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StreetStuff Daily March 31, 2017

fade. On a quarterly basis, we forecast PPI inflation peaked in Q1 and will moderate to 5.1% in Q3 and 2.1% in Q4 based on Barclays commodity team’s forecast of lower copper and iron prices, and relatively stable oil prices (China: Drivers of China's PPI inflation, 13 March 2017).

30 March 2017

US Q4 real GDP growth revised slightly higher in third estimate on account of stronger consumer spending …Altogether, the third estimate of Q4 GDP paints a picture of a healthy consumer, likely fueled by ongoing gains in employment, modest increases in wages, and solid balance sheets. However, fixed investment remains soft. We expect the economy to grow at a broadly similar pace in Q1, although we expect the composition to change toward a slower rate of increase in consumer spending and less of a drag from net trade. As highlighted in US Economic Research: Delayed tax refunds may shift some household spending from Q1 to Q2, we think a slowing in the pace of federal tax refunds this quarter could be a factor weighing on near-term consumer spending.

30 March 2017

Global Rates Weekly Low anxiety •



31 March 2017

China Strong March PMI supports recent upgrades of our Q1 and 2017 growth forecasts China’s NBS manufacturing PMI rose to 51.8 in March, up 0.2pp from February’s 51.6 and slightly above expectations (Barclays: 51.6, consensus: 51.7). The rise was driven mainly by strong readings for the production and new orders indexes. The production index rose to 54.2, a 32-month high, from 53.7 in February, and the new orders index increased to 53.3 from 53.0 in February (Figure 2). The export orders index continued to improve, rising to 51.0 (previous: 50.8), but the import index retreated to 50.5 (previous: 51.2), suggesting a mixed near-term picture for trade (Figure 3). By firm size, the NBS PMI for large enterprises stayed at the high level of 53.3, and the activity in small enterprises recovered to 48.6 (previous: 46.4). We note that the input prices index fell sharply, declining to 59.3 (previous: 64.2), a six-month low. In our view, PPI inflation peaked in February, given that base effects will start to



In US, we believe that the Fed is likely to keep pushing back against benign market pricing of the hiking cycle. Separately, while downside risks may not have increased following the health care bill experience, the probability of a major fiscal stimulus has certainly fallen, in our view. We recommend a US-EUR convergence trade using 3m*10y10y receivers and keep our 3s10s curve-flattener view.

In Europe, while some ECB members could be concerned about the market getting ahead of itself, we do not necessarily think there is much of a misunderstanding in ECB communication. We maintain our EONIA reds/greens steepener, initiate an ECB Sep17/Jan18 EONIA steepener and maintain our 10y French and Spanish spreads widener trades. In the UK, the triggering of Article 50 had little effect on the rates market. With uncertainty over how the MPC will present May’s forecasts, duration remains driven by wider developments. We maintain money market and forward steepeners.

United States Low anxiety We believe that the Fed is likely to keep pushing back against benign market pricing of the hiking cycle. Separately, while downside risks may not have increased following the experience with the health care bill, the probability of a major fiscal stimulus has certainly declined, in our view. We recommend a US-EUR convergence trade using 3m*(10y10y) receivers and maintain our 3s10s curve-flattener view. …Overall, we believe the developments so far continue to argue for a flatter yield curve. With the Fed’s expectations to raise rates at a faster pace not entirely contingent on the scope of fiscal stimulus, there is still room for front-end yields to reprice higher. However, with

5y5y real yields at 1% looking high outright, as well as relative to other developed bond markets, there is limited room for the long end to lead the selloff. Hence, we maintain our recommendation to be in 3s10s flatteners. Market positioning appears much cleaner now with mutual funds no longer appearing underweight duration (Figure 5), although it seems that hedge funds are increasing their short exposure, likely as yields are trading close to the lower end of the recent trading range (Figure 6).

FIGURE 5 Mutual fund positioning is no longer short

Short OTR30s versus d-old30s In the past few months, the easing of balance sheet constraints has been one of the key developments in the fixed income markets. Figure 1 shows the first factor of the principal component analysis of a range of balance sheet-sensitive relationships (such as the cross-currency basis swap, corporate cash-CDS basis, errors to Treasury spline, and GC versus FF rates). This can be thought of as a measure of the liquidity premium. The higher the value, the more restrictive access to the balance sheet and the greater the excess return to providing liquidity. As can be seen, for most of 2014 and 2015, liquidity premium was rising as market participants were adapting to the new regulatory regime. Over recent months, these constraints appear to have eased up, probably due to the money market reform and as new entrants have likely stepped in, given the attractive excess return from taking liquidity risk. Figure 1 shows that the liquidity premium is now below the levels of 2013-14. FIGURE 1 Balance sheet constraints appear to have eased

FIGURE 6 Hedge funds positioning has become shorter

FIGURE 2 OTR 30s are trading quite rich to d-old 30s

UNITED STATES: TREASURIES

Fade the liquidity premium at the long end We recommend shorting OTR 30s (Feb 47s) versus dold 30s (Aug 46s), as, in our view, the liquidity premium reflected in OTR 30s is too high, given the general decline in the liquidity premium and the perceived reduction in balance sheet constraints across fixed income markets.

We believe the Treasury market has yet to fully reflect this development. Figure 2 shows OTR30s versus d-Old30s, on ASW, in the current cycle, as well as the average for the past four years. OTR30s are trading 1.7bp rich to d-old 30s on a one-month forward basis. To put this in perspective, at this stage of the auction cycle, they traded 0.1bp rich in 2013-14 and around 0.8bp rich in 2015-16. Figure 3 shows that OTR

30s are trading the richest (on a one-month forward basis) than they have traded over the past 16 auction cycles.

In Figure 4, we relate the liquidity premium in the long end with our balance sheet constraints index. As can be seen, when balance sheet constraints are perceived to be greater, OTR 30s trades richer. The current value of our index suggests that OTR 30s should have no liquidity premium on a onemonth forward basis. Hence, we recommend shorting OTR 30s (Feb 47s) versus dold 30s (Aug 46s). Neither of the securities is trading special in the repo market. The Fed owns $1.7bn of Feb 47s and $1.5bn of Aug 46s.

UNITED STATES: AGENCY MBS

Mortgages mostly flat again Mortgages were mostly stable this week, as markets brushed aside the demise of the GOP’s healthcare bill last Friday, as well as hawkish comments from some Fed officials earlier in the week. We remain neutral with a positive bias on the basis and continue to recommend the FN and G2 4/3 swaps. This week, we discuss the recent FHFA update to Single Security and review GLD/FN swaps in light of the update. Euro Area ECB means EONIA steepeners While some ECB members could be concerned about the market getting ahead of itself, we do not think there is much of a misunderstanding in ECB communication. We maintain our EONIA reds/greens steepener, have initiated an ECB Sep17/Jan18 EONIA steepener and maintain our 10y French and Spanish spreads widener trades. UK Heavy lifting Supply in Q2 17 is notably heavy in the ultra long end of the nominal curve. With a 40yr conventional syndication announced in May, as well as a reopening of UKT 2.5% July 2065 in April, the flatness of Gilt 30/50s should reverse over April and May. Japan Japanese investor behavior into the new FY Megabanks typically take some profits at the outset of new fiscal year, especially in JGBs and foreign bonds. This time around, however, such profit-taking could be limited, given the decline in unrealized gains on JGBs and latent losses on foreign bonds.

Lyngen/Kohli BMO Closing Call, March 30 …Attached is a 10-year yield market profile chart that shows the extent to which the volume bulge has already been created – the highlighted segment in the chart is this week: Mar 27-Mar 30. It’s not surprising that the bulk of the activity occurred between 2.375% and 2.390% -- that’s been a very ‘popular’ level this week and something of a battleground for those looking for a return to a higher rate environment versus those playing for a break to retest the 2.30% low-yield mark. Thursday’s price action also corresponded with a shift in momentum as stochastics curled and crossed with higher yields ostensibly the path of least resistance. We’d love to have an especially strong bias on the next 10 bp from the 2.40% pivot point in 10-year Treasuries, but we are at a bit of a loss other than to simply let the process of consolidation play out while we await the passing of monthand quarter-end flows as well as the Japanese new year. We started the week with the line ‘we’re reluctant to have particularly strong conviction on the market at this point – sometimes just sitting on our hands until the bullish feeling goes away can be the best strategy.’ That was certainly the prudent move for half of this week, but the more informative aspect of this week’s price action has been local rangedefining extremes of 2.35% (low yield print) and 2.45% (40day moving-average).

