
0.2
0
-0.2
-0.4
Chart 20: 2005 HIA repatriation flows vs
USD/JPY
140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
99 00 01 02 03 04 05 06 07
US Multi-national repatriation…
USD/JPY spot (RHS)
Source: BofA Merrill Lynch Global Research, Bloomberg, BEA
140
130
120
110
100
90
80
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 9
any further rebalancing to be unhedged, strengthening USDJPY. We believe the
Republican sweep of Congress makes it very likely that HIA 2.0 will be passed
(Homeland Investment redux?). Following the 2005 HIA, USD/JPY rose from 102 to
117 (Chart 20). Given US corporate exposure is heavily concentrated in European
and Asian countries (including Japan), flows out of these currencies into USD would
be the most pronounced.
Trade: We recommend buying a 6m USD/JPY digital call for 10% spot ref: 108.95).
The strike aligns with our end-2017 USD/JPY forecasts of 120, and with a 10%
entry level provides a 10 to 1 return. The risks to the trade are a decline in risk
sentiment, a retreat from the US Treasury’s “strong dollar” policy by the new
administration, and/or a failure of the US to meet already high expectations for
significant fiscal easing.
EM sovereign credit has more downside
Our bullish dollar + bearish US rate view leaves us bearish on EM. In our view, Mexico,
Brazil and Colombia (longer duration low spread foreign currency bonds) are especially
vulnerable, while the higher yield and lower duration of lower quality and shorter EM
bonds will be more defensive. A review of the taper tantrum (May 2013) shows that: 1)
EM underperformed UST at the start; 2) BBB sovereigns underperformed the most, and
had not yet recovered in a year; and 3) BB and B-rated bonds recovered to beat USTs 8-
10 months later. This time, we expect a sharp selloff with an eventual recovery.
Our bearish view on LatAm credits in particular is driven by 1) positioning in LatAm is
heavier than in EMEA or Asia – watch outflows from IG crossover investors who will
rethink their EM IG investments; 2) their exposure to commodities and 3) vulnerability to
a potential decline in US trade. Our choice of the basket is fairly obvious - Mexico is
clearly the most vulnerable to NAFTA and a decline in remittances, uncertainty on the
pace of the economic recovery and debt dynamics are extremely challenging in Brazil
while tax reform delays could mean a credit rating downgrade in Columbia.
Taking account of both oil and US rates as independent variables, a regression analysis
shows that a 100bp Tsy backup would be related to 30-45bp wider spread (Chart 22).
Note that residuals show spreads are currently about 35bp too tight.
The trade: Sell equally weighted basket of Mex 47s, Brazil 45s and Colom 44s
Current average yield: 5.74%, annual carry & roll 30bp; target: 6.35%; stop: 5.25%
On a portfolio basis for benchmark real money investors, we recommend moving out of
long higher quality LatAm, leaving higher yielding shorter bonds. A commodity price
rebound or a reversal of US rates is a risk to the trade.
Chart 21: Total return of EM sovereigns during taper tantrum May 2013
Total return index value
104
100
96
92
Chart 22: EM sovereign spreads widen with declining oil prices Jun
2014
100
75
50
Taper tantrum
Commodity collapse
475
425
375
325
275
88
May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14
US try master BBB rated BB rated B rated
Source: BofA Merrill Lynch Global Research, Bloomberg
25
May-13 May-14 May-15 May-16
Brent IGOV Index (rhs)
Source: BofA Merrill Lynch Global Research, Bloomberg
225
10 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Leading Indicators
Carlos Capistran
Merrill Lynch (Mexico)
carlos.capistran@baml.com
Brace for faster global growth
• Our leading indicator of leading indicators (LILI), shows that global growth will likely
continue to improve in early 2017.
• Faster global growth as anticipated by LILI supports higher rates and reflation.
A leading indicator of leading indicators
Investors use leading indicators to try to anticipate turning points in economic activity
because those turning points drive FX, rates and stocks. One transmission channel is
that turning points usually anticipate monetary policy changes. The most reliable leading
indicators available summarize a battery of activity, financial and qualitative variables.
One example is the set of Composite Leading Indicators (CLIs) calculated by the OECD,
which is heavily used by policy makers and market participants.
The problem that we have with leading indicators is they are not really useful to market
participants because they move after the market does. That is, leading indicators
anticipate growth but not the market because they use financial variables to anticipate
growth. Leading indicators rely heavily on interest rates, stock market indexes and
exchange rates because they incorporate vast information quickly.
LILI solves the problem in two dimensions. It is not based on financial variables. Rather,
LILI is based on qualitative data, consumer and business confidence, which we believe
are optimal to capture “animal spirits.” And, it is constructed explicitly to anticipate the
CLI, as we use a dynamic forecasting regression with lags of consumer and business
confidence to calculate LILI.
The signal for early 2017
LILI indicates that in early 2017 global growth will continue with an improving economic
outlook (Chart 23). Consumers and firms seem to be bullish around the world, because
LILI anticipates an even stronger outlook than the CLI. Here global growth means
growth in the OECD plus the six largest non-OECD members. LILI anticipates the CLI by
four months, and the CLI in turn anticipates growth by three months.
LILI supports our house view of higher rates and reflation, as the peak of the business
cycle is not in the forecasting horizon. Since LILI is not based on market measures, we
are confident that LILI anticipates market movements as well.
Chart 23: LILI is our leading indicator of leading indicators that leads growth by 7 months and OECD’s CLI by 4 months
103
101
99
OECD + 6 LILI
97
OECD + 6 CLI
OECD +6 growth
95
Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16
Source: BofA Merrill Lynch Global Research, OECD. Note: OECD + 6 includes the 33 OECD member countries plus the largest 6 non-OECD members: Brazil, China, India, Indonesia, Russia and South Africa
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 11
The nuts and bolts of LILI
We used the OECD database of monthly economic indicators to look for non-financial
variables that could anticipate the CLI. We use small and simple forecasting regressions,
as they sometimes adjust more quickly to structural changes than large regressions or
regressions based on large data sets. And, we already have a big-data leading indicator,
published in our Year Ahead a year ago. We looked only at models with two independent
variables (and their lags) and with variables of the same “type” (production variables, or
employment variables, or confidence indicators). Further research can be done to use
models that mix variables, although those models are more difficult to interpret.
We used two criteria to select between models. One was Granger-causality tests, which
amount to joint tests that the lags of the independent variables are statistically
different from zero in our dynamic regressions. The other was the Bayesian Information
Criteria (BIC), a measure that looks at the fit of the regression (the r-squared) but that
penalizes large models. We found that production measures and confidence indicators
usually performed better in our training sample (1980 to 2014), although confidence
measures usually had a larger lead. The model that used has a lead of four months and
uses up to four lags of the standardized consumer confidence indicator (CCI) and of the
standardized business confidence indicator (BCI) calculated by the OECD. Many models
showed similar performance, which indicates that a combination strategy could be
fruitful, although we did not take that route. No out-of-sample tests were performed.
We like LILI because it can anticipate the OECD’s leading indicator without the use of
financial variables. But we also like it because it is easy to interpret as it is based on
confidence indicators and because those indicators are not subject to data revision,
unlike variables such as GDP or payrolls.
12 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Best Inflation Trades
Mark Capleton
MLI (UK)
mark.capleton@baml.com
David Beker
Merrill Lynch (Brazil)
david.beker@baml.com
Sebastien Cross
MLI (UK)
sebastien.cross@baml.com
Athanasios Vamvakidis
MLI (UK)
athanasios.vamvakidis@baml.com
Inflation party starting but Eurozone not invited
• Eurozone breakevens have benefited from US move, but we see its sub-target
problem becoming more entrenched. Sell OATei 2047 vs OAT 2066
• FX pass-through considerations and the prospect of firmer oil prices and leave us
favoring breakevens in Thailand and Mexico.
• We expect inflation divergence in G10 economies. Our analysis of inflation and
deflation risks support buying USD/JPY and selling CHF/SEK.
Rising Eurozone breakevens – the triumph of hope over experience?
The rally in Eurozone breakevens and inflation swaps looks mild compared with the
recent US experience, for obvious reasons, but it has still been meaningful. The widely
followed 5y5y has rallied from a 1.25% low to 1.58% and the 10y20y forward rate is at
1.96% (which qualifies as meeting the ECB’s ‘below but close to 2%’, we’d say, albeit
without the inflation risk premium we were used to in the past).
It is hard to argue with what looks like a beta-weighted response to the US move,
perhaps. After all, there is a global component to inflation and if the US is driving that
now, then Eurozone inflation expectations should firm, it can be argued. And if we are in
for a Reaganomics-style fiscal stimulus, then it is quite possible that we will get the
dollar strength associated with that experience; if so, the Eurozone might get to import
a little inflation by being on the other side of that currency move.
However, we are somewhat troubled by the fact that the inflation options market has
priced out the risk of deflation almost completely (Chart 24). Has that threat really been
extinguished? Yes, inflation expectations have risen but the rise in real yields has also
tightened monetary conditions and there remains the threat that in December the ECB
fails to commit to ongoing stimulus on a sufficient scale to satisfy markets that it can
return inflation to target.
Chart 24: Euro inflation expectations rally; long term forward at target,
%
3.0
2.5
2.0
1.5
1.0
10 11 12 13 14 15 16
Source: BofA Merrill Lynch Global Research
5y5y
10y20y
Chart 25: Perceived deflation risk goes; 5y ZC 0% inflation floor price, c
120
100
80
60
40
20
0
10 11 12 13 14 15 16
Source: BofA Merrill Lynch Global Research
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 13
Chart 26: The Euro HICP – weighted index proportions recording
inflation below 0% and above 2%
Chart 27: Eurozone member country inflation rates, with bubble sizes
proportionate to index weights
70
1.2
60
1.15
50
1.1
40
1.05
30
1
20
0.95
10
0
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
>2% <0%
0.9
0.85
0.8
-1 -0.5 0 0.5 1 1.5 2
Source: Eurostat, BofA Merrill Lynch Global Research
Source: Eurostat, BofA Merrill Lynch Global Research
Core inflation at 0.8% is barely above the 2015 low of 0.6%. One statistic that often
grabs attention is the high proportion of HICP index components recording deflation
(currently 31% on a weighted basis). However, much of this represents volatile non-core
components so is less of a concern. The bigger problem is the fact that even after we
take out all these components recording deflation, the 69% of the index remaining is
only recording a weighted average inflation rate of 1.3%. Chart 26 shows that the more
serious problem is that only 10% of components in the basket are recording inflation
rates above the 2% target. So there is a “lowflation” clustering problem by index item
and Chart 27 shows that there is also a lowflation clustering problem by country. In fact,
the country clustering is even more concentrated than it looks if we allow for the fact
that the bigger of the two upside outliers, Belgium (1.8% inflation), has experienced a
presumably unrepeatable increase in the tax rate on electricity from 6% to 21%, as well
as other excise duty increases.
One might be tempted to give the Eurozone the benefit of the doubt on inflation,
insofar as its output gap remains material. However, the closure of the output gap still
requires strong and continuing stimulus, we would argue, and even that does not
guarantee that somehow inflation resets to target.
Our worry about item and country lowflation clustering is not that inflation is
“unanchored”. Our concern is that it flags a “re-anchoring” of inflation at a level well
below 2% and that this new anchor will prove difficult to dislodge.
Chart 28: Output gap as % potential GDP
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
-5%
-6%
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
Source: BofA Merrill Lynch Global Research , AMECO
EA UK US
Chart 29: Influence of current inflation on 5y5y EUR inflation swaps
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
-0.05
-0.10
Confidence interval +/- 2SD
-0.15
2009 2010 2011 2012 2013 2014 2015 2016
Note: The chart shows the slope of the regression of 5y5y on current inflation, with rolling windows
of 29 quarters
Source: BofA Merrill Lynch Global Research, Bloomberg
14 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Economists place great store in the importance of expectations and their impact on
inflation. Chart 29 suggests an adverse feedback problem has emerged, with actual
inflation an increasingly influential driver of 5y5y inflation (and economist long-term
consensus expectations).
With 10y20y inflation effectively at the ECB’s target, we favor short positions in 30y
breakevens. In the case of the OATei 2047, the “observed” breakeven drastically
understates what we would consider to be a fairer measure. The issue here is that the
linker is almost 10 years longer than its nominal 2045 comparator in modified duration
terms. On a duration basis, the linker lies in between the 2060 and 2066 nominal OATs
and, of course, the 30s50s OAT curve is very steep.
Trade: we recommended a more closely-matched breakeven trade, shorting OATei
2047s to buy OAT 2066s to give a breakeven of 163.3bp, targeting 130bp with a
stop-loss at 180bp on October 14. The breakeven has risen, against our
expectations, to 169.6bp currently and we regard this as an attractive entry level.
We will nudge our stop-loss level higher to 185bp.
The relative cheapness of the nominal 50y partly reflects the 31y maturity limit to ECB
buying. We regard the ECB eligibility premium for bonds within the ECB’s buying range
(like this linker) as material, so the trade should be a beneficiary in the event of an ECB
“taper tantrum”. An important additional feature in these turbulent times is the greater
dispersion of the nominal’s cash flows (in PV terms). This means the trade is
significantly net long convexity.
We see the risks to the trade being a strong Eurozone recovery causing a general
repricing of breakevens higher and the possibility of further heavy issuance of 50-year
bonds across the Eurozone.
EM linkers: feeling the contagion for higher breakevens
The prospect for higher yields in the US clearly affects the appetite for Emerging
Market (EM) assets including inflation-linked bonds. The discussion is about not only EM
becoming less attractive on a relative basis, but also how the higher yields in the US
affect the dollar and thus EM currencies.
Fiscal stimulus prospects in the US should continue to drive some correction across EM
assets, but at this point, there is still too much uncertainty on the actual reach of such
stimulus. Investors faced strong returns in EM this year and because of the calendar
effect, this puts pressure to square positions and reduce risk. While this correction may
last for a while, it is clearly creating more value in some assets. For now, the discussion
will be about re-sizing positions rather than valuation. Only when volatility declines and
yields stabilize in the US will we be able to resume discussion on valuation and the level
of yields across EM.
Liquidity is a key issue when looking into EM linkers, in particular across EMEA, but we
find some interesting opportunities in Asia and LatAm.. Currency weakness ends up
adding risks for higher inflation in some countries but FX pass-through varies a lot
depending on output gap. In general, we believe there is room for higher breakevens in
EM, with key highlight for Thailand and 10y in Mexico.
Attractive breakevens in Thailand and Mexico
In Asia, we believe breakevens are pricing in too much complacency on the inflation
outlook. With prospects for higher oil prices, it makes sense to position for higher
breakevens in both Thailand and Korea in our view. Breakevens appear cheaper in
Thailand as inflation is already increasing, while breakevens have clearly lagged the
movement.
In EMEA, linkers are mostly illiquid and/or expensive so there is more to do in nominals
and/or FX in our view. Yet, the currency move has triggered a widening in breakevens in
some countries like South Africa. We expect this movement to continue for now.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 15
Chart 30: Breakevens to increase in some EM
10%
8%
6%
4%
2%
Brazil
Turkey
3.9
3
2.1
1.2
Chart 31: In Brazil, high correlation between breakeven and BRL
10% Brazil breakeven 10yr BRL - RHS 4.5
4
8%
3.5
6%
3
2.5
0%
0.3
2/28/2014 1/24/2015 12/20/2015 11/14/2016
Source: Bloomberg
4%
2
2/28/2014 1/24/2015 12/20/2015 11/14/2016
Source: Bloomberg
Finally, in LatAm, we expect inflation to increase in Mexico, driving breakevens higher
across the curve. Although FX pass-through is very low in the country, the ongoing MXN
depreciation may add some pressure on inflation at the margin. In the case of Brazil, the
central bank was very successful in anchoring long-term inflation expectations driving
breakevens lower across the bond curve. For long-only investors, we believe linkers
should be more resilient versus nominal bonds.
