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March 20, 2018

BECAUSE: The way to get good ideas is to go through LOTS of ideas, and throw out the bad ones…

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Mon 3/19/2018 4:51 PM

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March FOMC Preview Stephen Stanley Chief Economist

Attached is a preview of the March FOMC meeting, including a discussion of the economic and dot projections and FOMC statement. …Any changes to the dots and statements language are likely to be in the hawkish direction, though I would expect that the new information will be more evolutionary than radically different. …there is likely to be some upward migration in the individual dots for 2018 from December to March. However, I look for the median dot to remain 2.125%, implying three quarter-point hikes for the year…

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improving conditions were the rise in participation and flows from unemployment to employment. The labor market differential and rise in hours offset weakness in hourly earnings and part-time employment. The Barclays Indicator of Labor Market Momentum rose by 0.08 points and is down a modest 0.05 y/y. Factors supporting momentum were hours worked, employment, initial claims, and temporary help. Offsetting this were the rise in participation (relative to its underlying trend) and NFIB hiring intentions. Labor markets are consistent with a mature cycle. Current labor market conditions are above those reached in 2006/07. At the average monthly rate of improvement over the past two years, labor market conditions will exceed the 2000 peak in about 10 months, or by the end of 2018.

Risks of a hard landing are rising. The Fed characterized its outlook for the labor market as “solid” in December at the time of its last economic projections, which, in our view, is a nod to how far unemployment has fallen below its longer run level. Sizeable fiscal stimulus is likely to keep the unemployment rate on a downward path as we do not see the pickup in participation as likely to continue.

FIGURE 1 Barclays Indicators of Labor Market Conditions and Labor Market Momentum

19 March 2018

US Labor Market Monitor Labor market conditions improve in February amid strong hiring The Barclays Indicator of Labor Market Conditions and the Barclays Indicator of Labor Market Momentum both improved in February. Our indicators were stable at the turn of the year, but strong hiring and flows from unemployment to employment have pushed our labor market conditions index to recoverylevel highs. • The Barclays Indicator of Labor Market Conditions rose 0.11 points to 1.20 in February. The main factors

March 19, 2018

Lyngen/Kohli BMO Close: Something's Gotta Give A descending triangle formation in 10-year yields is becoming more pronounced and while we’d love to see another test of the upper (and lower) bounds of the formation to give us more confidence in the

pattern, we expect that the market will respect the upper and lower boundaries until the Fed offers a reason to break in either direction. Key levels we’re watching are 2.884% at the top and at a yield bottom of 2.793% which will be far more significant in indicating a break to much lower yields. The history of such formations means we’re biased to see yields trade lower (though that is our wont). Volume bulges at 2.819% and 2.863% in 10s provide the bookends to the nearby trading ranges and offer the key levels worth watching before we focus on the broader technicals.

19 Mar 2018 07:46:25 ET

US Economics Flash FOMC Preview: Gradual hikes now, faster pace later 

Tactical Bias: We remain biased to see some pressure on the front-end and belly later this week as the runup to the FOMC and the chasm of data are likely to keep that event at the center of the market’s focus. Our views are in line with the consensus in expecting a hike at this meeting with additional hikes likely telegraphed either this year or next. For one, markets are not likely to wait until June or September to price in a Fed that is believable and if investors truly expect that the Fed will hike four times this year, 2s and 5s will be a good deal cheaper than they are now. Aside from the obvious takeaway of the dot changes and whatever narrative emerges from the event, one of the most important facets will be Powell’s reaction to the markets. We’ve often drawn sharp contrasts between the handling of the presser by the two former Fed chairs with Yellen letting the statement speak for itself (after a few early stumbles) and Bernanke intervening more forcefully to correct large moves in the markets. We also noted in prior research that while Bernanke could be counted on to correct a market reaction that was too severe, in nearly every situation with a presser, markets continued on their initial path after a Yellen conference, only pausing long enough to hear her out.