As we contemplate the choppy nature of the price action within such a narrow range, we’re reminded of the market’s collective assumption that 2017 would be the most volatile year for the market that we’ve seen in a long time. Well, we’re nearly 25% of the way through and that certainly hasn’t been the case with all of the activity occurring between 2.30% and 2.63%. That’s not to suggest we couldn’t see a more meaningful break in either direction, in fact that’s what the market has been positioning for. The broader unknown is what will be the ultimate trigger that gets such a move underway. To be sure, the data hasn’t told a decisive story in either direction yet – but it really

all comes down to politics and the potential for Trumponomics to deliver and as we’ve seen thus far, that’s a difficult outcome to call.

… Tactical Bias … Looking to the week ahead, Friday’s employment report will be the main event and be preceded by the employment proxies to aid the process of skewing the risks for the BLS data. There is no coupon supply, but the Treasury Department will announce the upcoming 3-, 10-, and 30-year auctions. We’re anticipating $24 bn 3s, $20 bn 10s, and $12 bn 30s for a total gross issuance of $56 bn. This supply will be offset by a significant round of maturities totaling $76.8 bn, leaving a net paydown of $20.8 bn – a nuance to supply that should at least remove some of the bearish concerns from the auction process, if not leave one with a more constructive outlook.

US by about two and a half years. The eurozone output gap is closing, lagging the US by about one year. Eurozone core CPI is expected to accelerate from current levels, lagging the US by about eight months. Overall, nominal GDP in the eurozone has followed the US upwards since the ECB followed the Fed into quantitative easing (QE); the lag has been about three months over the long term. European yields have been rising with US yields, ahead of the improvement in EU data. This is also typical of this stage in the growth cycle because financial markets can be forward-looking in a way than economic indicators cannot be. The time in the cycle is approaching where EU yields underperform US, but it’s probably too early to position for that yet, because: (1) the US-EU spread typically does not narrow until the pace of US yield increases moderates; (2) long US versus EU has negative carry in intermediate and longer maturities; and (3) the ECB is expected to continue to suppress yields via QE and forward guidance for several more quarters.

Better is to benefit from the positive roll of EU forward flatteners vs US steepeners: the 10-year USEU spread is – perhaps surprisingly – positively correlated with the 2s10s box, because the front ends of the curves are more volatile than the back ends. With its 2.2bp/mth positive roll, we continue to favour 1y forward 2s10s flattener in EU vs steepeners in US. Key views and trades for the week

…US: Getting less fiscal The failure to repeal and replace Obamacare with the AHCA has led our economists to reduce the expected fiscal boost to the economy over the next two years. Rates have fallen and we expect mixed short-term forces to keep 10y USTs in their 2.31-2.62% range. We continue to favour positive carry positions and recommend paying 2s5s10s (1x1.72x1) 29 Mar 2017

Global Rates Plus: Economic improvement reaching Europe Euro area economic recovery is beginning: The euro area economy is following the US economy into a genuine (if unexciting) recovery. This is typical of what happens at the beginning of the growth cycle. Eurozone unemployment is falling towards the NAIRU, lagging the

The withdrawal of the AHCA – the Obamacare repeal and replace bill – has dampened expectations that the administration will push through its proposed tax reform, allowing USTs to rally. Our economists still expect a boost to growth from fiscal policy (worth 0.7% in 2018), but less than previously expected (see US: The Fiscal Agenda). In last week’s Global Rates Plus, we discussed the bullish momentum in the US rates market, technicals, and shortcovering as reasons to be patient before re-engaging in short duration positions. Structurally, we continue to expect higher rates in 2017, even with less fiscal stimulus, because:





Fundamentals: The synchronised global upswing in growth and inflation should see higher US rates, but not necessarily wider cross-market spreads as other regions catch up with US momentum and eventually policy dynamics. Fed tightening: Multiple Fed speakers have mentioned the possibility of four Fed rate hikes in 2017 (Evans, Rosengren and Williams on 29 March alone). We continue to expect balance sheet normalisation in early 2018.

Short-term market forces could be more mixed in their impact on rates, keeping 10y UST yields in their 2.312.62% range.  Cleaner positioning may be less supportive of USTs: CTFC positioning report on 21 March confirms our suspicions of short-covering. Speculative shorts on TY (10y UST) futures have dropped to their lowest level since late November, helping to explain the recent rally in bonds (top chart).  Overseas investment could be supportive of bonds: A new fiscal year and better yield differentials when USTs are hedged back into JPY (lower chart) should see inflows. Furthermore, risks of less fiscal stimulus could encourage other low yielding markets (EUR, GBP) to reconsider USTs. With the 10y UST yield expected to stay in the range, we still favour positive carry positions, including forward starting steepeners (2y fwd, 2s5s), long 5y TIPS breakevens, and are focusing more on relative value.

Short-covering of 10y UST futures sees yield fall below 2.40%

Yield differential attractive for JPY investors in new fiscal year

US: Hedging directionality in the 2s5s10s butterfly Tactical positions which carry positively are one way to benefit from a range-bound regime in the near term. The 2s5s10s 1x2x1 swap butterfly carries positively (+2bp over three months), but has masqueraded as a 5y swap for the last year (top chart). To be tactical, we would like to eliminate the rate directionality and trade 2s5s10s when it turns rich or cheap to fair value to the 5y. We accomplish this in two steps: (1)Develop a framework to hedge directionality:  Run a linear regression between the level of 2s5s10s 1x2x1 butterfly and the 5y swap rate.  Use the beta coefficient between the two factors to attempt to eliminate the directionality.  Regression: 2*5y – 2y – 10y = ß*5y+ε; where ß = beta coefficient and ε the residual.  Therefore: (2 – ß)*5y – 2y – 10y = ε and a butterfly weighted as 1 x (2 – ß) x 1 should reduce the relationship between the butterfly and the direction of the belly. (2) Identify the correct regime:  Continuing with 2s5s10s as the example, the top chart demonstrates the changing relationship between the 5y swap rate and 2s5s10s since 2003.  This dynamic is easier to see when different time periods are scatterplotted (lower chart), identifying six rate regimes: the 2004 hiking cycle, the end of the hiking cycle until QE, QE1 to QE3, QE tapering, the end of tapering to Brexit, and Brexit to present.  Each regime has its own beta, varying in magnitude and direction, and its own measure of the reliability of the regression (r-squared).

2s5s10s fly (1x2x1) has traded like the 5y rate for the last year

Chart 2: Fed pricing struggles, despite hikes

MBS: Short-term vs long-term flows The new fiscal year in Japan is expected to bring fresh demand for MBS as lower hedging costs have increased MBS hedged returns. In the longer term, however, the expectation of Fed balance sheet reduction should cause MBS outflows

Macro Matters

30 Mar 2017

BIG PICTURE: Synchronised global upswing Economic surveys suggest growth prospects are improving across both DM and EM, and point to a synchronised upswing. While there are some exceptions, momentum in world trade is at its strongest since July 2010.

Global FX Plus USD Expected to Fare Better in Q2

EURUSD at risk: April showers ahead for EURUSD 

 

We think the case for USD appreciation in 2017 remains strong, and it makes sense to add long dollar exposure during periods of reduced confidence in the outlook. Market participants have reduced EUR shorts and USD longs in recent weeks. We are adding a 2-month EURUSD put fly: buy 1x 1.0700 put, sell 2x 1.0450, buy 1x 1.0200 to our portfolio.

…Markets may be overestimating the significance of recent indications that the ECB is moving towards removing stimulus. While we think the ECB will deliver a hike in its deposit rate in September, for the time being it is likely to continue to emphasize policy accommodation. A Reuters story on 29 March cited ECB officials who supported this view, noting that Governing Council members are wary of triggering a premature tightening of financial conditions. A stable or weaker EUR is probably somewhat of a pre-requisite for the ECB to move ahead with its exit process. The bottom line is that, while US vs G10 central bank policy will become more synchronized moving into 2018, we have not yet seen the maximum extent of spread widening in the USD’s favour. For example, US 2yr Treasury yields are currently 200bp above comparable German yields; we expect this spread to reach 240bp by June and to peak at 260bp in Q4.