While Brazil continues to have one of the highest nominal and real yields across the
globe, further compression requires stabilization in US yields. As long as the Brazilian
government is able to deliver on the reform front, approving a social security reform bill
next year, we see room for real yield compression from levels above 5.5% right now.
Buy USD/JPY, sell CHF/SEK
Inflation may not be back yet but deflation risk is most likely gone in most regions in our
view (the notable exception being the Eurozone, we believe, as discussed above). A year
ago we argued that the market deflation position was stretched and that there was
room for inflation surprises. Indeed, average inflation surprises in G10 economies have
been increasing since then and are now clearly in positive territory (Chart 32). Monetary
policy in G10 economies is the loosest it has even been, suggesting that global inflation
could continue rising (Chart 33). This is not necessarily bad news, as the threat of
deflation is now gone. However, inflation rather than deflation trades are likely to
become an important driver in G10 FX.
We update a heatmap of inflation risks in G10 economies to determine how to position
for such risks in FX. We have discussed the methodology in Inflation and FX: What if the
dog starts barking?. The idea is to rank currencies based on a number of early warning
inflation indicators. Using equal weights, if most indicators point towards higher
inflation for a currency, we take this to suggest that investors should go long, against a
currency for which most indicators point towards deflation, both in relative terms.
Chart 32: G10 inflation surprises (average)
Chart 33: G10 sum of spreads from Taylor rule
40.0
30.0
20.0
10.0
0.0
-10.0
-20.0
-30.0
20
15
10
5
0
-5
-10
-15
-20
-25
-30
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
Feb-99
Feb-00
Feb-01
Feb-02
Feb-03
Feb-04
Feb-05
Feb-06
Feb-07
Feb-08
Feb-09
Feb-10
Feb-11
Feb-12
Feb-13
Feb-14
Feb-15
Feb-16
Source: BofA Merrill Lynch Global Research.
Source: BofA Merrill Lynch Global Research.
16 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Table 1: Heatmap of inflation risks (green for high, red for low, in relative terms)
Total Inflation gap since 2007 Inflation Inflation change Core Core change Taylor spread Housing prices Output gap Change in structural fiscal Inflation surprises Credit growth Unit labour cost Unemployment gap
NOK
SEK
USD
CAD
GBP
NZD
AUD
CHF
EUR
JPY
Source: BofA Merrill Lynch Global Research.
The results in Table 1 are supportive of the USD and the scandies against JPY, EUR and
CHF. This is fully consistent with our projections for 2017, expecting USD strength to
continue, particularly against JPY, and the scandies to do well against EUR and CHF.
Based on this analysis, we recommend buying USD/JPY and selling CHF/SEK, to position
for inflation risks in G10 economies. Long USD/JPY is also our top directional trade for
2017 and we already have a trade recommendation to sell EUR/SEK. Therefore, we
would recommend selling CHF/SEK as a new trade to position for inflation risks.
CHF/SEK is one of the most overvalued crosses in G10. It is currently at its highest
value ever, with the exception of the level reached when the SNB removed the EUR/CHF
floor. We also expect the SNB to intervene to offset FX pressure, while higher
uncertainty increases risks of a rate cut.
The risk to this view is if tail risk scenarios unfold in European politics, such as an early
election in Italy with Five Star winning, or Le Pen wining the second round in the French
elections. Although we expect markets to be more concerned about European politics
following the US elections, we do not see tail risk scenarios in our baseline.
Trade: We recommend selling CHF/SEK, from spot at 9.184, with a target of 8.4
and stop loss at 9.5.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 17
Best Relative Value Trades
Athanasios Vamvakidis
MLI (UK)
athanasios.vamvakidis@baml.com
Erjon Satko
MLI (UK)
erjon.satko@baml.com
Arko Sen
MLI (UK)
arko.sen@baml.com
Shusuke Yamada, CFA >>
Merrill Lynch (Japan)
shusuke.yamada@baml.com
Relative value in a macro world
• Long EUR/JPY: data and positioning supportive; the BoJ has more tools to address
sustainability challenges than the ECB.
• Long RUB/KRW: US fiscal expansion suggests more upside for reflation sensitive
Russia than interest rate sensitive Korea.
• Sell German 2y vs OIS, buy 10y vs OIS: fade the impressive richening of shortmaturity
German govies.
Long EUR/JPY
In a recent report we argued that EUR/JPY could appreciate in the months ahead as the
BoJ gains credibility and the ECB has to deal with QE constraints. Since then, the
EUR/JPY has appreciated by 3%, but we see more upside. Although we expect the ECB
to extend QE by a further six months in December, we see more difficulties next year.
Extending QE will require difficult decisions, such as relaxing the capital key or buying
below the depo rate. QE tapering is therefore a risk and the market could start testing
the ECB. Even if Draghi succeeds, the Euro could strengthen in the meantime. In
contrast, the BoJ’s new framework should address the sustainability challenges that
Kuroda faced this year, and allows more fiscal stimulus by keeping the government’s
borrowing costs at zero. The ECB cannot do this, in our view. We have been short
EUR/JPY this year, as we were expecting the ECB to extend QE, while the BoJ faced
challenges.
Data also suggests further EUR/JPY upside. Relative GDP growth would be consistent
with a stronger EUR/JPY, as the Eurozone has been gaining momentum, while growth in
Japan remains weak (Chart 34). Relative central bank balance sheets give the same
signal (Chart 35). Positioning is also in support, as our analysis suggests a short EUR/JPY
market position (Chart 36).
If the external environment improves, we think Japanese investors are likely to be JPY
sellers again as the hedge ratio and hedge costs have both risen. One of key factors of
the yen’s appreciation this year might have been that, as the USD/JPY fell, institutional
investors implemented additional FX-hedging to their existing forex positions as part of
their risk management, which caused the USD/JPY to fall further and supply-demand to
worsen in a vicious circle. However, this mechanism probably ran its course when the
USD/JPY reached 100 on the Brexit vote as we argued in $/¥’s eventual surge: Buy
Nikkei 06 September 2016. In fact, the USD/JPY has stopped falling during Tokyo
trading hours since the summer. Based on the decline of foreign yields and higher hedge
costs, hedged US Treasuries and German bunds had lost nearly all of their attraction for
Japanese investors by the summer. US and German 10yr government bond yields sank to
about 0% after being hedged to the JPY, reflecting that downward pressure on yields
had reached the limit. Institutional investors are expected to increase their exposure to
unhedged foreign bonds in H2 FY16. Investor behavior is especially liable to change in
April, when the new fiscal year starts.
18 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Chart 34: EUR/JPY and real GDP growth
180
170
160
150
140
130
120
110
100
90
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
Mar-15
Mar-16
EURJPY (LHS)
Real GDP growth difference (RHS)
Source: BofA Merrill Lynch Global Research.
5
4
3
2
1
0
-1
-2
-3
-4
-5
Chart 35: EURJPY and relative central bank
balance sheets
55.0
45.0
35.0
25.0
15.0
5.0
-5.0
BoJ-ECB balance sheets (GDP shares, LHS)
EURJPY (RHS)
Source: BofA Merrill Lynch Global Research.
145
135
125
115
105
95
Chart 36: EUR and JPY market positions
relative to the last 12 months
50.00
40.00
30.00
20.00
10.00
0.00
-10.00
-20.00
-30.00
-40.00
-50.00
Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16
EUR
JPY
Source: BofA Merrill Lynch Global Research.
For more details, see Liquid Cross Border Flows.
EUR rates are probably more vulnerable against US rates movements, as the market
questions whether the next ECB move will be expansion or tapering. On the other hand,
Japanese rates are insulated from foreign movements as the BoJ directly targets the
10yr yield. Japanese fiscal easing is also a possibility in light of reduced odds of TPP
implementation and a potential snap election. Any positive impact of Japanese fiscal
easing on growth is likely to manifest in higher inflation expectations under the BoJ’s
yield-targeting regime, which means Japanese real interest rates could actually fall.
Based on these considerations, we recommend buying a 6M EUR/JPY 122/130 call
spread for 1.2312% EUR (spot ref. 116.84). Risks to our trade include a severe global
shock that could strengthen the JPY, or the return of the Eurozone crisis; for example, if
the government in Italy falls after Renzi loses the referendum in December or Le Pen
wins the elections in France.
Long RUB/KRW
Post US elections and the improved outlook for fiscal expansion in the US, we see more
upside in being long oil and reflation sensitive Russia than short technology and interest
rate sensitive Korea.
We recommend being long RUB/KRW heading into 2017 targeting a move to 19.4
(spot ref 18, stop 16.7). The trade is positive carry 2% per quarter.
The rise in US breakeven inflation is positive for risky assets broadly but could be
painful in the short term for highly indebted countries with low interest rates. Higher US
breakeven inflation rates are historically associated with higher RUB/KRW (Chart 37).
Higher US real rates are also less of a threat for Russia where local real yields are
significantly higher than Korea (Table 2) and most EM peers. Korea also has relatively
high private sector debt which could face pressure if BoK is forced to raise rates.
Household debt has been rising at an alarming rate and domestic political turmoil facing
the Park administration has also added to concerns.
In our baseline scenarios, we expect a modest growth recovery for Korea but a stronger
delta for Russia where the oil price collapse over 2014-15 led to a much sharper
slowdown earlier and activity is now in recovery stage.
The ToT trade shock that hit Russia in 2014 led to material underperformance in exports
vs Korea. Over 2011-13, Russia and Korean exports were growing at about the same
rates but since 2014 that gap widened has materially against Russia. Since early 2016,
however, this has reversed with Russia catching up. In 2017, Russian exports growth
could outperform Korea given the outlook for oil. Moreover, it is less reliant on China or
Japan and more reliant on Europe. CNH/KRW as well as JPY/KRW remains near multi year
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 19
lows suggesting this will be a source of pressure on the Won given the greater trade
linkages (Table 2).
Our current account forecasts for 2017 anticipate deterioration in Korea’s current
account surplus compared to marginal improvement in Russia’s. Recent issues at
Samsung and Hanjin pose risks for the goods and service balances, respectively.
Electronics account for 30% of Korea’s exports. While a stronger dollar and energy deregulation
in the US could dampen the oil market, our energy strategists continue to
expect further modest gains in Brent over 2017. The RUB/KRW cross has a modest
positive beta to oil at 25% since the beginning of 2014. Risks to the trade are mainly
material downside to oil prices vs our baseline scenario.
Sell German 2y vs OIS, buy 10y vs OIS
In H2 2016, we saw an impressive richening of short-maturity German govies and repo:
we like fading the move by selling 2y Bund vs OIS and buying the 10y vs OIS.
German 2y is pricing-in structurally high demand and low supply
The German 2y trades at the richest against OIS since the peak in 2011 due mainly to
demand/supply dynamics driven by: 1) European regulation on mandatory central
clearing and minimum initial margin requirements generating €350bn in extra collateral
needs in 2016-19; 2) LCR regulation and negative rates having pushed cash-rich
corporates into holding short-end German bonds/bills in order to store liquidity; and 3)
net bill issuance having been cut to negative in Q4 because falling yields created €42bn
of excess cash for governments.
Supply pressures are expected to ease in 2017E
Bubill auctions will resume after more than two months of absence while more
treasuries may be the answer to an excessive rise in yields by increasing net issuance in
the front-end. The ECB may also be concerned by the richness of front-end German
govies (see Couré’s speech on 3 November). If the Eurozone fails to create enough
safe/low-volatility securities for the market to work efficiently, then the central bank
could compensate by lending more collateral, by adjusting counterparty frameworks and
running higher balance sheets or even by issuing bills to satisfy safe asset demand in
the non-bank system.
ECB QE and potential periphery stress supports 10y outperformance
Given the tail risks in 2017 and our call of ECB QE extension to September 2017, we
prefer to add a 10y DBR long vs OIS – we expect 10s to outperform in such a scenario.
In Chart 38 we show that ECB tapering expectations have now pushed 2s10s vs OIS to
levels before the announcement of ECB QE on 22 January 2015. However, we see even
more reasons for the ECB to extend the €80bn per month in QE to September 2017.
Chart 37: Return to a different time
45
3.5
40
3.0
35
30
2.5
25
2.0
20
1.5
15
10
1.0
5
0.5
0
0.0
Jan-10 Oct-11 Jul-13 Apr-15 Jan-17
RUB/KRW (LHS)
Source: BofA Merrill Lynch Global Research, Bloomberg
US 5y5y breakeven (RHS)
Table 2: Russia vs S. Korea factors
RUB KRW
Real rate* 4.2 0.9
CA change forecast, '17 vs '16 1.2 -1
Growth delta forecast, '17 vs '16 1.6 0.2
NFA / GDP+ 1 -5
Pvt credit (% GDP) 50 80
Foreign holdings of local debt (USD bn) 20 67
FX reserves / ST debt 6 3
Share of US in exports 2 13
Share of China in exports 10 25
* 1y fwd 5y yield vs inflation forecast
+Countries net external position vs BIS-reporting banks
Source: BofA Merrill Lynch Global Research, Bloomberg
20 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Chart 38: Low repo rates and ECB QE tapering push 10s to pre-QE levels
20
Periphery blow-out
ECB QE announc. Brexit
10
0
-10
-20
-30
2s5s 2s10s
-40
Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16
Source: BofA Merrill Lynch Global Research
Chart 39: 10y Germany is historically cheap on the OIS curve
40
OIS-Bund spread
35
30
25
20
15
10
5
0
2y 5y
Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16
Source: BofA Merrill Lynch Global Research
10s would be particularly supported if the ECB increases the holding limit of non-CaC
bonds to 50% – a tweak we see as the most likely. Also, given the already stretched
valuations in the 2y, we think a rise in geopolitical risks or a blow-out in peripheral
spreads would increase collateral values of 5s and 10s more than the front-end – as
happened during the first BTP spread widening in 2011 or the Brexit referendum.
We recommend investors go long the DBR Aug26 vs OIS and short the BKO Dec18
vs OIS at current levels of -17bp, targeting 14bp and with a stop at -34bp. The
position has 1.1bp in 3m Carry and Roll. The main risk in the short term is ECB QE
failure, while tighter short-maturity securities supply or lending is the main risk over the
longer term.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 21
Best Contrarian Trades
David Hauner, CFA
MLI (UK)
david.hauner@baml.com
Ezequiel Aguirre
MLPF&S
ezequiel.aguirre@baml.com
Mark Cabana, CFA
MLPF&S
mark.cabana@baml.com
Rohit Garg
Merrill Lynch (Singapore)
r.garg@baml.com
Kamal Sharma
MLI (UK)
ksharma32@baml.com
What if populism is too popular?
• G10: Short inflation/long duration through US 3-year 0% US inflation floors as
stimulus may falter. Short EUR/GBP as “sending the letter” may be the low point.
• EM: Short JPY/KRW, short BRL/MXN as US policies may hurt EM less than feared.
Long Turkey Eurobonds as sentiment may improve by the referendum in spring.
“Long populism” becoming consensus
While we received a lot of pushback for pointing out the risks ahead of the US elections,
now “long populism” is quickly becoming consensus. The naysayers may argue that the
establishment could reassert itself: conservatives may constrain fiscal stimulus and
protectionism, and central bankers may stay dovish (remember the ECB too). We
suggest five trade ideas: 1) short inflation/long duration; 2) short EUR/GBP; 3) short
JPY/KRW; 4) short BRL/MXN; and 5) long Turkey sovereign where populism may calm.
Populism is getting popular
5y5y US inflation swaps have spiked 60bp since summer to about 2.5% – the biggest
move since 2009. As a consequence, EM has sold off sharply. Our pre-election
sentiment surveys partly explain the violence of the moves since 8 November: investors
were long EM bonds and equities and neutral duration in the US (Chart 40). The latest
CFTC data show a similar picture, with short GBP and long BRL, Crude, RUB and even
MXN most extreme vs history; note also a short in US Treasuries. Purely statistically
speaking, the shorts in GBP and US Treasuries are most vulnerable to a near-term
reversal – though momentum may prevail for a while in Treasuries (Chart 41). When the
dust settles, the contrarian may find opportunities in “short populism” trades.