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A 25bp rate hike at the March 21 FOMC is fully priced and almost universally expected. The hawkish/dovish takeaway will hinge on revisions to “dots” indicating the appropriate level of short term rates at the end of 2018, 2019, 2020 and in the “long-run.” We expect the 2018 median dot to stay put but the 2019 median to move higher. Our call remains for three 25bp rate hikes in 2018 and three in 2019.

US Rates at the Bell March 19th, 2018 Traders Tab:

Citi Econ FOMC Preview: (Full Report: http://citi.us/2ppvaDO) - A 25bp rate hike is fully priced and universally expected. This means the hawkish/dovish takeaway will hinge on revisions to “dots” indicating the appropriate level of the policy rate at the end of 2018. 2019, 2020 and in the “long-run.” We expect the 2018 median dot to stay put but the 2019 median to move higher. 

Recap & Discussion: …Data-wise, the slate was completely barren,

which left USTs generally sympathetic to riskassets (though not entirely an effective hedge in real-time). EGBs closed largely unchanged (Gilts underperforming), as a “decisive step” in Brexit negotiations was articulated by the EU's chief Brexit negotiator Barnier (GBP +0.9%, EUR +0.5%), while ECB ‘sources’ did a 180 from last week’s inflation-related pessimism, saying that “the debate is shifting from guidance on QE to

interest rates”. The key phrase was the speculation that “with policymakers comfortable with market forecasts, including for a rate hike by mid-2019, the debate is increasingly about the steepness of the rate path thereafter.” As for tomorrow, the main focus data-wise will likely be on the February inflation report in the UK with CPI, German PPI, and then the March ZEW survey. Initial expectations are for a dip to 13.5 from 17.8, with European markets remaining relative (and outright) underperformers YTD as EU PMIs have come off the DEC/JAN peaks. 19 Mar 2018 10:37:08 ET

RPM Daily Short Covering But Still Short 

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In North America – Long cash (+1.1) / short futures (-3.1): Short covering and flattening flows dominated last week, with around $7m DV01 added to the long side. However, one-sided short positioning is still very much in play with large shorts and profits held at the front end. Meanwhile further out (TY/FVs), short positioning remains vulnerable, with 20% of the large short base (of 50mln DV01) remaining offside. In Europe – Long cash (+1.1) / short futures (-0.5): Large buying flows over the week (with around $18m DV01 added to the long side) as Europe outperformed. However positioning remains lighter (relative to the US) with long end flatteners still in place. In Equity / FX – S&P (+1.8) / EUR (+1.5) / Credit (2.8): The long equity and short Dollar positioning has lightened up as investors closed out positioning. Meanwhile short momentum remains intact in short credit (given large profits).

19 Mar 2018 22:33:03 ET

Municipal Weekly What’s the new normal for long municipal ratios?

Key municipal developments 

Bloomberg reported that Americans age 65 and older will outnumber Americans age 18 and under by 2030. The imbalance is a structural reason for sickly pension systems nationwide, to go along with economic and political reasons. When this milestone is

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crossed, it will be the first time in US history that senior citizens outnumber children. The American Public Transportation Association said canceling the Capital Investment Grant New Starts program will affect 53 different projects. The federal program, part of the Federal Transit Administration, is up for elimination under the White House’s 2019 budget proposal. The total investment between the 53 mass transit projects is expected to be $52 billion unless the program is cut, as in the proposal. The cuts would presumably be made in part to create spending room for the White House’s new infrastructure investment plan. The White House also wants to eliminate TIGER grants. The Transportation Investment Generating Economic Recovery grants have been quite popular since they began in 2009, totaling $5.6 billion and being awarded in all 50 states. The grants continue to be awarded in volume even as the future of the TIGER program is called into question by the Trump Administration’s budget proposal.