30 March 2017

THEMES OF THE WEEK Germany: Lessons from the “Dutch miracle” The late 1990s saw the Dutch economy experience a period of protracted overheating, dubbed the “Dutch miracle”. We see some striking similarities with Germany today and look at the lessons to be learned. India: Enough already The de-monetisation shock is now fading but, with only about a third of the fall in currency in circulation recouped, the banking system remains flush with liquidity. Reserve Bank of India is struggling to mop up the excess cash. Japan: No silver bullet for manpower shortage The labour force and employment levels have expanded in the past four years, but demographics mean that there is limited scope for the labour supply to grow and hence no magic pill to end the country’s manpower shortage. Brazil rates: Cut faster, go lower The BCB’s quarterly inflation report boosts the chance of a (larger) 100bp rate cut next time. Cyclical and structural factors will determine how far rates drop in the current easing cycle. We reaffirm our end-2017 rate call of 8%. Chile: IPoM to clarify on rates Recent policy moves were widely expected, but no consensus exists on the near-term outlook. We project no additional easing and expect the next meeting of the monetary policy committee (IPoM) to lend proof to our view

Global Daily Macro Monitor

31 March 2017 

Eurozone: Downward surprises in Spanish and German flash HICP prints pose a downside risk to our belowconsensus eurozone flash March HICP inflation forecast of 1.7% y/y.



US: February personal income and spending data are likely to show a slowdown in spending, suggesting a soft consumption print for Q1.



Brazil: The BCB’s quarterly inflation report boosts the chance of a (larger) 100bp rate cut next time. We reaffirm our long-standing, below-consensus, end-2017 rate call of 8%.

30 Mar 2017 09:32:26 ET

RPM Daily

Large Short Covering in Schatz In US, the short bias continues to increase on more hawkish comments from Fed speakers, with more than $2.5mln DV01 of new shorts added. Meanwhile, the market has become increasingly bearish cash, with large selling across the curve (with 2y positioning moving to max -5.0). Currently, the net short bias in cash is x4 greater than in futures. Meanwhile RPM finds investors have faded dovish curve positions in cash.

30 Mar 2017 08:55:06 ET

Weekly Supply Monitor Euro, US and UK Supply Outlook US There is no UST supply or cash flows next week.

US net cash requirement (NCR) over the next 4 weeks On a settlement date basis, the NCR is neutral over the next two weeks as there is no supply/ cash flows settling over this period (Figure 20). Figure 20. US weekly cash flow profile for next four weeks, USD billions

30 Mar 2017 15:25:11 ET

European Rates Weekly Is reflation a distraction? The reflation theme has waned as Trump optimism fades and inflation peaks. Global yields are not much higher because of it. Why? Because it was just a distraction from the real driver which is the struggle of central banks to escape the effective lower bound. The Fed is the latest to try, but the market still rallies after every hike. Euro inflation may fall sharply in the coming months. That likely means lower 5y5y inflation swaps on unanchoring and lower Bund valuations too. ECB doves are pushing back on policy sequencing, but the debate is only just beginning. … The reflation theme of the last six months has been propelled by expectations of Trump stimulus and base effects driving up spot inflation. It has led many to call – for the umpteenth time – that the great bond bull market is over. But Trump optimism is now beginning to wobble and inflation rates may be peaking. The foundations of the reflation sell-off are looking shaky to say the least. Reflation may just be the latest market theme to fade. It distracts from the real driver which is the struggle of central banks to escape the effective lower bound post

financial crisis. The Fed is the latest to try, but the market still rallies after every hike.

but the consistency of the post-hike rallies alludes to the pricing of policy error.

In Europe, reflation has taken nominal yields higher vs six months ago, but yields have remained very much anchored by the bigger picture, hence 10yr Bunds are still just 0.33% (and 10yr gilts – the one market where inflation is still rising – are just 1.12%). Scarcity has been a factor for Bunds (and Brexit for gilts), but yield curves everywhere are shouting loudly that central banks are likely to be powerless at the next recession. Low yields are here to stay. And it’s time for the market to start talking Japanifcation again, not reflation.

Figure 2. Treasury yields rally after rate hikes

Peak inflation does matter for near-term Bund valuations. The likely sharp fall in March HICP on Friday (looking for 1.6% YoY vs 2% in February) adds weight to our view for lower 5y5y inflation (targeting 1.4%) which, all else equal, will reduce 10yr Bund fair value to 0.15% on our models. Lower inflation in March will also keep the focus on the growing debate at the ECB on policy sequencing. Improving growth feeds the hawks while disappointing inflation feeds the doves. The debate may get louder in the weeks ahead. ECB sources suggest the 27 April meeting is too soon to change guidance. But, Draghi may have to acknowledge the growing debate in the Q&A. We stick with existing front-end euro shorts.

No escape The reflation theme has dominated for the last six months. Strip that away and you are left with global bond yields still stuck in low-yield ranges and central banks struggling to escape the effective lower bound. The inference being that if reflation fades – which seems to be the case – then the structural pull lower in yields can reassert itself. Figure 1 highlights the challenge. Low yields are here to stay with the market pricing central banks that are unable to create policy space to deal with the next recession. And hiking now can be viewed as locking in low inflation. That may well be the case for the Fed and Treasuries. The Trump sell-off was sudden and large. But, despite that, 10yr Treasury yields are only 12bp higher than just before the first Fed rate hike in December 2015. So 10yr Treasury yields are little moved despite +75bp on Fed Funds. This is illustrated by Figure 2 which also shows that the market rallies after every Fed hike. Positioning has played a role – with the market looking for more dots in March –

Peak inflation and Bund valuations The reflation theme has been built on expectations of Trump stimulus and higher spot inflation. Optimism for Trump is fading with time as policy implementation fails to materialise. And inflation may be about to peak. Base effects are nearly over as past declines in oil prices fall out of the annual comparison. For US inflation, 2.7% YoY in February may well be the peak. The inflation swap market prices a pullback to just below 2% in the coming months (Figure 3). February also looks like the peak for the euro area. The flash euro HICP estimate for March is out on Friday and low readings in Spain and Germany today point to a fall to 1.6% from 2%. That would be the first decline in the annual rate since April 2016. More importantly, the pullback could be quite sharp, with euro inflation swaps priced for inflation (ex tobacco) to drop below 1% by year-end. For the UK, the picture is different of course with peak inflation unlikely to be seen until Q4 thanks to sterling’s depreciation.

Net, the reflation theme doesn’t have legs as it loses credibility when spot inflation is falling. Figure 3. US inflation may have peaked…

30 Mar 2017 14:10:29 ET

North America Rates Focus The brave new world for tri-party repo? •



The DTCC has announced the expansion of its centralized repo clearing service to the tri-party market, a venue known as CCIT. Expectations of the richening impact on the repo market may have contributed to widening of swap spreads and OIS/Tsy spreads. However, we believe the proposal’s effect on the repo market is likely to be minimal due to the limited scope of participants and the limited balance sheet benefits for dealers. While there is potential for a larger impact on the repo market if the scope of the clearing platform broadens, we do not expect this to happen any time soon.

optimism in Bloomberg news stories. NISI peaked mid-December, well ahead of other indicators suggesting doubts about the reflation theme – see Figure 2 LHS. Also note that the ratio of total returns of stocks relative to bonds reached the 2000 peak recently, another reason for at least a pause (Figure 2, RHS). 2. Peak Reflation Optimism Predicted by NISI and Relative Returns

30 Mar 2017 11:48:42 ET

Global Macro Strategy Weekly Views and Trade Ideas – Buy the Dip? What Dip? 







Market over-exuberance on the immediate prospects for tax reform/ US fiscal stimulus has been followed by disappointment post the AHCA debacle. Advance warning was actually given by our own NISI, picking up fading Trump optimism in Bloomberg news stories. We see low, not high, volatility in any remaining consolidation absent big unforeseen shocks. However, we just haven’t seen enough pull back to want to chase stocks (or credit) yet. Given we believe in the reflation theme medium term, however, we still consider paying rates the optimal expression. Citi economists continue to anticipate that tax reform/ fiscal stimulus will be accomplished this year. What are commodities saying now about the reflation trade? Neither price action nor fundamentals in copper and iron ore worry us overly at the moment. In oil, price action appears attractive for bulls. Our preferred exposure is via a long NOK FX position, which appears cheap to both oil and rates. Elsewhere in FX, markets remain sanguine on EM with overall market volatility low and carry in vogue. Well guided Fed hikes, robust Chinese data, rangebound USTs and a softer USD all contribute to our (selectively) bullish EM view. Despite politics we’re actually more worried about BRL than ZAR in our longs at present due to positioning. We continue to like long MXN/JPY.