Chart 40: Our pre-election surveys show investors bearish GBP, duration
Cash
EM Duration
USD FX
EM equities
Commod
JPY FX
JPY Duration
EUR FX
USD Duration
US equities
Japan equities
Eurozone equities
Bonds
Equities
EM FX
GBP Duration
UK equities
EUR Duration
GBP FX
-4 -3 -2 -1 1 2
Note: positioning score relative to history. Source: BofA Merrill Lynch Global Research
Chart 41: CFTC data show positioning is very short GBP
65%
60%
55%
50%
45%
40%
10y US
Treasury
Notes
EUR
GBP
JPY
BRL
Crude oil
MXN
RUB
-1 0 1 2 3 4
Note: x-axis: 1y z-score of net long spec positioning as of November 8; y-axis: probability of a price
reversal in the week after. Source: BofA Merrill Lynch Global Research, Bloomberg, CFTC
22 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Rates: short inflation/long duration
Positioning surveys generally indicate that the rates market is neutral or short duration
amid rising inflation expectations. According to our rates & FX sentiment survey, clients
are relatively short in relation to their average positioning across major fixed income
markets including the EU, UK, and to a lesser extent the US (Chart 42). Such position
indications suggest that contrarian investors should be long duration in Europe, the UK,
and the US. These positions have been factored into some of our pre-existing
fundamental views, which include receiving euro vs US rates and expecting UK
supply/demand dynamics to be supportive of longer-dated Gilts going into year end. We
are reluctant to recommend outright long duration positions in US rates at present
given that the sharp election-induced selloff could extend over the coming weeks.
Consensus expects rising inflation
Instead, we focus on contrarian views regarding the outlook for inflation, which
underpinned some of short rates positioning and is expected to increase with US fiscal
policy expansion and base effects. According to our recent Global Fund Manager Survey
taken prior to the election, global inflation expectations are on the rise, with 70% of
survey respondents expecting higher global CPI readings in the near term. Headline CPI
has been moving higher in the US, and Chinese PPI recently turned positive for the first
time since 2012. Similarly, global market-based measures of inflation expectations have
been rising, with 5y5y forward inflation swaps in the US, UK, and Europe all rising over
recent months and US inflation protected funds receiving nearly $2 billion in inflows
since the start of October.
Disinflation may strike back
Risks to the near-term outlook for inflation could rise if: (1) expectations for US fiscal
stimulus disappoint as House deficit hawks insist on revenue-neutral tax cuts or
spending measures; (2) Beijing pushes the RMB lower before President-elect Trump
takes office leading to risk-off and imported disinflation; (3) commodity prices decline if
an OPEC deal cannot be reached, the USD meaningfully appreciates, or if EM growth
falters; or (4) EU slowdown fears rise should the ECB taper due to technical constraints.
We recommend buying 3-year 0% inflation floors in the US, which currently
demand only 9 basis of premium. These levels are low in relation to recent history and
could increase if Beijing were to more rapidly weaken the RMB or if commodities falter
(Chart 43). Investors seeking to offset the premium could consider selling longer-dated
more deeply negative floors under the assumption that any near-term disinflation scare
would be short-lived and likely be offset by more activist monetary policies thereafter.
The risk to the trade is a spike in commodity prices or a continued rise in core inflation.
Chart 42: Z-score of duration positioning: short except in Japan/Canada
0.5
Chart 43: Cost of 3Y 0% deflation floor has spiked with weak RMB (bps)
60
0.0
-0.5
-1.0
-1.5
20
-2.0
10
-2.5
EU Core UK EU Periph US JP CA 0
2011 2012 2013 2014 2015 2016
Note: negative z-score values indicate short positioning, positive z-score values indicate long
positions; z-score taken from survey net exposure index with responses dating back to 1992 for US,
Source: BofA Merrill Lynch Global Research, Bloomberg
CA, JP, UK & EU, EU periphery data available back to 2013. Source: BofA Merrill Lynch Global Research
50
40
30
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 23
FX: Sell EUR/GBP
GBP remains a consensus short. Despite GBP appreciating following the High Court
decision for a Parliamentary vote to activate Article 50 and the US elections, the
market’s short GBP position remains stretched according to our positioning analysis
(Chart 44). Our Global Fund Manager Survey flags short GBP as the strongest consensus
view in G10 FX. Our FX & Rates Sentiment survey also suggests that the majority of
investors look for some type of hard Brexit. Although we have been arguing for upside
GBP risks after the recent flash crash, our baseline projections expect GBP/USD to hit a
new low of 1.15 in Q1 after the UK activates Article 50.
However, we have argued that GBP tail risks are skewed to the upside. UK data have
been strong post-referendum and could continue surprising to the upside. There is room
for positive headlines at the political front, if the UK agrees on the transitional period
that could extend the current regime until a final trader deal with the EU. A
Parliamentary vote on Article 50 activation could reduce the chances of a hard Brexit.
And Trump’s victory could lead to an early bilateral US-UK trade deal, while it increases
the geopolitical importance of the UK for the rest of the EU. Moreover, we expect
markets to become more concerned about political tail risks in the rest of Europe
following Trump’s victory in the US elections. Political risks in Italy and France could
question the sustainability of the Eurozone, thus weakening EUR/GBP.
If Prime Minister Matteo Renzi loses the referendum on the constitutional reform in
December, Italy could have a snap election, which the Five Star party could win based on
the latest polls. Even if Italy avoids elections in 2017, the next election will take place by
May 2018, and markets could become concerned about it earlier if Renzi loses the
referendum. The 2017 French election is another concern. President of the far-right
party and presidential candidate Marine Le Pen is ahead in the polls to win the first
round. Winning the second round is much more difficult, as she will need more than 50%
of the votes, but investors could start to expect the unexpected after being blindsided in
the UK and the US. Other considerations also support selling EUR/GBP. Data are
consistent with a weaker EUR/GBP (Chart 44). The market is short both EUR and GBP,
but long EUR/GBP, with the latest flows pointing to more EUR downside and GBP
upside.
Using a spot reference of 0.8672, we recommend selling EUR/GBP via a 6M
0.84/0.80 put spread, to capture both the referendum in Italy and the French
elections, but also give time for GBP to recover in case it weakens further
following activation of Article 50 in Q1. The structure costs 1.07% EUR.
Chart 44: Positioning is short EUR but even more so in GBP
Chart 45: Data surprises suggest that EUR/GBP should be lower
50
40
30
20
10
0
-10
-20
-30
-40
100.0
50.0
0.0
-50.0
-100.0
-150.0
0.89
0.84
0.79
0.74
0.69
-50
AUD USD JPY NOK NZD EUR CAD GBP SEK CHF
Latest Positioning
Change in positioning
EZ-UK data surprises (RHS)
EURGBP (RHS)
Source: BofA Merrill Lynch Global Research.
Source: BofA Merrill Lynch Global Research.
24 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Asia: short JPY/KRW
Positioning surveys generally indicate that the most consensus Asia FX trades at current
juncture are short KRW and SGD against USD through and short SGD against the NEER
basket and short CNH against a narrow version of CFETS basket. Not surprisingly, these
two basket trades also form a part of our trade recommendations. In fact, these shorts
might have increased after US election outcome due to fears of protectionism.
As a result, we believe that contrarian investors should be long KRW, CNY and SGD
against USD or JPY. Amongst these, our favourite contrarian trade is long KRW vs JPY.
Three triggers
Three reasons why the current developments may ironically be positive for Korean Won:
• After a brief period of outflows from the equity markets, we believe inflows are set
to resume. A sustained rally in S&P Index due to the anticipated de-regulation and
fiscal push will undoubtedly be positive for KOSPI (given the high positive
correlation) and as a result for KRW. Moreover, history suggests that the current sell
off in rates and KRW is unlikely to spur considerable outflows from the debt market.
• It is still not very clear if the outcome of this US election is going to be negative for
foreign trade. Should these concerns decrease, positive impact from looser US
fiscal policy could push Asia growth higher.
• The recent sell off in KRW vs USD from 1100 to 1150 is indicative that domestic
concerns around politics, Hanjin shipping troubles and Samsung related issues
seems to have been largely priced in. As a result, we believe that any additional
domestic negative news is unlikely to adversely impact KRW materially.
Additionally, in terms of valuation, our long term COMPASS model indicates that the
Korean Won is one of the most undervalued currencies in Asia.
JPY better than USD as funder
We believe it makes sense to express this contrarian view by short JPY instead of USD.
Currently JPY/KRW is at 10.9 and our forecasts indicate it to be at 10.6 by Q4 2017. In
the case of a stronger USD, we expect BOK to sound cautious with the pace of KRW
depreciation and smooth the move higher in USD/KRW. Moreover, USD/JPY has greater
sensitivity to USD rates than KRW.
Chart 46: KRW, KOSPI, SPX highly correlated
1.5 3m correl SPX and KOSPI
3m correl KOSPI and KRW/USD
1
0.5
0
-0.5
-1
Chart 47: KRW more influenced by equity flows than bond flows
8000 Bond flows Equity flows
6000
4000
2000
0
-2000
-4000
-6000
Source: BofA Merrill Lynch Global Research
Source: BofA Merrill Lynch Global Research
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 25
LatAm: short BRL/MXN
Our top contrarian trade in Latin American markets is selling BRL/MXN (spot 6.00,
target 5.00, stop 6.75). The trade benefits from valuation, positioning and our views of
the expected effects of the US election on the Brazilian and Mexican economies.
MXN 10% undervalued, BRL 5% overvalued
We estimate the Mexican peso is about 10% undervalued while the Brazilian real is
about 5% overvalued, based on our Compass valuation model. The model provides
estimates of long-run equilibrium trade-weighted exchange rates consistent with the
convergence of current account balances toward levels that are in line with country
fundamentals that determine savings and investments.
Mexico’s real exchange rate index is at its lowest since at least 1999, and about 35%
cheaper than its long-run average. Brazil’s real exchange rate has risen sharply in 2016
and is now around 8% stronger than its long-run average (Chart 48).
LatAm under Trump’s world
We believe the election of Donald Trump as the next president of the US will be
negative to Latin American economies. His economic plan will likely involve a significant
fiscal expansion, perhaps tighter monetary policy and some protectionist’s measures.
These will likely lead to higher US rates and a strengthening of the US dollar. Higher
international interest rates are a negative shock for emerging economies and any
acceleration in US economic growth will be skewed to domestic nontraded goods.
We think Brazil’s economy will likely be more negatively affected since its strategy to
gradually reduce budget deficits is based on low global rates, capital inflows and higher
domestic growth.
Mexico, on the other hand, may benefit on relative terms from a construction and
infrastructure boom in the US. Any revival in US manufacturing would also be good for
Mexico, particularly if Trump’s protectionist measures are not as substantial as feared.
Market is not positioned for a MXN rally and BRL selloff
Selling BRL/MXN is a contrarian trade. Foreign investors are significantly long BRL
according to our positioning index based on BM&F data. Market positioning by local
investors is even more stretched toward long BRL. On the contrary, speculative
investors are short MXN according our positioning index based on CFTC data (Chart 49).
So positioning unwinding would actually help our short BRL/MXN strategy.
Chart 48: Real exchange rate is cheap in Mexico, expensive in Brazil
Chart 49: Market is positioned long BRL and short MXN
150
130
110
90
70
50
Long-run average = 100
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
150
130
110
90
70
50
3
Long BRL and MXN positionining
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
2013 2014 2015 2016
3
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
Brazil real exchange rate
Mexico real exchange rate
Long BRL position
Long MXN position
Source: BofA Merrill Lynch Global Research, Bloomberg
Source: BofA Merrill Lynch Global Research, Bloomberg
26 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
EEMEA: long Turkey credit
Turkey has been one of the big underperformers among the major EM lately, and now
valuations are the most attractive in a long time. Sovereign credit spreads are down to
BB- levels even though the country is still rated as a BB+ credit (Chart 50). The lira
which our Compass model has shown as overvalued for many years is now finally in line
with the equilibrium of about 3.30 vs USD. The REER is almost down to the lows
reached during the 2013 taper tantrum and 2015 China devaluation. In equities the
discount vs GEM is at historical highs (Chart 51). So contrarians should get interested.
To be clear, we have been warning for a long time that the leverage and stimulus driven
growth model was weakening and needed a boost through supply side reforms. And
obviously political events have been manifold. But as we are talking about year-ahead
trades rather than the near-term ideas, we believe it is worth noting that Turkish
markets have a habit of alternating between bad and good years: 2010, ‘12, ‘14 good;
2011, ’13 and ’15 bad. After another bad year in 2016, one could consider a possible
rebound in 2017.
Not a short-term trade
This is not a 1-month but rather a 3-6 months trade, where Q1 will likely be critical. In
the short term, US rates volatility is harmful for countries like Turkey that have funded
large current account deficits with short-term debt. This interacts with the local
sentiment weakness that has lately resulted in rising deposit dollarization. An
acceleration of this trend would now be the biggest risk to asset prices, in our view.
Before entering the trade we should see dollarization stabilize. Lately households have
been net buyers of dollars for the first time since the coup attempt. We should see a
couple of weeks of dollar selling to confirm that this potential risk is dissipating.
The trigger for a rebound from low valuations likely lies in a stabilization of sentiment
which could occur during the first half of next year. Currently the state of emergency is
scheduled to end in January, and the news flow suggests a referendum by April/May. In a
positive scenario, politics calm down by the referendum which may also reduce the need
for further stimulus through fiscal, monetary policy or moral suasion of the banks.
Among asset classes, we think Eurobonds provide the best risk/reward as the rating is a
natural valuation “magnet”, and the credit remains a solid BB+ fundamentally, in our
view. Our preferred bonds would be the 26s (current: 5% for October 26s) on the 10y
tenor and 45s (current 6.5%) on the long end. However, a rebound would also favor
equities and local spreads. FX is least compelling as TRY has been asymmetric in recent
years: big sell-offs and small recoveries. We think the reason is high inflation and a
policy bias for a weaker exchange rate. In FX a positive view would be best expressed by
selling the USD/TRY risk-reversal which is currently at around 5.0 and could target 4.0 in
a scenario where the sovereign rallies back to BB+.
Chart 50: Turkey sovereign priced too cheaply at implied BB- rating
Chart 51: Real effective TRY and Turkey equities near the 5-year lows
BBB
BBB-
BB+
BB
Implied rating for 10y Turkey
Actual rating - Turkey
55
50
45
40
Real Effective Exchange Rate for TRY
Turkey-GEM P/E gap, rhs
2
0
-2
-4
-6
BB-
Mar-2015
Apr-2015
May-2015
Jun-2015
Aug-2015
Sep-2015
Oct-2015
Nov-2015
Dec-2015
Jan-2016
Feb-2016
Mar-2016
May-2016
Jun-2016
Jul-2016
Aug-2016
Sep-2016
Oct-2016
Nov-2016
35
Jan-11
Nov-11
Sep-12
Jul-13
May-14
Mar-15
Jan-16
Nov-16
-8
Source: BofA Merrill Lynch Global Research, Bloomberg,
Source: BofA Merrill Lynch Global Research, Bloomberg, Haver, EPFR
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 27
Best Vol Trades
Ralf Preusser, CFA
MLI (UK)
ralf.preusser@baml.com
Herve Belmas
MLPF&S
herve.belmas@baml.com
Sphia Salim
MLI (UK)
sphia.salim@baml.com
Christopher Xiao
MLPF&S
christopher.xiao@baml.com
Tension in Trump’s policies are bullish for vol
• Weighing up the impact of fiscal easing vs protectionism and shifting from
deflation to inflation risks should be bullish for vol.
