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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
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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