…Advance warning was actually given by our

own NISI, picking up fading Trump

…Which

Way Will The Recent UST Range Trade Break? Turning to rates markets, after yields shot higher immediately post-election, major bond markets have actually just traded in a range since December. On the 10y UST, this range comes in between 2.30-2.60%, with the topside resistance also reinforced by 2014 yield highs. We previously suggested a break below 2.30% would constitute a worrying double top formation, but for now it seems that yields have bounced higher from trend line support at around 2.35% (Figure 7). Figure 7. USTs: Just A Range Trade For Now?

As the market awaits Trump clarity, and for now was largely disappointed, positioning is surely one of the factors why yields were unable to

extend higher so far this year1. As we have shown before, UST positioning is stretched net short (Figure 8) but note how, more recently, this short is concentrated at the front end of the curve. As a matter of fact, at the 10y point, net shorts reduced by 80% since the start of the year. With long end positioning perhaps a bit cleaner, we remain exposed to higher yields for our medium term view assuming fiscal expansion is still on the horizon – see above. And if we dig a little deeper into UST price action, we still see that especially real rates are low in their historic range – a function of QE and as such something which has room to re-price if Trump delivers (Figure 9, LHS). Figure 9. Digging Deeper

30 Mar 2017 16:50:53 ET

US Agency MBS Focus Relative Value in Short Duration MBS Move to neutral from overweight 15s/30s. We move to a neutral from overweight on 15s/30s (Agency MBS Weekly, January 27, 2017). 15y performance has been remarkably resilient despite yield curve flattening and a decline in volatility since January, but the improved carry and wider OAS in 30s could reverse this. DW 3.0s could continue to outperform 2.5s until carry on the lower coupon improves. Hybrid-ARMs remain at historically rich levels to 15s and we maintain an underweight. The sector has asymmetric risks – little upside in a selloff but considerable downside in a rally. We recommend owning 5/1s over 7/1s and 10/1s, and Quicken pools offer more value than Tier 1 and Tier 2 servicers. Move to underweight 10y MBS. 10y MBS have richened sharply vs. 15s since we recommended an overweight in January. We now recommend an underweight on 10s, after turning neutral last month. 20s appear fair to 30s and we maintain neutral. For very short duration exposure floaters continue to look attractive despite recent tightening. PACs are beginning to look attractive on wider spreads and increasing risk of a rate rally. 31 Mar 2017 02:47:50 ET

Japan Rates Weekly FY17 yen rates outlook We also played around with term premia estimates this week. On the RHS of Figure 9 we show nominal 10y USTs against the spread between real rates and term premia i.e. “pure real rates”, perhaps a better cyclical measure for growth? Thoughts welcome on how to interpret this, but interestingly, it is back to pre-GFC levels and suggests we should be trading much higher nominal yields. Given we believe in the reflation theme medium term and consider rates the optimal expression relative to elevated equities, we hold our (pay 10y rates) trade for now but will continue to monitor the 2.30% yield support closely…

Range likely to be maintained but uncertainty still high We do not expect a change in the BoJ’s long-rate target and think yield curve control will limit movement in rates. We recommend an emphasis on the range trade and to prepare for the breaking of the range using options. Foreign currency funding costs are declining across the board, but it is unclear whether Japanese investors will increase investment in foreign bonds. 31 Mar 2017 00:36:35 ET

Global Economics View What Can and Will President Trump Do On Int’l Trade? 

Trump Administration to Launch International Trade Policy Blitz — In the wake of the AHCA vote defeat, President Trump is set to initiate reviews of current trade agreements and sign a number of executive orders on international trade. These actions may include significant changes to NAFTA, and



 

investigations into currency manipulation and trade abuses. Administration Poised to Use Delegated Powers to Influence Trade — Congress has delegated significant powers to the President on directing international trade policies and the new administration seems intent to utilize them. What Citi Expects — Trade wars and radical changes to trade agreements are unlikely, in our view, but remain risks to the global economy. Events to Watch – Aside from the various pending executive actions, the US Treasury is due to release its semi-annual report on the FX policies of major trading partners by end-April. Also Chinese President Xi Jinping meets with President Trump on 6-7 April.

with inflation still below target a May hike seems unlikely to us. We expect the ISM Manufacturing Index to increase again in March, rising to 58.5 from 57.7 in February. We currently see global industrial production growth peaking in Q1 before moderating slightly.

Deutsche Bank 30 March 2017

Special Report - Is there a Trump policy premium in US manufacturing surveys? 30 March 2017



US Economics: The Week Ahead Next Week's Highlights The FOMC minutes, the Employment Report, and the ISM manufacturing index are the key releases next week. The Fed hiked rates at their March meeting, but the median rate projections remained essentially unchanged and Chair Yellen noted the hike did not represent a reassessment of the economic outlook or the course for policy. However, the minutes could reveal a slightly more hawkish tone, in our view. New “fan charts” and bar charts that illustrate uncertainty and risks around FOMC participants’ economic and interest rate projections will come out together with the minutes. Uncertainty is likely to shift higher in the March release given the lack of fiscal clarity. Despite Yellen’s emphasis on an unchanged policy outlook, the risks could also shift marginally to the upside among Fed participants based on the recent rhetoric.

After two months of strong jobs gains, we expect payrolls growth to slow down to 190K in March, slightly below its three-month average of 209K. Average hourly earnings is expected to grow by 0.2% for the third consecutive month. The YoY measure is likely to decline to 2.7% from 2.8% given a relatively challenging base. We expect the headline unemployment rate to remain unchanged in March at 4.7%, but slack should continue to diminish gradually this year. This is the last employment report before the May FOMC meeting. A strong report could raise the odds of a rate hike in May, but



At this point the sharp divergence between hard and soft data in the US is well known. Less well understood is how much, if any, of the improvement in survey data is dependent on expectations for progrowth policy reforms from President Trump's administration. If this Trump "policy premium" is large, survey data may be at risk of softening in the coming months if there are policy disappointments out of Washington -- a development that could undermine the market's positive view on US growth momentum which has so far (rightfully) ignored weaker hard data and has instead focused on robust survey data. While the improvement in some manufacturing surveys is consistent with fundamentals, we find that others have risen more than can be justified by improving domestic and international economic momentum. This excess optimism in manufacturing survey data could represent a Trump policy premium. And the scope for a retracement in survey data is potentially large if policy changes disappoint. If we correct for the premium built into several surveys, it could lower real GDP growth forecasts based on survey data by about 0.5-0.75 percentage points. This would leave growth forecasts based on surveys at a still strong 2.5-2.9%, but below the 3.4% growth rate anticipated by projections that include this premium.

29 March 2017

US Daily Economic Notes Still tracking 2% for Q1 2017 real GDP…. Commentary for Friday: This morning’s personal income and spending data will hone forecasters’ estimates of current-quarter real GDP growth.

Consumption should rise slightly given what we know from the February retail sales and unit motor vehicle data. Retail control, which is a subset of retail sales and is a direct input into the consumption figure in the GDP accounts, is currently tracking 4.3% nominal annualized growth. Post inflation, this is broadly consistent with our estimate of 2.3% real consumer spending growth, down from a 3.5% gain in Q4 2016. …Regarding the outlook for interest rates, we expect two more 25 basis-point Fed rate hikes this year, in June and September. The December FOMC meeting will likely be used by Chair Yellen to announce the Fed's intention to begin tapering the reinvestment of Treasury and mortgage-backed securities next year. This will act as a de facto rise in interest rates as financial conditions should tighten in response to the announcement. We expect the yield on the 10-year Treasury note to move up to 3% by year-end. 31 March 2017

Special Report - Euroland Strategy: Communication turnaround 











The expected decline in the Eurozone March inflation print does not detract from our expectation of an improving outlook for core inflation. We expect the core inflation rate in April to be above the February level. There has been a significant reduction in French election risk as reflected in the chances assigned to a LePen win by bookmakers. Equity volatility measures have retraced back to early January levels while the OAT-Bund spread seems to be lagging. There has been concerted push back against an imminent change in sequencing from a number of ECB speakers including Nowotny. Compared to previous episodes of a turnaround in messaging this one has occurred on the back of relatively muted market moves. This suggests that the ECB is becoming increasingly wary of the impact of its communication especially ahead of the upcoming political events. From current levels we see limited room for the ECB to deliver a more dovish message at the April meeting. Even if there is no one-off hike to the deposit facility rate we see room for the money market curve to steepen. We maintain our Eonia 2Y fwd 1Y vs. 4Y fwd 1Y steepener. We update our analysis of the available universe of German PSPP eligible bonds. The analysis confirms that it is unlikely that the ECB will be forced to taper their QE programme very aggressively because of a lack of German PSPP eligible bonds. There has been a change in directionality between the level of rates and slope of the curve beyond the 5Y sector over the past few weeks. The bear

flattening of the 5s10s slope shows a significant change in regime which has been in place since mid 2014. We recommend a 1Y fwd 5s10s steepener. 31 March 2017