• In rates, we see room for the belly of the curve to reprice to the dots. 2y1y should
cheapen 75bp, vol is cheap vs rates and the skew the least expensive in that sector.
• In FX, we think vol and skew have room to reprice higher compared to the repricing
seen in rates. We like cheapening a EURUSD put with a 3m30y strangle.
• In EM, USDCNH calls are attractive in our view. A stronger USD adds pressure to
depreciate, while the risks of trade tariffs, labelling China a currency manipulator,
etc could lead to a sharp re-pricing or risk premia higher.
Highest conviction in FX, belly of the US curve and CNH
We view Donald Trump’s election as bullish for USD, bearish for real rates and
challenging for EM. The inherent tensions in President-elect Trump’s policy proposals,
as well as the question marks over the Fed’s reaction function should also support a
repricing of vol higher, especially since neither FX, nor front-end rates volatility look
stretched by historical standards.
However, expressing a view on long-end nominal rates is harder, and implications for
rates vol are less clear. USD 5y5y breakevens are consistent with the Fed’s definition of
price stability for the first time in more than a year. In Europe, the sell-off in rates (both
Bunds and BTPS) is tightening monetary conditions at a time when the ECB should do
more, not less. Finally, the BoJ’s yield curve control should provide an anchor for JGBs.
Consequently we focus on the following three trades:
11. Buying US$100mn 2y1y payer, struck at 2.50% (ATM+69bp)
12. Buying a EURUSD 3m 1.05 put, partly financed with a 150bp-wide 3m30y strangle
13. We recommend buying a 6m USDCNH 7.60 call
US rates to converge to the dots: attractive in vol
The view on long-end rates is complicated by the significant repricing of breakevens,
the likelihood of the ECB doing more, and the BoJ defending its JGB yield target. We do,
however, see room for a further increase in risk premia in the belly of the US curve. We
believe that the market will ultimately view the Fed dots as a floor, rather than a cap.
Supply pressures will weigh on the belly of the curve, rather than the long-end. This
makes the cheapness of the upper left corner of the vol surface attractive.
As we look for a repricing of Fed expectations, to levels more consistent with the dot
plot, we recommend buying US$100mn 2y1y payer, struck at 2.50% (25-delta), i.e.,
ATM +69bp. The cost is US$165K, equivalent to 17bp of yield. We target a PNL of
US$300K.
28 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
We estimate that it is in 3y1y, 2y2y and 2y1y that the selloff would be largest (75-85bp
– see Table 5) were the OIS curve to align with the median dots up to end of 2019.
Options are attractive to position for a selloff in those forwards for two main reasons:
1. Volatilities in 1y and 2y tails appear to trade cheap on our macro model. More
specifically, accounting for the relationship between implied vols and the first
three principal components of the swap curve, we find that 2y1y implied vol
should be trading 22bp normal higher (Chart 52), and 2y2y vol should be 19bp
higher. A simpler historical regression of 2y1y vol vs the 2y1y forward rate also
suggests normal vol should be around 21bp higher (Chart 53).
2. Payer skews could richen in 2y1y and 2y2y. While they are looking rich across
6M+ expiries in 1y and 2y tails (based on payer-ladder breakevens/ATM vol), we
note that this has been the case for some time now and it’s rather in gamma on
5y+ tails that skews now appear richest on a 6m z-score basis. Relative to what
has been realized in the past month, the payer skew appears just fair in 2y1y,
while it is rich across tails in longer expiries.
Chart 52: Market vs fitted level of 2y1y vol, based on macro model (*)
120
100
80
60
Chart 53: 2y1y implied vol is 21bp too low on a regression vs 2y1y fwd
140
120
100
80
40
20
0
2y1y market implied vol
2y1y fitted
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
Dec-14
Mar-15
Jun-15
Sep-15
Dec-15
Mar-16
Jun-16
Sep-16
60
40
y = 35.017x + 28.016
R² = 0.8667
20
0.5 1 1.5 2 2.5 3
past 6y since July last Linear (past 6y)
Source: BofA Merrill Lynch Global Research. (*) Based on a regression of log(2y1y vol) on the first
three principal components of log of rates (derived with a PCA ran since Sep11). Rsquare = 0.91
Source: BofA Merrill Lynch Global Research
Another way to look at this trade is through an analysis of payout ratios for 25-delta
OTM payers under the scenario of a convergence towards median dots. Table 3 below
confirms that the 2y1y point is attractive relative to other forwards (2 nd best), with a net
payout ratio of 1.9 (2.9:1 gross) after three months. The best payer on that metric is the
3m5y 25-delta OTM payer (strike of 2.05%), which we recommend as an alternative for
those confident that the repricing of the OIS curve to the dots will take place by Feb-17.
Table 3: Payoff ratios when buying a 25-delta OTM payer, under the selloff scenario where forwards converge to the levels implied by the median Fed dots(*)
Trade 3m1y 3m2y 3m5y 3m10y 6m1y 6m2y 6m5y 6m10y 1y1y 1y2y 1y5y 1y10y 2y1y 2y2y 2y5y 2y10y 3y1y 3y2y 3y5y 3y10y
Strike (25-delta), % 1.31 1.54 2.05 2.44 1.49 1.73 2.23 2.60 1.84 2.08 2.51 2.84 2.50 2.65 2.95 3.21 2.98 3.08 3.28 3.47
ATM forw ard, % 1.14 1.34 1.77 2.13 1.24 1.43 1.83 2.17 1.44 1.62 1.96 2.25 1.81 1.92 2.17 2.38 2.04 2.12 2.32 2.47
Premium, bp of yield 4.1 4.9 6.9 7.4 6.5 7.5 9.6 10.0 10.4 11.5 13.4 14.1 17.0 18.5 19.2 19.6 23.8 24.2 23.8 23.8
3m roll, bp of yield -4.1 -4.9 -6.9 -7.4 -5.1 -5.4 -5.9 -5.4 -5.0 -5.0 -4.3 -4.2 -4.4 -4.3 -3.3 -2.8 -3.5 -3.2 -2.6 -2.2
3m selloff to the dots 11 31 59 48 18 30 54 45 35 58 65 45 75 80 65 45 85 74 57 45
Return, bp of yield -4.1 -4.4 16.5 5.4 -0.6 3.8 16.0 10.7 9.3 21.3 24.8 13.2 32.6 35.1 26.4 16.3 39.6 33.5 24.2 18.3
Net payout ratio -1.00 -0.89 2.41 0.73 -0.10 0.51 1.66 1.08 0.90 1.85 1.85 0.94 1.91 1.90 1.37 0.83 1.66 1.39 1.01 0.77
Source: BofA Merrill Lynch Global Research. Data as of 15-Nov. (*) 3m selloff to the dots = the selloff in the different forward OIS if the OIS curve aligns with median dots up to Dec-19, with a flat rate of 2.5% thereafter.
The risk to the 2y1y and 3m5y trades is a rally and/or decline in implied volatility, i.e.,
the reversal of the selloff recorded since the elections.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 29
Own FX vs rates vol: cheapen USD call with rates strangle
We like owning USD calls against selling US rates vol. In particular, we recommend
buying a EURUSD 3m 1.05 put for US$100 pips (off 1.0730 spot), partially
financed with the sale of US$100mn 150bp-wide 3m30y strangle (sold at
US$600k).
While potential fiscal stimulus has already been priced into rates term premia and rates
volatility to some extent, it is not sufficiently priced into the FX market, in our view:
• Rates skew in gamma on long-tails has moved decisively for payers, while EURUSD
skew is just beginning to price in higher US rates (Chart 59). This suggests to us
that the market may already be partially protected against higher rates in the longend,
such that a further selloff may not see as strong a rally in gamma on long-tails.
• On the other hand, a further rally in the USD may catch investors under positioned
and result in greater volatility in the currency markets.
• A principal component analysis of rates (US, EUR and JPY) and FX vols highlight that
US rates vols and USDJPY vol are expensive, while 3m10y vol in EUR and JPY are
cheap, along with EURUSD vol (Chart 60). While the cheapness of 3m10y vol in EUR
and JPY can be explained by expectations of QE expansion in the two regions, we
think that there is value in owning EURUSD vol.
From a terminal rates perspective, we are comfortable selling a 150bp-wide strangle for
the following reasons:
• We believe the result of the elections are a game-changer for the outlook on the US
economy. As such we have probably entered a new regime for US rates whereby we
are unlikely to retest the historical lows in 30y rates recorded in Aug-16 (1.67%).
This suggests little downside in selling an ATM-75bp receiver (1.66% strike).
• In a scenario where US rates sell-off, USD is also likely to strengthen. The positive
correlation between US yields and the USD has returned due to expectations for
fiscal stimulus boosting economic growth. Furthermore, we would also argue that a
substantial selloff in US rates, accompanied with USD strength may be selfdefeating
as it would put pressure on emerging markets and risky assets, thereby
resulting in a flight to quality bid for USTs. The risk is that of large foreign reserve
selling by EM central banks, putting upward pressure on US rates and downward
pressure on the USD.
Chart 54: FX vol just beginning to price impact of higher rates
Chart 55: Residual of FX and rates volatilities based on a 1y PCA (*)
8
6
4
2
0
-2
-4
-6
Source: BofA Merrill Lynch Global Research (*) payerReceiver = 3m30y 50bp OTM payer vol-50bp
OTM receiver vol. EURUSD = 6m 25% OTM EURUSD put vol- 25% OTM call vol.
Source: BofA Merrill Lynch Global Research(*) Residuals derived from the first 2 principal
components of FX and rates volatilities – based on a 1y Principal Component Analysis.
30 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
From a mark-to-market perspective, the risk to the trade is a further rise in 3m30y US
rates vol, coming this time with a depreciation in the USD (risk-off event in the US).
Potential US-China trade barriers: bullish CNH vol
The Republican clean sweep has already sparked a strong USD rally and US rates selloff,
but could put further pressure on the USDCNY exchange rate. A stronger USD by itself
adds pressure to depreciate as China still needs looser financial conditions to maintain
stability in the debt market, a relationship confirmed by the USDCNY rally following the
2015 Fed hike. With Trump’s victory, we see increased risk of a larger depreciation.
Trump publicly labeled China as a currency manipulator on multiple occasions during the
campaign, so any speculation of anti-trade policies could put significant depreciation
pressure on the Renminbi. Potential trade tariffs on Chinese exports to the US could
raise the probability of a trade war. Furthermore, Trump could encourage the Treasury
to alter its criteria for labelling currency manipulators, which could also hurt trade
relationships. Either scenario would lead to a sharp re-pricing of risk premia higher.
The Trade: Buy USDCNH 6m 7.60 call
We recommend buying a 6m USDCNH 7.60 call for 0.37% USD (off 6.9700
forward), with a target of 1% USD. USDCNH topside is now at the cheapest levels
since the August 2015 depreciation (Chart 56). The trade could benefit from either a
rally in spot as well as any increase in the risk premium between now and inauguration
on speculation of anti-trade policies. The structure appreciates significantly from
increases in volatility, which is plausible given the 300% increase in volatility in August
2015 and the 100% increase from October 2015 to February 2016. The risk to the trade
is that China increases capital controls and dampens USDCNH appreciation, which could
cause the options to expire worthless.
Chart 56: USDCNH topside the cheapest since pre-depreciation
20
16
12
8
4
0
+300
Source: BofA Merrill Lynch Global Research
+100
%
USDCNH 6m 10d call vol
Table 4: Hypothetical trade performance on Inauguration Day (Jan 20th)
Spot
Vols
unchanged
Vols 20%
higher
Vols 50%
higher
Vols 100%
higher
6.8 -81% -49% 24% 197%
6.9 -68% -30% 41% 235%
7 -51% -5% 100% 278%
7.1 -32% 49% 132% 305%
7.2 0% 103% 170% 378%
7.3 49% 122% 232% 441%
7.4 124% 200% 305% 522%
7.5 224% 319% 441% 630%
7.6 386% 470% 565% 741%
Source: BofA Merrill Lynch Global Research
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 31
Stress testing CNY
Claudio Piron
Merrill Lynch (Singapore)
claudio.piron@baml.com
Yang Chen
Merrill Lynch (Hong Kong)
ychen8@baml.com
Gabriele Foa
MLI (UK)
gabriele.foa@baml.com
Ronald Man
Merrill Lynch (Hong Kong)
ronald.man@baml.com
Stress testing CNY
• We stress test China’s FX reserves to capital outflows and warn of a potential
USD520bn fall in FX reserves in 2017, translating into higher CNY volatility.
• We also look at broader EM FX sensitivity to CNY depreciation and find ZAR and
RUB most vulnerable.
• We examine if bond index and MSCI inclusion could significantly offset outflows,
but are doubtful for now.
CNY – anything left in reserve?
We forecast USD/CNY to rise to 7.25 by year-end 2017 based on sustained capital
outflows from China and the People’s Bank of China (PBoC) allowing the exchange rate
to depreciate accordingly. A key change in the PBoC’s new FX regime, announced in
August 2015, is to raise the influence of market forces over the exchange rate.
We showed that not all outflows are created equal. Some outflows are good and reflect
structural changes in China’s economy and liberalization of China’s financial account;
some outflows are ugly in the sense they represent illicit outflows. Yet both types of
outflows are influenced by policy uncertainty in China, which we showed can explain a
significant amount of capital outflows through Chinese purchases of overseas assets.
The impact of capital outflows alone on China’s FX reserves is negative. A decline in FX
reserves is also associated with an increase in volatility of the RMB (Chart 57). But the
negative impact on FX reserves may be offset by China’s trade balance. If China’s trade
balance and capital outflows are similar to that recorded in 2015 and 2016, then China’s
FX reserves would be between USD 2,600bn and USD 2,900bn in 2017. This represents
a fall of USD520-220bn given current FX reserves of USD3,120bn and would amount to
China having diminished control over its currency and higher CNY volatility – assuming
no dramatic changes to capital controls.
Chart 57: China FX reserves (down) and RMB volatility (up)
4,000
3,750
3,500
3,250
3,000
2,750
1,500
1,250
1,000
750
500
250
2,500
0
2011 2012 2013 2014 2015 2016
China FX reserves, USDbn USD/CNY 1Y rolling standard deviation, pips (RHS)
Source: BofA Merrill Lynch Global Research, Bloomberg
32 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Table 5: Scenario analysis of China’s 2017 FX reserves (yellow denotes lower reserves/ blue higher)
Trade balance, USDbn
100 150 200 250 300 350 400 450 500
300 2,885 2,935 2,985 3,035 3,085 3,135 3,185 3,235 3,285
350 2,835 2,885 2,935 2,985 3,035 3,085 3,135 3,185 3,235
400 2,785 2,835 2,885 2,935 2,985 3,035 3,085 3,135 3,185
450 2,735 2,785 2,835 2,885 2,935 2,985 3,035 3,085 3,135
500 2,685 2,735 2,785 2,835 2,885 2,935 2,985 3,035 3,085
550 2,635 2,685 2,735 2,785 2,835 2,885 2,935 2,985 3,035
600 2,585 2,635 2,685 2,735 2,785 2,835 2,885 2,935 2,985
650 2,535 2,585 2,635 2,685 2,735 2,785 2,835 2,885 2,935
700 2,485 2,535 2,585 2,635 2016 2,685 rate 2,735 2,785 2,835 2,885
750
800
2,435
2,385
2,485
2,435
2,535
2,485
2,585
2,535
2,635
2,585
2,685
2,635
2,735
2,685
2,785
2015 rate
2,735
2,835
2,785
850 2,335 2,385 2,435 2,485 2,535 2,585 2,635 2,685 2,735
900 2,285 2,335 2,385 2,435 2,485 2,535 2,585 2,635 2,685
Source: BofA Merrill Lynch Global Research, Bloomberg. 2016 rate is annualized from the first 3 quarters of data.
Capital outflow, USDbn
Table 5, above, shows a scenario analysis of China’s FX reserves in 2017 under different
trade balance and capital outflows. The analysis makes two assumptions. The first
assumption is all the changes in the Balance of Payment’s (BoP) reserve assets are
reflected in the headline FX reserves figure. The second assumption is that the income
balance is USD -36bn, which was derived from the annual rate since 2015.
We believe a decline of FX reserves to USD 2,600bn to USD 2,900bn would only be a
problem for China if it attempted to implement a “fixed exchange rate” without capital
controls. Such an FX regime requires heavy FX intervention and would put downward
pressure on its FX reserves, making this FX regime choice no longer tenable for China.
The IMF’s framework for calculating adequate FX reserves is based on whether there
are capital controls and whether the currency operates on a fixed or floating exchange
rate regime (Table 6). The latest readings show a fixed exchange rate regime without
capital controls in China would require USD 2,911bn of FX reserves, which probably
won’t be achieved, as shown in Table 1. Meanwhile, a floating exchange rate regime
with no capital controls would require USD 1,618bn of FX reserves. Fewer FX reserves
would be needed to manage a floating currency that would adjust freely to capital flows.
This reinforces the view that the CNY is moving toward a more flexible FX regime as its
FX reserves are depleted (barring a draconian step capital control measures).
Skeptics may counter that China could always ratchet up capital controls to reassert
control over its currency. However, the efficacy of this is questionable. The experience
of 2016 shows that in spite of more capital controls introduced in late 2015 (e.g.,
onshore window guidance restricting the sale of FX by onshore banks) capital outflows
have continued along with FX reserve depletion, albeit at a slower pace. Ultimately, this
means China’s ability to exert control over the CNY is being eroded, while the risk of
more CNY volatility is rising. This is our scenario for 2017, with the tail risk that “ugly
flows” or illicit capital flight due to domestic financial stability concerns could drive
sharper CNY depreciation and FX reserve depletion. It is under this tail risk scenario that
the temptation for draconian capital controls becomes a danger. For this reason, we
believe it will be important to monitor the nature of the capital outflow and not just the
size of the outflow. Good outflow such as Overseas Direct Investment by state-owned
Table 6: China reserves adequacy recommendations based on IMF guidelines
Latest,
USDbn
Capital control
No capital control
Fixed Floating Fixed Floating
Weight, % USDbn Weight, % USDbn Weight, % USDbn Weight, % USDbn
Short-term debt 767 30 230 30 230 30 230 30 230
Other liabilities 961 20 192 20 192 20 192 15 144
Exports 2,156 10 216 10 216 10 216 5 108
Broad money 22,728 5 1,136 2.5 568 10 2,273 5 1,136
Recommended reserves 1,774 1,206 2,911 1,618
Source: BofA Merrill Lynch Global Research, Bloomberg, SAFE
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 33
firms can be naturally slowed by internal directives. Bad outflow such falling CNY
deposits among foreign subsidiaries of China banks can also be managed. However, it is
the inherent speculative and unstable nature of domestic capital flight that we
characterize as ugly flows that poses the greatest risk to the central bank.
Regressions and scenario implications for EM FX
We used a simple regression to quantify the impact of the RMB depreciation on key EM
FX: BRL, RUB, INR, TRY, and ZAR 1 . We analyzed two cases: 1) Base case – USD/CNY rises
to 7.25 and market volatility, which we use the VIX as a proxy, is unchanged from its
current level; 2) Risk case – USD/CNY rises to 8.00 and intense RMB depreciation
expectations cause market volatility to rise by three standard deviations. We find:
• The most vulnerable currencies to RMB depreciation are ZAR, RUB and TRY (Chart
58). The impact of RMB depreciation on BRL and INR is small. This is probably due
to stronger idiosyncratic factors for BRL and INR in recent years.
• An increase in market volatility associated with USD/CNY rising to 8.00 would raise
the depreciation of EM FX by 1ppt (BRL)-11ppt(ZAR) relative to our 7.25 baseline.
• In our base case of USD/CNY rising to 7.25 by end-2017, the market is overpricing
depreciation pressures from the RMB on EM currencies. This partly reflects other
factors have more sway over market expectations at the time of writing, such as
implications of the US elections outcome.
• In our risk case of USD/CNY rising to 8.00 and high volatility, there is room for
additional depreciation in the ZAR and RUB (Chart 58).
Chart 58: EM FX sensitivity to RMB and market volatility
5
0
-5
-10
-15
-20
ZAR RUB TRY BRL INR
Forecast change vs SDR, % (Volatile markets and USD/CNY at 8.00)
Forecast change vs SDR, % (Same volatility and USD/CNY at 7.25)
Source: BofA Merrill Lynch Global Research, Bloomberg
Chart 59: Scenario analysis of EM FX against market pricing
5
0
-5
-10
-15
-20
ZAR RUB TRY BRL INR
Forecast change vs SDR, % (Volatile markets and USD/CNY at 8.00)
Forecast change vs SDR, % (Same volatility and USD/CNY at 7.25)
Forward implied change by end-2017, %
Source: BofA Merrill Lynch Global Research, Bloomberg
Can bond and equity inflows save the day? Not in the near term
Given the problematic issue of capital outflows and limited efficacy of moderate capital
flows, another solution could be to attract more foreign portfolio inflows into China’s
sizable bond and equity markets. More favorable investment policies geared to overseas
investors investing in China’s interbank bond market reveal a clear policy intention to
open up China’s financial market. As a result, expectations are rising for China to be
included in global bond indices. However, the following key obstacles for index inclusion
remain, although reasons vary depending on the index: 1) lack of full accessibility:
currently qualified investors only include medium and long-term investors while hedge
funds are excluded; 2) insufficient clarification on requirements of fund remittance; 3)
lack of clarification on tax issues; 4) lack of accessibility to onshore FX/rates hedging
tools. Back from our 2016 China Conference, we believe allowing foreign private
investors to access onshore repo, onshore FX swap and forwards would be the next
steps to follow.
1 Our dependent variable is the weekly changes of SDR/EM; our independent variables are the weekly changes in the
SDR/EUR, SDR/CNY, SDR/USD and the VIX index, and a constant. Natural logarithms were taken for all variables and our
sample period is Jan’14-Nov’16, when the start of the RMB depreciation trend. We base our currencies against the SDR
to define their value (See Assessing China’s Exchange Rate Regime, Frankel and Wei (2007) for a detailed explanation.).
To compute the forecast change in each currency, we use our global FX forecasts to obtain our independent variables.
34 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
The most influential global bond index is believed to be the Citibank World Government
Bond Index (Citi WGBI), which is used as the benchmark for more than $2tn of AUM. The
most influential EM bond index is the JPM Government Bond Index – Emerging markets
Global/Diversified (JPM GBI-EM Global/Diversified), which is used as the benchmark for
about $200bn AUM and caps each country’s share to 10%. A caveat, however, is that
the actual size of indexed money or ETFs should be smaller. The most crucial country
criteria of Citi WGBI is “fully accessible to foreign investors,” which makes China less
likely to be included by far given its accessibility to only medium- and long-term
investors. Even if China is being considered, the assessment usually takes a long time.
So we believe the case for China to be included into Citi WGBI in 2017 is unlikely.
By contrast, JPM GBI-EM Global/Diversified only requires accessibility to the majority of
foreign investors and does not factor in tax hurdles in eligibility. We believe China has
better chance to be included into the JPM GBI-EM Global/Diversified index. While the
exact timing is hard to predict, an optimistic scenario possibly leaves 2H17 on the table.
Usually when a big country is being included, bonds are introduced slowly over many
months to enable clients to rotate without too much disruption.
We would expect China’s inclusion to account for 10% of the JPM GBI-EM Global
Diversified index. Turkey, Malaysia, S. Africa, and Thailand would lose the largest shares
in the index, while the shares of Brazil, Mexico, Poland and Indonesia are expected to
remain given their large absolute size. Inflows to China could be around $20bn, or
equivalent to 1.5% of the aggregate central government bond market cap. Turkey,
Malaysia, S. Africa, Thailand and Columbia could see outflows of $2.4bn-3.3bn each,
with the most expected impact on Thailand given its lower relative foreign ownership.
We would expect China to account for 4.4% of the Citi WGBI index. The biggest losers
of market share will be the US, followed by Japan and Europe. Inflows to China could be
around $87bn, or 6.5% of its CGB market cap. This would present a very bullish scenario
for CGBs, and the curve will likely steepen.
MSCI inclusion – more about good will, then real flow
Another potential implication of China capital account opening is equity inflows. The
MSCI has been considering the inclusion of China A-shares in its index. These are shares
of local Chinese companies trading at the Shanghai and Shenzhen stock exchange,
whose trading is so far limited to local investors (China: Will A-shares be included in
MSCI in June this year?). The associated flows aren’t likely to be too large, so positive
price reaction is likely to come mostly from sentiment. The MSCI has discussed most
recently a 5% inclusion factor for A-shares, which would translate in an additional 1.1%
MSCI weight of China in the index. The scope for additional foreign capital looks small,
when considering that China already weighs 27% in the index. Our equity strategists
estimate the total AUM tracking MSCI EM to approximately USD1.6tn (total market cap
of the index is USD3.8tn), so that inflows upon inclusion would be roughly USD16bn.
The inclusion was delayed in June 2016, mainly due to obstacles regarding the quota
allocation process, capital mobility restrictions and beneficial ownership.
Chart 60: Estimated loss of share if China is included in JPM GBI-EM
Global Diversified
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
0.0% 0.0% 0.0% 0.0%
BRL
MXN
PLN
IDR
Source: BofA Merrill Lynch Global Research
-1.3%
-1.2%
-1.6%
-1.5% -1.5%
TRY
MYR
-0.9% -0.9%
-0.1% 0.0%
-0.3%
-0.5%
ZAR
THB
COP
HUF
RUB
RON
PEN
PHP
CLP
Chart 61: Estimated loss of share if China is included into Citi WGBI
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
-1.5%
USD
-1.2%
-1.1%
JPY
EUR
Source: BofA Merrill Lynch Global Research
-0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
-0.3%
GBP
CAD
AUD
MXN
MYR
DKK
CHF
PLN
SEK
SGD
ZAR
NOK
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 35
Best Carry Trades
Claudio Irigoyen
MLPF&S
claudio.irigoyen@baml.com
Mai Doan
MLI (UK)
mai.doan@baml.com
Rohit Garg
Merrill Lynch (Singapore)
r.garg@baml.com
Vadim Iaralov
MLPF&S
vadim.iaralov@baml.com
Carry trades and blond swans
• We do not expect traditional carry trades such as ARS and BRL to perform well in a
strong USD and increasing interest rates environment, so we focus on USD neutral
carry trades.
• We like short EUR/RUB, short SGD/INR and long PEN/CLP. For more neutral
commodity exposure we like baskets of EUR, CAD, COP and CLP, AUD to fund RUB
and PEN trades respectively.
Carry is in the eye of the beholder
To focus on identifying best carry trades in the current environment of rising US
interest rates sounds counterintuitive at least. It is well know that carry trades perform
nicely in risk-on periods as well as in a low volatility environment, which is the opposite
of what we expect in the coming months. However, once proper factor exposure of
currency returns is considered, smart carry reemerges as an interesting proposition. As
we have documented (Forecasting with Compass30), most of the variation in currency
returns can be explained by the first two principal components, which can be labeled as
dollar and carry factor respectively, as they are highly correlated with USD and carry
performance.
Expected returns of carry strategies are defined by interest rate differentials (ie, carry),
assuming no change in spot exchange rates. Uncovered interest parity states that the
carry should be offset by a change in the spot of equal magnitude. However, empirical
evidence (so called forward premium puzzle) clearly shows that carry trades are
profitable on average, which indicates the presence of currency risk premium. Since
both dollar and carry, are priced factors, any sensible carry strategy in an environment in
which US rates are rising needs to hedge the USD exposure. This is just a necessary
though not a sufficient condition, since the carry factor is also correlated with global
measures of risk. Interestingly, post-election currency losses is not as highly correlated
with carry, indicating that carry trades were not as a strong investment theme as it was
the case during the taper tantrum episode (Chart 62).
Chart 62: Carry didn’t drive currency reaction to US elections
25
1m carry (annualized)
Currency depreciation since Nov8 (rhs)
20
15
10
5
0
-5
ARS
IDR
BRL
RUB
ZAR
PHP
TRY
INR
COP
PEN
MXN
MYR
CNY
CNH
CLP
NZD
AUD
PLN
THB
KRW
TWD
NOK
SGD
RON
HKD
CAD
HUF
GBP
ILS
CZK
JPY
EUR
SEK
CHF
Source: BofA Merrill Lynch Global Research, Bloomberg
15
12
9
6
3
0
-3
Chart 63: Asia and LatAm display the highest risk-adjusted carry
3
2
1
0
-1
IDR
ARS
PHP
CNY
INR
CNH
BRL
TRY
RUB
PEN
MYR
ZAR
COP
CLP
MXN
THB
NZD
AUD
PLN
KRW
TWD
NOK
SGD
CAD
RON
HUF
GBP
JPY
CZK
SEK
EUR
ILS
CHF
HKD
Source: BofA Merrill Lynch Global Research, Bloomberg
1m carry (annualized) / 1m implied ATM vol
1m carry (annualized) / max 1m DD (5y, rhs)
36 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Characterizing carry
Efficient carry strategies involve buying and selling dynamic portfolios of currencies
with certain risk characteristics. Carry strategies are supposed to work better over long
investment horizons, so that the cushion provided by the carry compensates for the
currency volatility through mean reversion.
Here, we analyze carry from a different perspective, as our goal is to identify standalone
attractive carry opportunities. We define the investment horizon to end 1Q17. We sort
currencies based on risk-adjusted carry. We then characterize the factor exposure of
currency returns, isolating global and idiosyncratic sources of risks, in order to identify
smart carry trades that are not highly exposed to a massive re-pricing of global factors,
such as US rates, USD, commodity prices and global risk aversion. We identify carry
trades that have low exposure to global factors, in particular the USD factor, and offer
attractive risk-rewards.
Not surprisingly, purely based on carry considerations, EM currencies appear more
attractive than DM ones, which are mostly candidates for funding currencies. However,
carry trades returns are highly volatile, exhibit negative skewness and fat tails. Even
controlling for different measures of risk such as volatility or maximum drawdown, and
according to this criteria only, we find that EM currencies are the most attractive, in
particular ARS, BRL in LatAm, RUB, TRY and ZAR in EEMEA and INR, IDR and CNY in
Asia (Chart 63).
Even though volatility and drawdowns can be useful measures of risk, they don’t say
much about the exposure to different risk factors. Since carry trade strategies are
usually very sensitive to global factors, we study the cross sectional exposure of
currencies to key global factors: commodity prices, global risk aversion and US yields (as
a proxy of global yields). We report the R2 of regressions of two years of weekly returns
on the above mentioned global factors, for the last two years and the years 2013-2014
for the sake of comparison (Chart 64).
We find that currencies in LatAm and EEMEA are more exposed to global factors than in
Asia. Interestingly, LatAm and EMEA currencies are more sensitive to shocks in
commodity prices and risk aversion, while in Asia the shocks to monetary policy are the
most important ones (Chart 65). Within DM currencies, AUD and NOK are the two
currencies most exposed to global factors. Ideally, we seek for currencies with high riskadjusted
carry and low exposure to global factors. Under such a metric, ARS, BRL, RUB
and INR stand out as the best investment currencies, while EUR, CHF, JPY, KRW and
TWD are the best funding currencies. However, this filter is not enough in the current
volatile environment.