Japan FX Insights - JPY: Japanese investor flows now and next USD/JPY to trade in/around low-110s range supported by investors' dip-buying Long-term UST yields and the USD/JPY adjusted in January-February after rising on the Trump rally in November-December. Hopes that the adjustment would end with a US rate hike in March were disappointed; to the contrary the adjustment deepened, partly due to President Trump's failure to repeal and replace the Affordable Care Act. We look at moves by Japanese investors during that time, and how they are likely to act in the new fiscal year from April. The decline in USTs (rise in yields) in NovemberDecember last year was damaging to investors who had built up foreign bond holdings in recent years. The subsequent decline in French government bonds due to concerns about the presidential election in France dealt another blow. Unwinding of hedged foreign bond investment had a neutral impact on forex, while repatriation of funds from some unhedged foreign bond investment in January-February was likely bearish for USD/JPY.

31 March 2017

China Strategy Spotlight - Why & How Demand Recovers: Premature to call it a peak What we are saying to investors: Demand recovery & earnings surprise (p2-25) We expect domestic demand recovery to extend further, considering that: 1) manufacturing FAI may pick up visibly after years of cut in capex, payrolls, leverage and inventory, thanks to stronger industrial sales and higher asset returns; 2) consumption upgrade is to intensify in lower-tier cities due to both cyclical upturn (improving manufacturing job and household income) and secular

tailwind (household leveraging up and rising consumption propensity). We, therefore, believe it is premature to call it an end, instead we look for even stronger demand acceleration in 1H17, led by manufacturing FAI and consumption upgrade. Industrial profits/revenue surged 32%/14% in 2M17, reaching multi-year highs and implying another strong set of listco earnings in 1Q17, given their tight historical correlation. On FY16 results, MSCI China EPS improved to -1.3% in 2016 from prior -3.9%, beating consensus of -5.7%, but is largely in-line with our forecast of -0.9%. Ashare growth reached a multi-year high of 32% in 4Q16, a further sharp expansion from the 20% in 3Q16. Based on such strong FY16 and YTD results, we expect more analysts to upgrade their earnings estimates. We remain positive on Chinese equities and continue to see front-loaded returns this year. Key upside drivers are earnings upgrades and narrower equity risk premium in light of demand recovery. We reiterate our preference for Financials, Energy and Industrials, while underweighting Telecom, Utilities and Staples...

Published March 30, 2017

The Credit Trader: Lessons from 1Q and views for 2Q Performance    

After compressing in January and February, IG and HY spreads have decompressed in March. We continue to prefer IG vs. HY. Europe has been closing its performance gap with the US. Our European economists remain of the view that the odds of a populist win in France are low. The back end of IG curves is slowly steepening. We reiterate our preference for 7/10-year tenors. CCCs further outperformed. We remain underweight CCCs and overweight Bs.

Defaults and downgrades  

HY defaults continued their slow decline; a trend we expect will persist. Similarly, we continue to expect a benign environment for rating actions.

Technicals     

IG new issue volumes have had their strongest quarter on record, driven by a surge in bank bond issuance. HY issuance has also returned in force, with a notable increase in the CCC share. Record-high loan repricing volumes have resulted in significant carry erosion for investors. We still prefer loans over HY bonds. Except for HY, retail appetite for spread products has remained strong, with continued growth in the ETF complex. Dealers’ net inventories have made two-year highs, in both IG and HY.

…Record high repricing volumes and substantial carry erosion for leveraged loans. Loan repricing activity was very strong in the first quarter as issuers aggressively exercised their redeem option. According to pipeline data collected from S&P Capital IQ LCD, the combined outstanding of newly repriced loans reached a record high level of $228 billion in January, double the previous record of $113 billion reached in first quarter of 2013 (Exhibit 11). For investors, the ensuing carry erosion has been significant, at 17bp roughly cumulatively this quarter, which has offset the 15bp back-up in the 3month LIBOR (Exhibit 12). With 72% of the leveraged loan market trading above par as of the end of February, the robust demand for floating rate products will likely continue to stimulate repricing volumes and thus fuel more carry erosion in leveraged loan portfolios. Earlier in the year, we had envisioned a cumulative repricing drag on carry in the vicinity of 25bp cumulatively by year-end. The pattern shown in Exhibit 12 suggests the risks to this view are skewed to the upside. Still, our US economics team’s forecast of three hikes in 2017 followed by four hikes in 2018 and 2019 leave us comfortable with our view that the carry/ price return tradeoff is more attractive in leveraged loans relative to the HY bond market. Exhibit 11: Repricing volumes in the leveraged loan market reached record high levels this quarter…

30 March 2017 | 3:17PM EDT

31 March 2017 | 10:30AM HKT

US Daily: GSAI Moderates in March (Thakkar)

China: Higher official PMIs in March





The Goldman Sachs Analyst Index softened by 5.2pt to 51.5, but continues to signal expansion. The decline was primarily driven by a sharp drop in the materials prices index, but most sub-components also softened. The March decline in the GSAI is consistent with the modest pullback in survey data overall, following strong acceleration in recent months. Despite the pullback, analyst commentary remains generally positive about the pace of growth in business activity this year, in spite of a few sector analysts citing potential headwinds stemming from policy uncertainty and commodity price volatility.

Main points: … Judging from the NBS PMIs, March activity growth appeared to be solid, and inflationary pressures in the manufacturing sector softened. One caveat though is that the NBS manufacturing PMI tends to increase in March when the Chinese New Year holiday is at a similar date as this year. We will wait for other indicators such as trade and IP to confirm the trend.

NBS manufacturing PMI rose in March

Exhibit 1: GSAI Moderates Further in March

31 March 2017 | 5:21PM HKT

30 March 2017 | 10:08AM EDT

USA: Q4 GDP Revised Up to +2.1% on Stronger Consumer Spending; Smaller than Expected Decline in Initial Claims BOTTOM LINE: GDP growth was revised up two tenths to +2.1% (qoq ar) in the third estimate for Q4, reflecting upward revisions to consumer spending and inventory investment, though other details were mixed. Initial jobless claims edged down by less than expected. We believe that claims were once again affected by filings related to Winter Storm Stella.

Asia Credit Trader: Notes from Singapore: fear of missing out vs rising rates risk The direction of US treasury yields continued to set the tone for the Asia credit market. With 10yr UST yield stable over the past week, Asia credit spreads tightened across the board, with IG spreads around 5bps tighter and HY prices around 0.25pts higher. Primary market activity continued to be robust, with USD 7.4bn in new issuance. Next week there will be the meeting between the China and US Presidents, and key data to watch will be China foreign reserves and US payrolls. 30 March 2017 | 2:52PM BST

European Economics Analyst: The long march to Brexit — Three issues to watch 

Yesterday (March 29), the UK government triggered Article 50 and thus fired the starting gun on a twoyear negotiation towards the UK's exit from the EU. These negotiations will be complex and contentious. The open question is whether they will prove constructive or adversarial.









In the context of political negotiations in general — and EU negotiations in particular — process is an important determinant of outcome. Keeping track of process is central to understanding whether we will end up with a mutually beneficial agreement or a Brexit that is unnecessarily costly for both sides. Given each party has its own interests and domestic political constraints, EU negotiations inevitably require an element of compromise. By broadening the set of issues that the contracting parties can trade off against one another, two mechanisms underlying EU negotiations promote such compromise: (1) the principle that "nothing is agreed until everything is agreed"; and (2) the practice that agreement is only achieved at the last moment. Applying these mechanisms to the Brexit negotiation may improve the chances of a constructive final outcome. But they imply that few concrete decisions will emerge in the coming months. In the meantime, businesses are left in limbo. We identify three indications that would suggest Brexit negotiations are proceeding in a constructive rather than adversarial manner, increasing the likelihood of a benign outcome: a. Substantial discussions on a broader final agreement (including on post-Brexit trading arrangements) start before agreement is reached on the mechanics of the exit itself. b. The EU-27 show flexibility over the timing (and thus immediate magnitude) of payments to settle the UK's legacy liabilities to the EU, which would avoid them becoming an obstacle to constructive negotiation owing to domestic political resistance in the UK c. Most importantly, the UK government shows a preparedness to accept ECJ jurisdiction over any transitional phase after Brexit, even if this entails a political climb-down from its established 'red lines'.