Chart 64: LatAm is more exposed to global factors than Asia
0.6
Depend on global factors
0.5
0.4
RSQ '16 RSQ '14
0.3
0.2
0.1
Chart 65: Sensitivity to global factors across regions
0.8
Normalized beta of global factors
0.6
0.4
0.2
0
-0.2
Monetary
Commodities
Equities
0
COP
CAD
MXN
LATAM
EMEA
RUB
ZAR
JPY
NOK
CLP
AUD
BRL
IDR
TRY
MYR
CZK
INR
SEK
EUR
SGD
ASIA
NZD
THB
RON
PEN
HUF
PLN
PHP
CHF
ILS
KRW
TWD
GBP
HKD
CNY
ARS
-0.4
COP
CAD
MXN
LATAM
EMEA
RUB
ZAR
JPY
NOK
CLP
AUD
BRL
IDR
TRY
MYR
CZK
INR
SEK
EUR
SGD
ASIA
NZD
THB
RON
PEN
HUF
PLN
PHP
CHF
ILS
KRW
TWD
GBP
HKD
CNY
ARS
Source: BofA Merrill Lynch Global Research, Bloomberg
Source: BofA Merrill Lynch Global Research, Bloomberg
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 37
The role of fundamentals
From a purely mechanical perspective, we could stop the analysis here and choose those
currencies with better risk-reward prospects according to the metrics so far described.
However, in order to analyze carry trades with relatively short investment horizon, we
need to complement our analysis with our views on future exchange rates dynamics.
We expect US rates to continue moving higher and the USD to strengthen across the
board due to easier US fiscal policy and significant uncertainty regarding foreign policy.
In EM, we think LatAm is the region that will suffer the most in the new global scenario,
followed by Asia. We find EEMEA relatively more resilient to US driven shocks. We want
to avoid countries with high financing needs (i.e., high fiscal and current account
deficits). We also prefer trades with neutral commodity exposure. Since carry trades
tend to underperform when US rates are moving higher and the USD strengthens, we
want at least to avoid USD funded carry trades, crowded carry trades and currency
crosses highly exposed to the USD factor. Hedging the USD factor leaves us with the
pure carry exposure, which by being a price factor, is also related to standard measures
of risk, as well as idiosyncratic factors.
Best carry trade: Cherry picking among rotten cherries
Given our views, and focusing on those trades where ex-ante high carry is consistent
with ex-ante expected returns, we choose our best carry trades across EM and DM.
Since DM currencies offer very low carry vs the USD, there are not many attractive carry
opportunities in DM in a strong USD environment, so much so that the most attractive
carry proposition is simply to go long USD/JPY. Since this trade is mostly predicated on
a strong USD view and is being developed in other sections of this report we refer the
reader to those sections (please see: USD/JPY will the main beneficiary of Trump win,
FX: GOP sweep emboldens core USD/JPY view, Long EUR/JPYAsia: short JPY/KRW).
Therefore, we focus mostly on EM or EM/DM carry trades.
EEMEA: short EUR/RUB
We like selling EUR/RUB (spot 69.28, target 66.15, stop 71.02). We see EEMEA as
relatively more resilient to higher US rates, though with some heterogeneity within the
region. On the one hand, high current account deficit countries like Turkey or South
Africa should continue suffering from a re-pricing of risk. On the other hand, CEE
countries are expected to some more resilience. One currency we find particularly
attractive is the Russian ruble, which still offers an attractive risk-adjusted carry,
controlling for standard measures of risk such as implied volatility and maximum
drawdown. The outcome of the US election should remove some risk premium from
Russian assets as the geopolitical backdrop improves. Economic activity is expected to
pick up in 2017. A hawkish central bank, coupled with a favorable external position and
an energy-driven current account surplus will likely limit its exposure to a reversal in
capital flows.
On the geopolitical side, we expect Russian foreign policy to become more conciliatory
Chart 66: Oil prices are a major risk factor
Chart 67: Russia tends to be more market-friendly with lower oil
1.5
1.0
0.5
RUB/(EUR,CAD,COP) Jan 4 '13 =100
RUB/EUR Jan 4 '13 =100
Brent oil (RHS)
0.0
Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16
Source: BofA Merrill Lynch Global Research, Bloomberg
150
100
50
0
100
50
0
Oil price, $/bbl 10y MA
Privatization,
Georgia
Gaidar reforms war
Start of
Yukos
Perestroika
case
Afganistan war
Jan-70
May-72
Sep-74
Jan-77
May-79
Sep-81
Jan-84
May-86
Sep-88
Jan-91
May-93
Sep-95
Jan-98
May-00
Sep-02
Jan-05
May-07
Sep-09
Jan-12
May-14
Source: BofA Merrill Lynch Global Research, Bloomberg
Ukraine
crisis
US-Russia
“Reset”
38 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
and less disruptive for markets, in particular given the expected improved foreign
relations with the US (Chart 67). However, the currency remains overvalued and highly
exposed to global factors, in particular oil price, and positioning is crowded. Despite our
forecast is for USD/RUB to remain around 63 in 1Q17, we prefer to mitigate the abovementioned
risks by choosing a more favorable funding currency.
If liquidity is a major consideration, we prefer to use the EUR as a funding currency,
which offers negative carry vs the USD, and gives the ruble the best risk-adjusted carry
across all potential funding currencies. In addition to the already seen impact on US
rates, Trump’s victory implies that political risks are becoming increasingly important in
Europe, with the Italian referendum in December and elections in Netherlands, Germany
and France in 2017. This scenario strengthens our call for a six-month extension to ECB
QE at the current pace. We expect the EUR/USD to trade at 1.05 by end 1Q17.
Since short EUR/RUB is still exposed to much lower oil prices, an alternative way to
express the trade is to use a basket of euro, Colombian peso and Canadian dollar as
funding basket (Chart 66). The COP remains overvalued, the central bank is expected to
ease monetary policy as the economy decelerates and oil represents 35% of Colombian
exports. We expect the COP to depreciate 2.5% by end 1Q17. Carry, on the other hand,
is higher than EUR and CAD. The CAD offers very low carry and we forecast a 1.5%
depreciation by 1Q17 vs the USD. The economy keeps displaying weak growth and we
expect the Bank of Canada likely to cut rates and maintain the accommodative stance of
monetary policy.
Asia: short SGD/INR
We like short SGD/INR (spot 47.96, target 47, stop 48.44). While the performance of
Asia FX can be influenced by broader risk conditions, we expect most to weaken vs. the
USD. The Korean won and the Singapore dollar, as well as the Taiwanese dollar for
instance stand out as being the most sensitive to a stronger USD, as they act as a high
beta proxy for CNY, which we expect to continue depreciating in this new high US rates
environment. Others like Indonesian rupiah and Malaysian ringgit are more sensitive to
higher USD rates. Consequently, outflows from these countries will adversely impact the
respective FX. That said, Bank Indonesia has built good amount of reserves to prevent
rupiah from weakening excessively. Moreover, tax amnesty related repatriation flows
and global bond issuance is still expected to come in December, which should also
support the rupiah.
Historically, large US tax cuts have been followed by a widening of the US current
account deficit driven by higher imports. This supported Asia export growth and
exchange rates, especially after the Bush tax cuts. However, this time could be different
partly because US household spending has been shifting towards non-tradable services.
More importantly, Trump’s policy platform itself is geared towards reducing dependence
upon foreign goods and services (Chart 68).
Chart 68: Export exposure to the US across EM Asia
20
Exports to the US in 2015 (% of GDP)
15
10
5
0
Source: BofA Merrill Lynch Global Research, Bloomberg
Chart 69: S$NEER has depreciated 50bp below par since Oct MPS
130
125
120
115
110
105
Index
Apr-08
Oct-08
Apr-09
Oct-09
Apr-10
Oct-10
Apr-11
Oct-11
Apr-12
Oct-12
Apr-13
Oct-13
Apr-14
Oct-14
Apr-15
Oct-15
Apr-16
Oct-16
Source: BofA Merrill Lynch Global Research estimates, Bloomberg
BofA-ML SGD NEER
lower end of band
mid-point
upper end of band
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 39
At this juncture, the Indian rupee seems to be the only one in the region that is expected
to display a much lower sensitivity to US rates, outperforming others within Asia. We
expect the Monetary Authority of Singapore to keep the SGD NEER in the weaker side
of the band for the next few months, which reduces the downside risk for the trade
(Chart 69). We like the INR as the preferred long, followed by the IDR, as they offer high
risk-adjusted carry, central banks are interested in keeping their currencies stable,
current account deficits are bounded, and the currencies are not expensive relative to
long term fundamentals. The main risk of the trade is of higher oil prices, and
considerable reversal of capital flows. Apart from that, a change in the behavior of
Reserve Bank of India it terms of managing INR to accumulate international reserves is
also a risk.
LatAm: long PEN/CLP
We like long PEN/CLP (spot 195.7, target 200, stop 195.5). LatAm is the most
exposed region within EM to global factors. Traditional carry trade candidates like the
Brazilian real and the Argentina peso are no longer attractive given the still fragile fiscal
stance in both countries. Local positioning in BRL has proven to be heavier than
thought, and we expect the currency to continue weakening until we observe some
stabilization in US rates. The Brazilian real is still overvalued and the economy will be
negatively affected since its strategy to gradually reduce budget deficits is based on low
global rates, capital inflows and higher domestic growth. In the case of the Argentine
peso, despite showing some detachment from global factors and some positive inflows
due to the tax amnesty, we think the currency needs to weaken given the recent
depreciation of the BRL and its current overvaluation as well as the government fiscal
needs for 2017, which is an important electoral year. Therefore, we remain neutral on
these currencies.
A more modest but more interesting carry trade within LatAm in an environment of
higher US rates is to be long the Peruvian sol, funded with the Chilean peso, in order to
make the trade more neutral to commodity exposure. The Peruvian economy is expected
to continue growing at rates above 4% due to strong mining activity; the new
government will likely implement expansionary fiscal policy and has room to finance it.
The exchange rate is close to its equilibrium value based on terms-of-trade and
productivity. In fact, we expect the currency to appreciate in real terms if growth
recovers as predicted. The currency still offers a decent carry. We forecast a nominal
depreciation but below the forward. The central bank has a strong preference for low
currency volatility and would be ready to intervene in case of a disorderly depreciation,
as it has been already the case in the last few days with small interventions in the
forward market.
On the other hand, Chile’s growth remains anemic and the economy is expected to
continue growing sub 2% in 2017 (Chart 71). The CLP is overvalued but recent flows
Chart 70: Copper prices are a major risk factor
Chart 71: Relative growth to favor Peru going forward
400
350
300
250
Copper prices
200 CLP (rhs, Jan2012 =100)
PEN (rhs, Jan2012 =100)
150
2012 2013 2014 2015 2016
Source: BofA Merrill Lynch Global Research, Bloomberg
80
100
120
140
160
230
pen/clp growth diff (rhs)
220
210
200
190
180
170
160
150
2010 2011 2012 2013 2014 2015 2016
Source: BofA Merrill Lynch Global Research, Bloomberg, Haver
5
4
3
2
1
0
-1
-2
-3
40 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016

from large domestic pension funds and the recovery in the price of copper explain the
relative resilience of the currency (Chart 70). Given the low carry, CLP offers an
attractive alternative as a funding currency as the portfolio rebalancing of pension funds
is expected to slow down. We expect the currency to weaken further in 1Q17 as interest
rates move higher in the US, and we do not expect the central bank to intervene, as it
would likely be the case in Peru. In order to reduce the carry cost of the funding
currency without losing the neutral exposure to metals, we like a basket of the Chilean
peso with the Australian dollar. The Australian dollar is also highly correlated with
commodities and China. We are bearish the AUD vs USD, as we expect the currency to
weaken about 4% by end 1Q17.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 41
Cheapest tail-risk Hedges
Adarsh Sinha
Merrill Lynch (Hong Kong)
adarsh.sinha@baml.com
Ralph Axel
MLPF&S
ralph.axel@baml.com
Gabriele Foa
MLI (UK)
gabriele.foa@baml.com
Tony Morriss
Merrill Lynch (Australia)
tony.morriss@baml.com
Shuichi Ohsaki
Merrill Lynch (Japan)
shuichi.ohsaki@baml.com
Tail-risk Hedges
• Four tail risks for 2017: 1) US deregulation, 2) EZ risk premia rises; 3) weaker bulk
commodity prices; 4) steeper and more volatile yield curve in Japan.
• Position for normalization of swap spreads; 30s50s BTP flattener; long EUR/HUF
vol; long AUD/USD digital puts; 1y10s20s conditional bear steepener in Japan.
There are three key lessons on tail risks from 2016: 1) tail-risk probabilities are generally
“fatter” than commonly assumed (Brexit and Trump’s victory); 2) hedging tail risks even
in a world of low implied volatilies is hard if the directional implications are unclear
(equity puts for a Trump victory); 3) investors worry about tail risks closer to the events
– Chart 72 shows the biggest perceived tail risks, according to our Fund Manager
Survey, were either during the event itself (China recession worries alongside capital
outflows) or at most a few months in advance (Brexit and the US election).
Looking ahead to 2017, we believe tail-risk hedging will be more important than ever,
but that investors should be sufficiently forward looking and focus on those where there
is clarity about the directional implications. We highlight four such opportunities in this
section, specifically: 1) US deregulation; 2) return of Euro zone risk premia; 3) Chinalinked
commodity prices weakening sharply; and 4) Japan’s yield curve targeting
triggering a steeper curve and volatility increase.
Chart 72: Biggest tail-risk, percentage of respondents in Global Fund Manager Survey
Oct-16
EU disintegration
Sep-16
Aug-16
Jul-16
Jun-16
May-16
Apr-16
Mar-16
Feb-16
Jan-16
Dec-15
Nov-15
Oct-15
Republican wins White House
Source: BofA Merrill Lynch Global Research
Republican wins White House
Republican wins White House
Brexit
Brexit
Quantitative Failure
Quantitative Failure
US recession
Tail risk 1: US deregulation
Normalized swap spreads, cross-currency basis & coupon vs principal STRIPS
Deregulation is a key focus for the incoming administration, and Dodd-Frank is a major
potential target. Paul Atkins, a former SEC commissioner under George W Bush, has
been named to lead transition strategy on financial regulation. Atkins has been
vehemently critical of Dodd-Frank since its inception, and in a statement to the Senate
Global FMS biggest "tail risk"
(past 12 months)
China recession
China recession
China recession
China recession
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
42 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
in 2011 called the law a calamity that increases business uncertainty and undermines
growth. Under Atkins, the transition team posted a statement that it will be “working to
dismantle the Dodd-Frank Act and replace it with new policies to encourage economic
growth and job creation." At this point there are no details on what parts of Dodd-Frank
are most likely to be repealed, but Republican financial policy leaders appear promarkets
and have flagged free movement of capital via open markets as the best policy
for economic growth and risk transparency.
There are several dislocations across markets today that we think have a chance of
normalizing in the tail-risk event that deregulation results in increased availability of
leverage and ability to take more risk. We have discussed these dislocations as resulting
in part from the lack of ability of hedge funds and other relative-value traders to access
enough balance sheet at a low enough cost to help these trades normalize. The top
trades we could see benefitting from the return of leverage would be:
• Normalization of swap spreads; balance-sheet intensive Treasuries, both nominal
and TIPS, are very cheap versus OIS and Libor swap rates.
• Normalization of cross-currency basis swaps, which currently allow USD-based
investors the ability to buy very cheap EUR- and JPY-denominated assets via the
basis swap.
• Normalization of coupon STRIPS versus principal STRIPS as these yield differentials
are near their all-time wides, particularly in the 2030-38 maturity bucket.
As a tail risk for deregulation, we like buying 30y swap spreads, a credit-risk-free
floating-rate US Treasury asset that provides 3m Libor + 56bp annually, which is about
100bp cheap to pre-crisis levels. Swap spreads could also benefit from deregulation that
removes cash and Treasury bonds from the leverage ratio requirements, which would
provide the ability of the dealer community to more easily absorb Treasury supply in the
primary and secondary markets.
The main risk is that policy changes retain strict capital requirements, which would
continue to limit the availability of leverage. For example, the Financial Choice Act, a
product of Texas Representative Jeb Hensarling's team, would provide banks an offramp
option to all Basel 3 requirements as long as banks hold a 10% capital ratio. This
plan would probably decrease the availability of leverage, and could also result in
reduced demand for short-dated Treasuries in HQLA portfolios. Another risk to 30y
swap spread normalization in particular would be a material increase in deficit spending
as part of a fiscal stimulus package. This would likely further cheapen Treasuries versus
swaps and other benchmark interest rates.
Trade recommendation: Buy 30y Treasuries versus 30y matched Libor swap at
3mL+56bp. Target 3mL + 0bp, stop loss 3mL+75bp.
Tail risk 2: Comeback of Eurozone risk premia
EZ risk hedges: 30s50s flatteners in BTPs, buy EUR/HUF vol
In Europe, the biggest market risk for 2017 is arguably a comeback of stress on
peripheral sovereigns. The next 12 months provide plenty of triggers, with increasing
concerns about the ability of ECB to continue with QE, and an intense political season
ahead (referendum in Italy on 4 Dec, and elections in France and Germany in 2017).
As hedges to Eurozone risks, we recommend buying 30s50s flatteners in BTPs as the
cheapest way to express a bearish view on the periphery, and buying EUR/HUF vol as a
proxy for Euro instability with better pricing than EUR/USD vol.
Concerns on EU politics and the ECB would likely lead to a switch of market focus from
monetary policy to fundamentals. The periphery would be hurt by this new focus: public
debt to GDP remains very high, and the low debt service costs enjoyed in the past five
years favored debt accumulation, rather than debt reduction (Chart 73). The cyclical
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 43
Chart 73: Fundamentals – CEE beats periphery
190%
140%
90%
40%
-10%
Source: IMF
Spain
France
Portugal
Italy
Hungary
Czech
Poland
Romania
Debt/GDP (lhs)
5y change in debt/GDP (lhs)
2016 growth (rhs)
5%
4%
3%
2%
1%
0%
Chart 74: Poland and Hungary wide relative to
Italy and Spain
Source: Bloomberg
juncture has also weighed on public finances, and all peripheral countries are running
deficits above the structural levels.
15
10
5
0
Jun/11
Mar/12
Dec/12
Italy
Portugal
Hungary
Romania
Sep/13
Jun/14
Mar/15
Dec/15
Spain
France
Poland
Czech
Sep/16
Chart 75: HUF vol lagging EUR and PLN
12
11
10
9
8
7
6
Jan/14 Jan/15 Jan/16
EUR/HUF EUR/PLN
EUR/USD
Source: Bloomberg.
The fundamental picture is not reflected in interest rate dynamics. ECB easing has
pushed Eurozone interest rates lower despite worsening public finances (Chart 74).
Participation in the QE program has been a strong determinant of low long-term rates,
as shown by the tightening of the periphery vs CEE. Hungary, Poland and Romania have
been yielding 3-3.5% in the past year, while Italy remained constantly below 2%. If
stress comes back, the gap will close.
Within the periphery, Italy is the most vulnerable. Fundamentals are the worst in the
region, only comparable to Portugal, which trades 160bp above it. Political risks also
remain high, with the referendum providing some downside risk to the prime minister.
The market is apparently reaching the same conclusion: during the most recent global
bonds sell-off (20 Sep-14 Nov), Italy widened 95bp, while Spain widened 70bp, in line
with CEE, despite the higher beta nature of the latter and the higher FX risk. Still, there
may be room for further widening: the 10y spread to Germany widened in the current
move, but is still lower than it has been the three years following the latest Italian
political crisis. Our European rates team argued this summer that the rally in Italy
spreads was far from fundamental. Flatteners in the 30s50s area look the best hedge as
50y are not eligible for QE, and term premia in the 2-31y sector would increase if QE
was to end. Also, in times of sovereign debt stress, the curve tends to invert, further
supporting long-end flatteners. Total carry is 1bp per month, making it cheaper and less
sensitive to timing of stress than an outright short bond position.
On further EZ stress, the euro would weaken and euro vol rise. While a less dovish ECB
would be euro-positive, peripheral stress would ignite concerns on the monetary union,
and ultimately weaken the euro (as in Dec 2011). A cleaner hedge is buying EUR/HUF
vol, as it proxies EUR/USD vol but has moved less so far. HUF options are historically
very reactive to EZ stress, but the increase in vol lagged EUR/USD post-elections, and
EUR/PLN vol has been higher in the past two years due to higher perceived risks in
Poland (Chart 75). In Dec 2011, the vol spike in the three crosses had been the same.
CEE rates tend to widen in times of Eurozone stress, but their fundamentals are much
more solid, so further EZ stress may bring opportunities to buy dips. CEE capitalized the
past five year much better, with fiscal consolidation in Hungary, balanced budget in
Czech Republic, and low debt/GDP ratios in Poland. Also, the growth picture is much
more rosy, making leverage much more manageable.
Trade recommendation: Buy 50y BTPs vs 30y BTPS at 30bp, targeting -8bp and
with stop at 55bp. Risk is ECB QE continues and peripheral risk premium stays low.
44 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Tail risk 3: China-led commodity weakness
Commodity collapse hedge: buy AUD/USD 6m 0.67 digital put
Metal and bulk commodity prices have skyrocketed in anticipation of infrastructure
spending in the US, We are wary of this rally: tax cuts are likely to be the first line of
fiscal stimulus and potentially easier to get through Congress than sizeable
infrastructure spending, which in any case will take a longer time to impact commodity
demand (allowing for supply adjustments). Perhaps most importantly, China is still the
swing factor for global commodity prices and the risks here remain to the downside.
The recent dramatic rise for China-linked bulk commodity prices, especially coal, has
been driven by a combination of supply and demand imbalances (China floods, pit
closures and inventory shortages) and an apparent rise in speculative activity in futures
markets that has already drawn attention from regulators (Chart 76). Our resource
analysts have raised forecasts but still see moderation over 2017 (Chart 77). The futures
forward curve has already moved into backwardation. We see iron ore prices back at
USD50/t in 2017 compared to a current spot price of USD74.
While global reflation might be positive for commodities, there are reasons for caution:
• We expect Chinese property investment, the most commodity-intensive sector of
the economy, to slow in 2017.
• Sizeable RMB depreciation would be an additional deflationary impulse for
industrial commodities.
• There will be a supply response as current prices bring uneconomic producers back
on line, admittedly with a lag.
• There is potential for trade friction to impact regional trade while higher US rates
are already impacting regional EM currencies. Australia is especially exposed to
intra-regional trade and resource demand from the region.
Persistent supply/demand imbalances ahead of Chinese New Year might delay
commodity weakness until after 1Q17, especially for coking coal due to a preference for
thermal coal supplies over the Chinese winter. However, the risk of a sharp reversal
beyond is worth hedging against given the demand dynamics in China, most obviously
through the AUD. While short-dated implied volatility rose following the US election, the
risk-reversal skew remains high as a percentage of implied volatility relative to G10
pairs. This suggests hedging via AUD/USD digital puts is appropriate, in our view.
Trade recommendation: Buy 6m AUD/USD 0.67 digital put, entry: 10% (spot
reference: 0.7550). Risk is global demand recovery provides support to commodity
prices.
Chart 76: Bulk commodity spot prices
USD/t
400
Iron Ore (china)
300
Aus Thermal Coal
Hardcoal (Coking) spot
200
100
0
11 12 13 14 15 16 17
Source: Bof A Merrill Lynch Global Research, Bloomberg
Chart 77: China Coking coal futures and BAML forecasts
Our 2017 forecasts for Liulin No.4 Coking coal are averages for 1H and 2H
RMB/t
1600
1400
1200
1000
800
600
Source: Bof A Merrill Lynch Global Research, Bloomberg
Coking Coal Future (lhs)
Futures Curve
BAML Forecast
Volume (rhs, 000s contracts)
400
Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan-18
3200
2800
2400
2000
1600
1200
800
400
0
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 45
Tail risk 4: BoJ triggers curve steepening and vol rise
BoJ keeps yield curve anchored out to 10y: 1y10s20s conditional bear steepener
The Bank of Japan (BoJ) has faced a tough 2016. Having switched its policy target from
quantity to interest rates at its September Monetary Policy Meeting, it tacitly
acknowledged that negative rates and JGB purchases were potentially approaching their
limit in terms of policy effectiveness. Inflation expectations fell and the yen
strengthened as a consequence as the market got accustomed to fading dovish
pronouncements from the Bank of Japan. BoJ Governor Haruhiko Kuroda himself said
"Central banks are, admittedly, not omnipotent."
The BoJ introduced yield curve control, taking into consideration negative effects of
great decline in yields and curve flattening on financial institution earnings or financial
markets. If the BoJ keeps purchasing at the current rate, however, yields will sooner or
later feel downward pressure. We believe the BoJ is likely to reduce its long-term JGB
purchase gradually. For the time being, JGB yield guidelines are probably around 0% for
the 10yr, 0.4% for the 20yr, and 0.5% for the 30yr JGB.
However, the BoJ appears to be concerned about the deterioration of financial
institution earnings caused by flattening of the yield curve. Kuroda said that even if
superlong-term yields rose slightly, he did not believe they would have to be lowered. He
went on to say he was also giving consideration to investors in superlong-term bonds,
and that he did not think it was good for the yield curve to get continually flatter. Based
on these and other remarks, we expect long-term JGB purchase operations to be
reduced and the curve to gradually steepen (Rates forecast: Attention on BoJ operations
when yields decline).
Before that can happen, however, preconditions most likely include steady progress in
US rate hikes, avoidance of excessive yen appreciation, and some degree of recovery in
the inflation rate. With a Republican clean sweep, US fiscal easing is now a foregone
conclusion and “Higher rates and higher dollar” may support our view for yen rates. If
JGB purchase operations were reduced and yen rates rose in the wake of higher US
Treasury yields and USD/JPY appreciation, that could easily be explained by
fundamentals.
Yen rates volatility is still low; however, purchasing cuts by the BoJ could add to
volatility risk amid declining liquidity in the super long-end (Chart 78). Even if risk-off
sentiment pushes down the yield curve, the BoJ may lower the 10yr JGB yield target
from zero to keep the curve steep. This kind of policy change also could increase
volatility. In either case, the 10yr is expected to be anchored and movement is expected
in the long end. We believe 1y10s20s conditional bear steepener may mitigate this risk.
Trade recommendation: Long 5bn 1y20y @0.62% (atm+11bp) payer vs Short 9.9bn
1y10y @0.18% (atm) payer. This position is zero cost, PV01 neutral, and zero carry.
Risk is the curve remains flat due to a deflationary backdrop.
Chart 78: JPY Swap 10y and 20y rate and 1y20y volatility
1.2
(%) JPY Swap 10y JPY Swap 20y 1y20y Volatility (RHS) (bp)
60
1
50
0.8
40
0.6
0.4
30
0.2
20
0
10
-0.2
0
Nov-15 Feb-16 May-16 Aug-16 Nov-16
Source: BofA Merrill Lynch Global Research
46 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Best Technical Trades
Paul Ciana, CMT
MLPF&S
paul.ciana@baml.com
Technical trends for Trump
• Bullish USD: Breadth and technicals favor USD. Overall they point to a stronger US
dollar in 2017. We are bullish USD/JPY.
• Higher yields: US 10y and 30y yield made large wedge bottom patterns, pointing to
a 61.8% Fibonacci retracement of 2.98% and 3.80%, respectively.
• We recommend buying a NZD/USD 5m .69/.66 put spread 1x1.5 for 43 USD pips
(off of .7100 spot).
USD rally is turning into an outright bull
The Bloomberg US dollar index is approaching all-time highs. The number of USD
crosses above their 200-day moving average has broken out higher. The number of USD
crosses reaching overbought on RSI (bullish momentum) continues to rise. The USD
cumulative advance-decline line recently signaled for tactical USD strength and would
turn outright bullish with a trend line break and new index highs.
Chart 79: Bloomberg US dollar index, weekly chart with USD breadth measures
Source: BofA Merrill Lynch Global Research, Bloomberg
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 47
Bullish USD/JPY
The election of Donald Trump catapulted USD/JPY through another resistance level, this
time a weekly trend line, adding to the list of technical signals that USD/JPY has
bottomed and is in an uptrend. We began discussing a bottom in our September 5 and
September 18 Technical Advantage reports. We estimate technical upside and
resistance in the area of 112. We also think this uptrend has the potential to reach the
full measured move target of 116.50 in 2017.
Chart 80: USD/JPY weekly chart
Source: BofA Merrill Lynch Global Research, Bloomberg
A higher yield environment
We continue to think yields will trend higher in 2017. We initially reported our view that
global yields would rise in our October 26 Technical Advantage report. Since then we
have seen added confirmation by US 10y, US 30y, 10yr bund, 30yr JGB and 10y Gilt that
yields will rise.
US 10y and 30y yield form wedge bottom pattern
US 10y and 30y yields formed wedge bottom patterns by breaking through the upper
trend line resistance (Breakout 1). A wedge pattern is composed of two converging
trend lines often consisting of multiple smaller trends followed by a breakout. Each yield
has a second resistant trend line and Fibonacci retracement to break. If 10y yield breaks
through 2.35% and 30y yield through 3.15%, then another breakout will have occurred
that technically triggers another leg higher to 2.98% and 3.80%, respectively. We think
this is the more likely outcome.
48 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Chart 81: US 10yr yield (top) and US 30yr yield (bottom) weekly chart
Source: BofA Merrill Lynch Global Research, Bloomberg
German 10yr bund yield breaks out
Bund yield has risen through resistance levels and is up about 60bps from the low. Prior
uptrends failed at trend line resistance levels; however, this time it broke through. The
distance traveled during prior moves include +140bps, +93bps and +108bps. Therefore,
we believe this uptrend has room to continue to 55bps (estimated 200wk SMA) by
1Q2017 and to 75bps in 2017.
Japanese 30y yields form head and shoulders bottom
The rapid decline in 30y JGB yield during 2016 led to a trend exhaustion signal at the
lows (TD Sequential 13), a rise resulting in the most overbought (higher yield)
momentum since 2010 and the formation of a head and shoulders bottom. Provided
yield remains above 44bps, we could see yield rising to 71bps and possibly 87bps in
2017.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 49
Chart 82: German 10yr bund yield – weekly chart
Chart 83: Japanese 30yr yield - weekly chart
Source: BofA Merrill Lynch Global Research, Bloomberg
Source: BofA Merrill Lynch Global Research, Bloomberg
Buy NZD/USD 5m .69/.66 put spread 1x1.5
NZD/USD is forming a head and shoulders top. It is breaking trend line support from the
January to June lows. It is also threatening to break the neckline at .7070. MACD recently
crossed bearish and is trending toward negative. This pattern suggests NZD/USD will
decline as low as .6615. Given the strong USD move in G10 thus far, we think NZD/USD
is near an attractive technical level to position for further USD strength. We
recommending buying a NZD/USD 5m .69/.66 put spread 1x1.5 for 43 USD pips (off of
.7100 spot).