March 30, 2017 Treasury Market Commentary

Daily Commentary, 3/30 …That easing in financial conditions in recent weeks and months was the backdrop for New York Fed President Dudley's speech on "The Importance of Financial Conditions in the Conduct of Monetary Policy," which, while more circumspect on the implications of recent easing in financial conditions than he had previously suggested before the first hike in 2015 the Fed would need to be, had a more hawkish tone than Chair Yellen's post-FOMC press conference in seeing risks for both growth and inflation shifting to the upside. His remarks came off like a bit of course correction by the FOMC leadership after the

dovish tone the market took away from the FOMC forecasts and press conference. In response, market pricing of a June rate hike moved up towards 50% in late trading. …Still, his discussion of risks to the outlook was notably more positive than Chair Yellen's positive but more cautious tone at her press conference. Recall that she downplayed several of the positive developments Dudley listed as supporting the March hike and raising risks to the outlook going forward, saying the Fed would not engage in "speculation" about what might happen on fiscal policy, warning of still a "set of very significant risks, medium-term, facing the global economy," and suggesting she wasn't closely monitoring developments in financial conditions in just saying "I think the conclusion" that "private sector analysts that produce financial conditions indices" have "reached is that financial conditions on balance have eased." As a result, Chair Yellen and the FOMC statement officially called risks to the outlook still just "roughly balanced" two weeks ago. Now, however, the FOMC Vice Chairman believes that "risks for both economic growth and inflation over the medium to longer term may be shifting gradually to the upside," and so it "seems appropriate to scale back monetary policy accommodation gradually in order to reduce the risk of the economy overheating, and to avoid a significant inflation overshoot in the medium term." There's still a lot of time between now and then, but June looks to be very much a live meeting in Dudley's mind, and we don't remember there ever being any meaningful divergence between the policy views of Dudley and Yellen, or at least none that he's ever been willing to express publicly.

March 31, 2017 China Economics

March PMI: Strong Growth, Softer Inflation Bottom Line: Official manufacturing PMI rose to its highest level since April 2012 and beat expectations, confirming that activity growth and the job market continued to gain strength amid external demand recovery, which provides room for policy makers to step up the pace of counter-cyclical tightening. Meanwhile, PPI YoY has likely softened in March on a higher comparison base.

March 31, 2017

March 31, 2017

FX Morning

US Economics GDP Revision

FX Daily Commentary, 3/31 … EUR has more weakness in store. The outlook for low yielding currencies remains bearish. Markets misjudged the ECB’s policy approach, now realising that ECB policy will have to take its lead from its weakest economic link, otherwise it risks EMU credit risks diverging further from here. This diverging credit risk has translated into very different monetary conditions between core and peripheral countries. Within a onerate-fits-all monetary policy and in the absence of harmonised and integrated fiscal policies, it is the credit risk which has been setting real rate levels. Concretely, Italy’s real rates are too high relative to the country’s lacklustre investment growth. Consequently, the ECB has to conduct a monetary policy allowing Italy’s real rates to moderate from here, pushing real rates within the entire EMU to much lower levels. This happens in Italy via a reduction of the credit risk and in Germany via a boost of its inflation expectations. Markets are now in the process of correcting their EMU real rate expectations and with the market long euros, we expect EURUSD to break below its February 1.05 low. We are GBP bulls . On the day the UK triggered Article 50, EURGBP topped out and now trades 2% lower. More weakness is in store with extreme GBP short positioning and valuation driving the pair lower. Today, EU’s Tusk will lay out the EU’s negotiation guidelines which will have to be adopted into Michael Barnier’s negotiation strategy. Interestingly, GBP continued its rally yesterday despite the EU Parliament laying out tough conditions for Britain to leave the EU. Tusk is unlikely to go beyond what had been suggested by the hawkish Parliament. We expect GBP to advance further from here, even outpacing the USD.

China has stabilised its economy with the help of expanding monetary conditions

…Incorporating these results, we see Q1 GDP growth rising 1.4% instead of 1.6%, largely as a result of a lower assumption for intellectual property products investment after the big cut to Q4. We'll update that Friday after release of monthly consumption results for February in the personal income and spending report and more underlying details from this GDP revision that don't get released until after the personal income report. We still see the trajectory into Q2 pointing to a reversal of the Q1 sluggishness with a 3%+ gain. … After-tax corporate profits on a GDP basis rose 9.5% annualized Q/Q, raising year/year growth to 15.7%. From the peak in 2014Q4, profits fell 18.3% to the low in 2015Q4, but with the subsequent rebound are now 5.4% below the 2014 peak. Much of the rebound from the low and all of the upside in Q4 came from overseas earnings, helped by the flattening out in the dollar since early 2016. Pre-tax "rest of world" earnings troughed in 2016Q1 and were up 14.5% year/year in Q4 after a 52.0% annualized quarterly gain to a record high. Profits from domestic industries bottomed in 2015Q4 and were up a more muted 7.5% year/year in Q4 after declining 7.4% annualized Q/Q in Q4.

March 31, 2017

The Oil Manual The Signal vs The Noise The lack of US crude inventory draws has been the dominant concern during recent investor meetings. However, examining less visible - but still reported inventories shows ~72 mln bbl of total oil draws globally since end-Jan. We expect this to gain momentum and see price risks skewed positively. Three concerns have been front and centre during recent investor meetings across Europe and the US: 1)

Why are US crude stocks building whilst the market is supposed to be tightening? 2) how fast will shale production rebound given the recent surge in the oildirected rig count? And 3) Will OPEC extend its production cuts beyond the end of May? Uncertainty over these three issues has driven the correction that started three weeks ago. However, this now appears to be coming to an end, and for good reasons: the incoming data has been more constructive than flat prices suggest. Less visible inventories have been drawing: For example, take inventories: in exhibit 3 we show the most comprehensive picture on global inventories that we can put together. It includes data for the US from the EIA, data for 'other OECD' from the IEA, China data from the Xinhua news agency, 'other non-OECD' data from JODI, and floating storage data from Reuters. As shown, total oil inventories (i.e. crude plus products) built in January, indicating a well supplied market. Beyond the end of January, we need to rely on those countries that have weekly reporting: the US, Japan, Europe (ARA) and Singpaore. The highly visible US crude inventories published by the US DOE have continued to built throughout February and March, by a relatively hefty 39 mln bbl. However, US product stocks have drawn by 52 mln bbl over that period. On top, Japan, Singapore and the ARA region (Antwerp, Rotterdam, Amsterdam) have shown draws of another 10 mln bbl in total oil stocks since the end of January. Finally, floating storage has nearly halved, falling 52 mln bbl from 119 mln bbl at the end of January to around 67 mln bbl at the moment, based on data from Thomson Reuters. Altogether, this makes for a total draw of 72 mln bbl in the last two months. US shale cost inflation appears to be accelerating: On the topic of US shale, our current forecast is for ~700 kbbl/d growth from 4Q16 to 4Q17. Given the increase in the oil rig count of ~14 units-per-week since midJanuary, risks to this number are skewed to the upside. However, even if exit-to-exit growth turns out to be 1 mln bbl/d, the impact on our average 2017 balance would probably be limited to a more modest 100 k/d as this growth is back-end loaded in the year. If this were to transpire, it would arguably be a greater risk to our 2018 balance.

Still, there are reasons to be somewhat wary about some of the very high

March 30, 2017 FX Pulse

Focusing on Commodity FX A higher USD against G10. The USD’s downward correction against low-yielding currencies such as the JPY and EUR seems complete. The Fed emphasizing its desire to hike rates gradually is not new; the USD is more sensitive to US rate expectations. In this respect, Friday's US labor market report is a key risk event which could push the USD higher against G10. We think EM can continue to rally as markets search for yield and fundamentals are somewhat stronger. USDJPY is the ‘cleanest' USD trade with the BoJ’s Deputy Governor Iwata suggesting yield curve management will remain in place until inflation has reached the BoJ’s target. Accordingly, the JPY should move lower as global reflation shows further signs of life. The reason the JPY did not follow this pattern over the latest quarter was that USD-based banks were able to provide new liquidity, contributing to the tightening in cross-currency basis. However, this arbitrage does not make sense at current levels, suggesting the global reflation theme may soon regain dominance in the JPY market. EUR follows JPY. Investors went too long euros too early. So far, the reasons for the bullish EUR story have not gone beyond cyclical economic recovery, leaving the success of this trade entirely in the ECB's hands. A fragmented banking sector and lack of fiscal integration leaves the ECB with few options other than to run monetary policy to fit its weakest economies. The EUR has to trade accordingly. Recent ECB communication expressing unease about recently rising EUR market rates and yields tells it all. The ECB views peripheral interest rates as too high. It has noticed that diverging

EMU credit spreads have steered monetary conditions within EMU into opposing directions. We stay bullish high-yield EM and GBP The cooldown in China-related commodities has recently eased some of the upward pressure on the AUDl However, bulk commodity prices and interest rate differentials remain fundamentally opposing forces for the AUD. We model the relative importance of these two, and our analysis suggests rate differentials and expected policy rates are highly relevant for the AUDUSD cross. With further downside to commodities on the horizon, we remain sellers of AUDUSD targeting 0.69.

Bottom line: EM assets should remain firmly supported as DM real yields remain low. The US economy looks strong enough to withstand a slower than expected pace of tax reforms. The anticipated rise in USD-denominated capital costs should be gradual, working in favour of higheryielding assets. Offshore USD liquidity conditions should remain supportive with USD-based banks using their balance sheet strength to arbitrage cross-currency basis swap spreads. The better USD liquidity conditions should remain supported even if commodity prices falter as China turns away from its ‘old’ commodity-consuming growth model.

Going into reverse. The globe has gone into reverse. Not so long ago the EM world caused worries while most of DM looked better, but now the opposite seems to be the case. EM inflows have reached record highs and may have further to go given that international investors have not reached 2012 levels of exposure, achieved when commodity prices where high and China was experiencing a 12% real economic growth rate. Strong EM inflows seem justified due to faster EM growth, and a widening differential to DM growth. (Exhibit 3)

March 30, 2017 China Economics Will the U.S. Grant Market Economy Status for China? Bottom Line: According to the Wall Street Journal (WSJ), US officials are preparing a review of China's "market economy status" (MES) and will announce the result soon. While the chance of the U.S. changing the status for China is very low, we think the upcoming XiTrump summit could provide a good opportunity for both countries to lay the groundwork for an economic and strategic grand bargain, including cooperation in key areas, such as opening China's service sector, facilitating US exports to China and Chinese investment in US infrastructure, as well as strengthening geopolitical stability within the region.

… Steady, but moderate, US growth...

Importantly, the US economy's output gap was already closing last summer, well ahead of the US elections. An economy with a closing output gap inspires ‘animal spirits’, and investment returns at the start of an investment cycle tend to be highest. The US economy has seen its capital intensity crashing over recent years which, combined with higher employment, has pushed productivity lower. Now as wages rise leading to a shift in relative factor costs, US capex is likely to break higher. Fiscal and social reform delays may weaken the anticipated shift towards higher US capital spending, but will not derail it. Hence, we do not see a slower pace of US reforms as a negative factor for risky assets. Instead, the more slowly reforms are implemented, the longer the US may be protected from exuberance, capital misallocation and rising USD capital costs.

31 March 2017 –

Flash Economics At what level will US long-term interest rates becom a problem for the euro zone? The upward move in US long-term interest rates is likely to be continuous, due to the rise in inflation, the monetary policy tightening by the Federal Reserve, and the effect of the policies that the Trump administration probably will conduct.

his rise in long-term interest rates in the United States is partially spreading to the euro zone. We seek to determine at what level of US long-term interest rates Germany, France, Spain, Italy or Portugal would be in trouble, by using as criterion the position of long-term interest rates relative to nominal growth and the average yield of bond portfolios.

MARCH 30, 2017

if, according to this calculation, the dollar 10-year interest rate exceeds:

FI WEEKLY

  

5.2%, Germany would be in trouble; 3.9%, France would be in trouble 5.6%, Spain would be in trouble.

The interest rate is already too high as regards Italy and Portugal.

NatWest Markets Closing Notes

March 30th, 2017 Recap and Comments: Treasury yields pushed higher throughout the domestic session today, with 10s giving back nearly all of yesterday’s rally. The move was led by the long-end, with the bond selling off by 4.5 bps and pushing 5s30s steeper for only the second time since the March FOMC (chart). The Treasury moves were consistent with what seemed to be a modestly risk-on tone as the S&P 500 increased by 0.3 percent. US dollar performance was somewhat mixed as it strengthened against the yen and euro, but fell against the pound. Oil rallied for a third day with Brent trading around $53 per barrel and closing at its highest level since taking a sharp drop on March 8th following a larger-than-expected inventory build (chart). It was tough to pinpoint any particular driver for today’s modestly upbeat tone as today’s marquee domestic data release was a significantly dated update to Q4 GDP and comments from Fed speakers were fairly uneventful. However, comments from NY Fed President Dudley should be hitting the wires shortly after the publication of this note so there might still be a chance for some lateday sparks.

THE SLEEPING BEAST Bonds are asleep, supported for the moment by central bank caution, Trump’s problems in executing policy and seasonalities. So the 4m range in Treasuries and Bund is holding. But the next two months will be more threatening for longs as US data improves, political risk in Europe ebbs, and investors refocus on progressive central bank exits from easy money.  With the US healthcare bill shelved, the focus is now

on the FY17 budget. The next risk is a government shutdown that would trigger a flight to safety, but we see the odds as low. This leads us to recommend a short position in the 5s10s30s fly to implement our bearish views, along with 2s10s curve steepeners outright. Time to re-set conditional EUR shorts. Official and “anonymous” ECB talk and weaker-than-expected German CPI drove down ECB rate hike expectations. But the ECB rates normalisation theme will inevitably return sooner or later, along with QE tapering. So now is a good time to add to conditional bearish trades in EUR. We also question the flat structure of the Eonia curve in the 23y sector in a context of accelerating growth and a quickly vanishing output gap.  Brexit has made GBP rates vol look again more like

EUR. The 2-5y curves in both currencies remain strongly directional, but forwards price GBP bear flattening. This results in value in zero-cost proxies of GBP 2-5y conditional bear steepeners.  Risks of a hard Brexit are likely to keep the MPC on

the sidelines, anchoring the UK gilt front end. The flatness of the gilt curve out to 10y makes less sense given rising inflation, ratings risks and our G4 bond bearish view there is scope for re-steepening of the gilt curve.  With

the first round of the French elections three weeks away, we still like selling French CDS; BTPs are holding well, but we see Italy CDS richening into year-end.

Graph 1. Treasury speculative shorts have been cut back

from the 2.90% and 3.85% obtained in the last update of the model on 19 January, reflecting improved macroeconomic fundamentals. Adjusted fair values, which take into account the effect of the global low-yield environment on the US curve, are currently at 2.40% and 3.50%, respectively (see Graphs 8a-b), also up roughly 15bp relative to the mid-January update. Graph 8a. Adjusted fair value model for the 10yT

United States

The way forward With the healthcare bill shelved for now, the focus quickly shifted to fiscal year 2017 budget, as the current CR is due to expire on 28 April. While the odds of a government shutdown have declined, we believe a few hurdles still need to be overcome. Previous government shutdowns have led to a flight to quality into Treasuries, with the belly leading the way. We could see similar price action this time, with 10yT dipping below 2.25% in the event of a government shutdown. Despite these risks, we continue to hold a short duration bias. While the “Trumpflation” trade seems to be gradually deflating, recent Fed speakers continue to lean towards two or three more hikes this year, which is not currently priced in. We continue to like the steepener theme, but recommend hedging for a more hawkish Fed scenario conditionally.