Chart 84: NZD/USD daily chart
Source: BofA Merrill Lynch Global Research, Bloomberg
50 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Bond Yield Forecasts
Table 7: Quarter-end bond yield forecasts
Latest 4Q16 1Q17 2Q17 3Q17 4Q17
USA 3m Libor 0.91 1.05 1.05 1.25 1.30 1.50
2y T-Note 0.98 1.10 1.35 1.50 1.60 1.65
5y T-Note 1.64 1.85 2.10 2.15 2.20 2.25
10y T-Note 2.21 2.35 2.55 2.60 2.65 2.65
30y T-Bond 2.95 3.10 3.30 3.30 3.35 3.35
2y Swap 1.23 1.30 1.53 1.66 1.75 1.80
5y Swap 1.68 1.88 2.10 2.15 2.20 2.25
10y Swap 2.07 2.23 2.41 2.44 2.49 2.49
Germany 3m Euribor -0.31 -0.30 -0.30 -0.30 -0.33 -0.32
2y BKO -0.62 -0.60 -0.60 -0.55 -0.50 -0.45
5y OBL -0.34 -0.35 -0.30 -0.25 -0.20 -0.10
10y DBR 0.30 0.40 0.45 0.50 0.55 0.65
30y DBR 0.93 1.05 1.10 1.15 1.15 1.15
2y Swap -0.13 -0.14 -0.16 -0.13 -0.06 -0.02
5y Swap 0.14 0.12 0.16 0.21 0.27 0.36
10y Swap 0.69 0.81 0.85 0.89 0.92 1.00
Japan 3m Libor -0.07 -0.03 -0.03 -0.03 -0.03 -0.03
2y JGB -0.17 -0.20 -0.20 -0.20 -0.20 -0.15
5y JGB -0.11 -0.15 -0.15 -0.13 -0.12 -0.10
10y JGB 0.01 0.00 0.00 0.00 0.00 0.00
2y Swap 0.01 -0.07 -0.07 -0.07 -0.07 0.00
5y Swap 0.04 -0.05 0.00 0.01 0.02 0.04
10y Swap 0.15 0.12 0.15 0.15 0.15 0.15
U.K. 3m Libor 0.40 0.40 0.25 0.25 0.25 0.25
2y UKT 0.22 0.20 0.20 0.20 0.20 0.20
5y UKT 0.66 0.70 0.80 0.85 0.90 0.90
10y UKT 1.40 1.50 1.60 1.65 1.70 1.75
30y UKT 2.04 2.10 2.15 2.20 2.25 2.30
2y Swap 0.67 0.65 0.65 0.60 0.55 0.50
5y Swap 0.96 1.00 1.10 1.15 1.20 1.20
10y Swap 1.34 1.55 1.70 1.75 1.80 1.85
Australia 3m BBSW 1.76 1.70 1.70 1.70 1.80 1.80
2y ACGB 1.77 1.90 1.95 2.00 2.05 2.10
5y ACGB 2.16 2.30 2.40 2.45 2.50 2.60
10y ACGB 2.66 2.80 2.95 3.05 3.10 3.10
3y Swap 2.22 2.00 2.10 2.15 2.20 2.20
10y Swap 2.81 2.95 3.10 3.20 3.25 3.25
Canada 2y Govt 0.66 0.70 0.60 0.50 0.40 0.40
5y Govt 0.94 1.00 0.90 0.80 0.70 0.70
10y Govt 1.52 1.50 1.40 1.40 1.35 1.35
2y Swap 1.00 1.04 0.94 0.84 0.74 0.74
5y Swap 1.29 1.35 1.25 1.15 1.05 1.05
10y Swap 1.78 1.76 1.66 1.66 1.61 1.61
Source: BofA Merrill Lynch Global Research
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 51
Global FX Forecasts
Table 8: Quarterly forecasts – G10 currencies
Spot Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18
G3
EUR-USD 1.08 1.08 1.05 1.02 1.02 1.05 1.06 1.07 1.08 1.10
USD-JPY 108 108 112 115 117 120 117 115 112 110
EUR-JPY 117 117 118 117 119 126 124 123 121 121
Dollar Bloc
USD-CAD 1.35 1.36 1.38 1.40 1.41 1.43 1.43 1.41 1.40 1.40
AUD-USD 0.76 0.74 0.73 0.72 0.71 0.70 0.70 0.71 0.73 0.75
NZD-USD 0.71 0.70 0.69 0.68 0.68 0.67 0.67 0.68 0.70 0.71
Europe
EUR-GBP 0.87 0.88 0.91 0.89 0.88 0.88 0.88 0.87 0.86 0.85
GBP-USD 1.24 1.23 1.15 1.15 1.16 1.19 1.20 1.23 1.26 1.29
EUR-CHF 1.07 1.08 1.09 1.10 1.11 1.12 1.12 1.13 1.13 1.15
USD-CHF 0.99 1.00 1.04 1.08 1.09 1.07 1.06 1.06 1.05 1.05
EUR-SEK 9.86 9.50 9.40 9.30 9.20 9.15 9.10 9.00 8.90 8.90
USD-SEK 9.14 8.80 8.95 9.12 9.02 8.71 8.58 8.41 8.24 8.09
EUR-NOK 9.08 9.00 8.90 8.80 8.70 8.60 8.50 8.50 8.40 8.40
USD-NOK 8.41 8.33 8.48 8.63 8.53 8.19 8.02 7.94 7.78 7.64
Forecast as of Nov-15-2016. Spot exchange rate as of Nov-15-2016. The left of the currency pair is the denominator of the exchange rate. Source: BofA Merrill Lynch Global Research
Table 9: Quarterly forecasts – EM currencies
Spot Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18
Latin America
USD-BRL 3.43 3.60 3.65 3.70 3.80 3.90 3.90 3.90 3.90 3.90
USD-MXN 20.48 21 21.25 21.5 21.75 22 22.25 22.5 22.75 23
USD-CLP 670 670 685 700 715 730 740 750 760 770
USD-COP 3,124 3,150 3,200 3,250 3,300 3,350 3,400 3,450 3,500 3,550
USD-ARS 15.60 15.80 16.00 17.00 17.50 18.00 18.50 19.00 19.50 20.00
USD-VEF 9.99 10 31.1 31.1 84.8 84.8 84.8 84.8 84.8 84.8
USD-PEN 3.44 3.45 3.47 3.50 3.52 3.55 3.60 3.65 3.70 3.70
USD-UYU 28.70 29 30 31 32 33 34 35 36 37
Emerging Europe
EUR-PLN 4.41 4.30 4.25 4.20 4.20 4.20 4.10 4.05 4.05 4.00
EUR-HUF 310 310 310 305 300 300 300 295 295 290
EUR-CZK 27.03 27 27 27 26.5 26 26 26 26 25.5
USD-UAH 25.91 25.8 25.8 25.8 25.8 25.8 25.8 25.8 25.8 25.8
USD-RUB 65.47 65 63 65 65 65 65 65 65 65
USD-ZAR 14.15 14.5 14.5 14.5 14.5 14.5 14.3 14.5 14.8 15
USD-TRY 3.27 3.15 3.1 3.15 3.2 3.2 3.2 3.25 3.25 3.3
EUR-RON 4.51 4.5 4.5 4.45 4.4 4.4 4.4 4.35 4.35 4.3
USD-EGP 15.47
USD-ILS 3.84 3.85 3.85 3.85 3.85 3.85 3.85 3.85 3.8 3.8
USD-AED 3.67 3.67 3.67 3.67 3.67 3.67 3.67 3.67 3.67 3.67
USD-SAR 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75 3.75
USD-QAR 3.64 3.64 3.64 3.64 3.64 3.64 3.64 3.64 3.64 3.64
Asian Bloc
USD-KRW 1,170 1200 1200 1220 1250 1270 1270 1230 1210 1190
USD-TWD 31.85 32.1 32.4 32.7 33.1 33.4 33.4 32.8 32.5 32.3
USD-SGD 1.41 1.44 1.45 1.49 1.5 1.51 1.51 1.51 1.51 1.5
USD-THB 35.36 36 36.5 37.5 37.8 38.2 39 39 38 37
USD-HKD 7.76 7.76 7.77 7.78 7.79 7.80 7.80 7.80 7.80 7.80
USD-CNY 6.85 7.00 7.05 7.10 7.15 7.25 7.35 7.35 7.30 7.20
USD-IDR 13369 13700 13900 14200 14400 14600 14500 14500 14400 14200
USD-PHP 49.07 50.5 51 52 53 53.5 54 54 53 52
USD-MYR 4.34 4.41 4.45 4.55 4.65 4.71 4.68 4.68 4.6 4.5
USD-INR 67.69 68.25 68.1 68.5 69 70 69.5 69 68.5 68
Forecast as of Nov-15-2016. Spot exchange rate as of Nov-15-2016. The left of the currency pair is the denominator of the exchange rate. Source: BofA Merrill Lynch Global Research
52 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Options Risk Statement
Potential Risk at Expiry & Options Limited Duration Risk
Unlike owning or shorting a stock, employing any listed options strategy is by definition
governed by a finite duration. The most severe risks associated with general options
trading are total loss of capital invested and delivery/assignment risk, all of which can
occur in a short period.
Investor suitability
The use of standardized options and other related derivatives instruments are
considered unsuitable for many investors. Investors considering such strategies are
encouraged to become familiar with the "Characteristics and Risks of Standardized
Options" (an OCC authored white paper on options risks). U.S. investors should consult
with a FINRA Registered Options Principal.
For detailed information regarding the risks involved with investing in listed options:
http://www.theocc.com/about/publications/character-risks.jsp.
Valuation & risk
Brazil (BRAZIL)
We are Marketweight Brazil's EXD with currently wide spreads compensating for the
risks. The political crisis concerns investors and growth has been weaker than expected.
However, spreads are quite high compared to LatAm investment grades. There are
positive and negative tail risks for growth, as a resolution to the political paralysis could
bring confidence back up quickly and improve the economic backdrop. With this positive
tail risk, and a stronger fiscal adjustment in 2016, economic recovery could start in
2Q16. On the downside, pressures on GDP could increase if the political scenario
deteriorates further, with the government failing to approve fiscal measures and/or
Brazil shifting to a heterodox policy.
Colombia (COLOM)
Spreads, which have widened this year adequately compensate investors for the risk, in
our view, and leads us to our Marketweight view. Downside risks are a rapid inflation
acceleration from pass-through effects, which would be a difficult problem for
macroeconomic policy. Also oil price weakness raises risk of recession. Fiscal and
external difficulties generate incentives to relax the fiscal rule. Upside risks are a rise in
commodity prices and stronger than expected growth.
Mexico (MEX)
Mexico's tight spreads fairly reflect the better quality of Mexican debt compared to
most of LatAm, in our view. We forecast Mexico's activity growth to remain in the 2-3%
range. Downside risks are lower growth in the US, lower oil prices and slower domestic
oil production. A disorderly normalization of US monetary policy is a risk to Mexico's
financial stability as well. Upside risks are higher oil prices and stronger US growth.
Turkey (TURKEY)
We are Overweight as Turkey Eurobonds lagged peers due to heightened political noise
during the summer. Since Moody's downgraded the sovereign, all negative impact of the
attempted coup seems to be priced and we think that bonds offer value vs peers.
Downside risks are stronger outflows than expected and heightened political noise.
Upside risks include a generalized rally on the back of more positive global backdrop.
Analyst Certification
We, David Woo, Adarsh Sinha, Arko Sen, Claudio Irigoyen, Jane Brauer, Kamal Sharma,
Mark Capleton, Paul Ciana, CMT and Ralf Preusser, CFA, hereby certify that the views
each of us has expressed in this research report accurately reflect each of our respective
personal views about the subject securities and issuers. We also certify that no part of
our respective compensation was, is, or will be, directly or indirectly, related to the
specific recommendations or view expressed in this research report.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 53
Disclosures
Important Disclosures
Credit opinion history
Brazil / BRAZIL
Sovereign Date^ Action Recommendation
Brazil / BRAZIL 12-Nov-2015 Initial Marketweight
Table reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of the
report under the heading "BofA Merrill Lynch Credit Opinion Key."
Colombia / COLOM
Sovereign Date^ Action Recommendation
Colombia / COLOM 12-Nov-2015 Initial Marketweight
Table reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of the
report under the heading "BofA Merrill Lynch Credit Opinion Key."
Mexico / MEX
Sovereign Date^ Action Recommendation
Mexico / MEX 12-Nov-2015 Initial Marketweight
03-Dec-2015 Restricted NA
03-Dec-2015 Coverage Resumed Marketweight
21-Mar-2016 Restricted NA
21-Mar-2016 Coverage Resumed Marketweight
08-Aug-2016 Restricted NA
10-Aug-2016 Coverage Resumed Marketweight
Table reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of the
report under the heading "BofA Merrill Lynch Credit Opinion Key."
Turkey / TURKEY
Sovereign Date^ Action Recommendation
Turkey / TURKEY 12-Nov-2015 Initial Marketweight
23-Feb-2016 Downgrade Underweight
17-May-2016 Upgrade Marketweight
27-Sep-2016 Upgrade Overweight
Table reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of the
report under the heading "BofA Merrill Lynch Credit Opinion Key."
Credit Opinion History Tables for the securities referenced in this research report are available at http://pricecharts.baml.com, or call 1-800-MERRILL to have them mailed.
MLPF&S or an affiliate was a manager of a public offering of securities of this issuer within the last 12 months: Brazil, Italy, Turkey.
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preceding the report: Brazil, Colombia, Germany, Mexico, Turkey.
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54 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
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Futures and options are not appropriate for all investors. Such financial instruments may expire worthless. Before investing in futures or options, clients must receive the appropriate risk
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 55
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56 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Research Analysts
Europe
Ralf Preusser, CFA
Rates Strategist
MLI (UK)
+44 20 7995 7331
ralf.preusser@baml.com
Mark Capleton
Rates Strategist
MLI (UK)
+44 20 7995 6118
mark.capleton@baml.com
Sphia Salim
Rates Strategist
MLI (UK)
+44 20 7996 2227
sphia.salim@baml.com
Ruairi Hourihane
Rates Strategist
MLI (UK)
+44 20 7995 9531
ruairi.hourihane@baml.com
Erjon Satko
Rates Strategist
MLI (UK)
+44 20 7996 5726
erjon.satko@baml.com
Sebastien Cross
Rates Strategist
MLI (UK)
+44 20 7996 7561
sebastien.cross@baml.com
Athanasios Vamvakidis
FX Strategist
MLI (UK)
+44 20 7995 0790
athanasios.vamvakidis@baml.com
Kamal Sharma
FX Strategist
MLI (UK)
+44 20 7996 4855
ksharma32@baml.com
Myria Kyriacou
FX Strategist
MLI (UK)
+44 20 7996 1728
myria.kyriacou@baml.com
US
David Woo
FX, Rates & EM Strategist
MLPF&S
+1 646 855 5442
david.woo@baml.com
Shyam S.Rajan
Rates Strategist
MLPF&S
+1 646 855 9808
shyam.rajan@baml.com
Mark Cabana, CFA
Rates Strategist
MLPF&S
+1 646 855 9591
mark.cabana@baml.com
Ralph Axel
Rates Strategist
MLPF&S
+1 646 855 6226
ralph.axel@baml.com
John Shin
FX Strategist
MLPF&S
+1 646 855 9342
joong.s.shin@baml.com
Carol Zhang
Rates Strategist
MLPF&S
+1 646 855 8311
carol.zhang@baml.com
Pac Rim
Adarsh Sinha
FX Strategist
Merrill Lynch (Hong Kong)
+852 3508 7155
adarsh.sinha@baml.com
Shuichi Ohsaki
Rates Strategist
Merrill Lynch (Japan)
+81 3 6225 7747
shuichi.ohsaki@baml.com
Global Emerging Markets
David Hauner, CFA
EEMEA Cross Asset Strategist
MLI (UK)
+44 20 7996 1241
david.hauner@baml.com
Claudio Irigoyen
LatAm FI/FX Strategy/Economist
MLPF&S
+1 646 855 1734
claudio.irigoyen@baml.com
Claudio Piron
Emerging Asia FI/FX Strategist
Merrill Lynch (Singapore)
+65 6591 0401
claudio.piron@baml.com
Helen Qiao
China & Asia Economist
Merrill Lynch (Hong Kong)
+852 3508 3961
helen.qiao@baml.com
Trading ideas and investment strategies discussed
herein may give rise to significant risk and are not
suitable for all investors. Investors should have
experience in FX markets and the financial resources
to absorb any losses arising from applying these ideas
or strategies.
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 57