Graph 8b. 10yT fair value model residual

Recommendations Hold or add to 2s10s steepeners (in swaps, consider 6m or 9m forward steepeners). Shorting the belly through the 5s10s30s fly. Long 3m10y versus 3m2y vega-weighted straddles. Hedge a June hike scenario with 3m fwd 2s10s bear flatteners expressed by buying a 3m2y payer atm+10bp and financing it by selling a 3m10y payer atm+20bp. … Since the mid-1990s, we have had three instances of a federal government shutdown. The shutdown in November 1995 came about when President Clinton vetoed the CR, causing the government to be shut down over 13-19 November 1995. The second shutdown was shortly after, from 15 December 1995 to 6 January 1996. The third was during President Obama’s term, from 30 September to 17 October 2013. This coincided with the debt-ceiling crisis, which exacerbated the impact on the bond market. Looking at the bond market’s reaction to prior episodes of government shutdown, it is not surprising that in every instance bonds rallied as investors flocked to their safety (see Graphs 2 & 3). The rallies were led by the belly, with the 2s10s curve bull flattening and the 5s30s curve bull steepening in the days leading up to the government shutdown (see Graphs 4 & 5). We could see similar price action this time, with 10yT dipping below 2.25% in the event of a government shutdown. … Trade recommendations An update of our fair value model for Treasuries yields 10y and 30y fair values of 3.10% and 4.05%, respectively. This is up

… Duration-wise, therefore, we continue to recommend trading the range with a short duration bias (see our FI Weekly form 5 January, where we first argued this view), taking advantage of upticks into the bottom of the range (and into rich territory – under the 2.40% fair value for the 10yT) to add to shorts. … On the curve, our near-term expectation is for the front end to stay anchored, and for the belly to lead the way the way in a sell-off. On bullish moves, however, we may see the belly and the back end moving somewhat in tandem. This is because a bullish bias could contribute to a further unwinding of the Trump trade, capping the potential for bull steepening of the back end. Outright, we continue to like 2s10s steepeners (we see the curve as too flat relative to the level of the 10yT, by roughly 10bp – see Graph 9) and find value in shorting the belly in through the 5s10s30s fly (where we see the 20yT roughly 4.5bp cheap versus the wings – see Graph 10). Carry on these positions is positive, by roughly 5.7bp/3m for the steepener and 2.3bp/3m for the fly (see here). We favour expressing these positions in both Treasuries and swaps. Swap expressions would find further support in a scenario of spread widening led by the belly, which is our core bias for spreads in 2017 (see our 2017 FI Outlook). For the 2s10s curve steepener in particular, we think it is attractive to express the view in the forward space, as we think the market is unlikely to realise the forwards (see Graph 11).

MARCH 30, 2017

The ECB is dampening hopes/fears of a 2017 hike

FX WEEKLY YIELD HUNTERS STILL SEARCHING FAR AND WIDE FOMC members have been actively trying to avoid the market getting too dovish in its assessment of Fed policy. ECB members have been trying to avoid the market interpreting their remarks as being in any way hawkish. Expectations micro-management keeps volatility down, ranges intact and sets investors off in a search for yield, (almost) anywhere they can find it. There’s a lot of central bank communication going on this week, in the absence of significant economic data. In the US, central bankers appear to be leaning against any downward revision to expectations about the path of future rate hikes. The market was briefly pricing the odds of a solitary further move being higher than those two. This week’s comments from FOMC members appear to have sorted that out (for now, at any rate). By contrast, ECB Council members are leaning against the market’s inclination to price the possibility of rates being slightly higher by year-end. The net effect is that the Fed has succeeded in putting a floor under Treasury yields and in the process a floor under the dollar, while the ECB has managed to cap yields and the euro. Volatility-junkies are not amused. Investors are looking further afield and over March as a whole, the top currencies were the Mexican peso, the Russian rouble, the Polish zloty, Indian rupee and South African rand. The rand is tricky as in the midst of the current Zuma/Gordhan showdown, but we’d like to buy a politically-inspired sell-off and the others are all currencies we like. If FOMC and ECB guidance keeps major bond yields in ranges at relatively low levels, investors will go looking for yield elsewhere.

Pricing of Fed moves: 2 more hikes good, 1 hike bad?

30 March 2017

Market Musings The Government Shutdown Risk 



In order to avoid a government shutdown, Congress must pass a continuing resolution (CR) bill by April 28. We expect negotiations over a government shutdown to go down to the wire. Democrats are threatening to vote against any CR that includes amendments de-funding Planned Parenthood or funding the building of a border wall. Thus the only viable option is a “clean” CR—an option not popular with conservative Republicans. Ultimately we believe that a shutdown will be averted at the last minute as a “clean” CR is passed. The market reaction to a shutdown has historically been a small decline in rates even as risk markets remained largely unfazed by the 2013 shutdown. The impact could be more pronounced this time around, however, as a shutdown would provide further evidence of disagreement on Capitol Hill, weighing on the perceived probability of tax reform occurring in the coming months.

…What are the market implications? With the risk of a shutdown remaining elevated in the near-term, we see several implications for markets:





Flight to quality: The 2013 government shutdown lasted for 16 days. Equity markets did not decline substantially ahead of the shutdown and actually rallied during the shutdown period. Fed pricing was nevertheless pushed out, with the market’s expectations for the first rate hike delayed by 6 months in the month prior to the passage of a CR (Figure 1). Lower likelihood of tax reform: While the 2013 episode did not significantly dent risk assets, a government shutdown this time around could be more impactful. A shutdown would serve to remind markets of the contention on Capitol Hill and highlight the disunity within the Republican party. We suspect that a government shutdown could prove more negative for risk assets than the 2013 episode suggests, with markets likely pricing in lower odds of tax reform being completed in 2017. While we expect a positive economic backdrop and ongoing Fed rate hikes to keep yields buoyed, a delay in the timing or decrease in the scope of tax reform could push Treasury yields lower in the near-term.

so much attention. To further add to this view, these rapid moves are following long periods of relatively low sentiment. Six of the nine measures we analyze were well below their long-run averages prior to the election. Most of these survey measures are now at post-crisis peaks. Business confidence—buoyed by high policy hopes—is the most noteworthy The most elevated of all survey measures is the NFIB's Small Business Optimism Index. Generally, the somewhat stronger performance of business surveys relative to consumer indicators likely in part reflects heavy expectations for pro-business government policies down the road. On this note, the NFIB survey was taken prior to failure of the repeal and replace of Obamacare. It is unclear how this will impact the NFIB and other surveys (including consumer ones). Financial well-being likely plays a strong role in driving sentiment measures Our simple statistical work shows that the underlying pattern of consumer survey measures resembles consumer spending. Similarly, we find that the underlying pattern observed for large firms looks similar to corporate profits.

30 March 2017

US Economic Perspectives Are Soft Data Predicting a U.S. Boom? "Soft data" have recently captured the imagination of forecasters and analysts Since the U.S. Presidential election last November, survey measures (i.e., soft data) for both consumers and businesses have been recording impressive gains. The performances of these surveys have led many to wonder if these movements in sentiment will eventually translate into actual activity. In other words, are soft data telling us a boom in economic growth is on the way?

Soft indicators in isolation point to strong growth in 2017:Q1 of 3.7 percent Our simple survey-based model shows very strong GDP growth for this quarter at a year-over-year rate of roughly 3.7 percent. Our own Q1 tracking estimate of 1.25 percent quarterly growth at an annual rate would be consistent with 2.1 percent growth YoY. Taking this estimate, the positive gap between expected growth from the surveys and where growth is tracking is the largest it has been in a decade and close to the highest it has been in 30 years. This is also true if we compare the implied growth from survey measures and the potential growth rate of the U.S. economy.

Survey measures are high but not historic Survey readings across the board are indeed relatively high by historical standards (all are well above their longterm averages) but we are by no means in unprecedented territory. Business surveys are currently on average 1.3 standard deviations above their longterm averages and consumer surveys are 1.1 standard deviations—elevated but not extreme.

In fact, extended overprediction of soft data does not happen too often Our model has actually diverged from actual growth since the middle of 2015. Soft data running far ahead of growth for this long is historically quite rare. The only other major time this occurred was in the mid-2000s and in this case, the survey measures corrected downward toward growth as we headed into the Great Recession. Given the few times soft data have behaved this way in the past, it is hard to say what to expect going forward. The hard data over the last few months cast doubts on a boom being the likely road ahead.

Yet the recent movements in surveys are quite noteworthy While the levels of surveys are not unprecedented, the movements we have seen over the last several months have been particularly rapid. These rapid changes are one reason we believe the soft indicators have received

…Moreover, when comparing the expectations of the model to actual growth, it appears that periods of soft data predicting stronger than actual growth for this extended of a period are relatively rare. The only other major period where this occurred was in the mid-2000s, when

surveys eventually corrected downward. Given limited historical experience, it is hard to say whether the expectation today is that hard data will move up to the soft data or if the opposite will occur. The data so far for 2017:Q1 do not make a boom seem all that likely in the nearterm.