What’s the new normal for municipal ratios? 10YR and 30YR municipal Treasury yield ratios are hovering in the late 80s and late 90s, respectively. Now, even if we believe that long ratios are cheap in light of the dramatically low supply, we are unable to utilize a statistical model to support this belief because such relationships are useful only during steady state market conditions and not across periods of changing market dynamics. But more importantly, have long ratios crossed the Rubicon i.e. taken the irrevocable step towards generally higher levels? We present our expectation for long ratios post TCJA using a qualitative analysis. … So yes, ratios are cheap vs. historical averages but that does not tell us much. This is because post TCJA, supply-demand dynamics have changed dramatically and historical averages have limited use. Diminished demand from crossover buyers such as P&Cs and banks has led to the cheapening of the long end over the last quarter despite sharply higher MMD yields. This is largely due to the fact that these buyers require higher yields from tax-exempt paper in order to maintain the same tax-equivalent yields (or gross-up factors). Given that banks account for a large portion of all municipal holdings and specifically long-dated, tax-exempt holdings (Figure 11), their reticence has been especially bearish for the long end of the tax-exempt curve.

… So what’s new fair value for 30YR ratios? Our assessment of the fair value of 30YR ratios prior to TCJA was around 93%, and 30YR ratios generally traded near this level during periods of normal issuance andnormal market volatility. Post TCJA, if corporate-based investors such as banks and P&Cs were to require the same tax-equivalent yields or gross-ups, ultra–long dated (30YR) taxexempt municipal yields would need to increase by about 60bp vs. other taxable high grades to keep tax-exempts attractive in terms of relative value (Figure 12). Given that banks and P&Cs together account for 35% of 20YR+ holdings (Figure 11), the net impact on yields should be about 35% x 60bp = 21bp, i.e. overall, 30YR municipal yields should cheapen by 21bp. So what would the net change in ratios? With 30YR TSY at 3.08%, using the pre-TCJA 30YR yield ratio of 93%, the 30YR AAA yield should be .93 X 3.08% = 2.87% Adding 21bp to 2.87%, the new required 30YR AAA MMD yield should be 0.21% + 2.87% = 3.08% Thus, it seems like the new post TCJA fair value of 30YR ratios is about 100% (i.e. 3.08/3.08). Let us consider the possibility that municipals are granted HQLA 2B status. In our last report2, we calculated that the net impact on 30YR MMD to be about 8bp (i.e. the long end would richen by 8bp due to an increase in bank demand). In this case, the anticipated 30YR MMD yield should 3.08% 0.08% = 3.00% This equates to a new 30YR yield ratio of 97% (i.e. 3.00/3.08). Admittedly, the calculation is a bit rough but this is our best attempt in the absence of a reliable statistical model. 19 Mar 2018 13:30:50 ET

UK Economics Flash Brexit Update – Cause for Optimism, But No Break-Through “Decisive” progress? – At their joint press conference today, Brexit negotiators Michel Barnier and David Davis reported “decisive” progress. While this sounds helps our optimistic view on the negotiations, today’s announcements look more

like ‘steady progress’ than a break-through to us. Barnier highlighted that there is plenty of work to do on crucial issues such as the Northern Irish border and the role of the European Court of Justice (ECJ). However, if Barnier paints a positive picture for the EU27 leaders at their summit on Friday, he should receive a mandate to expand talks to future trade relations, a politically important step for the UK.

Geopolitical Headwinds: U.S., Iran, and North Korea Time to Worry? By Tina M Fordham Chief Global Political Analyst

20 Mar 2018 00:13:44 ET - After a period of disinterest, investors are starting to take notice of political risk. Tina Fordham has been cautious in our approach to highlighting political risks with the potential to move markets, noting previously that it would take a large-scale macro global political risk to disrupt markets. In this Opinion piece, she looks at whether the recent geopolitical events are a storm in a teacup or whether alarm bells are starting to go off.

19 March 2018

European Economics Quick Take: The UK and the EU agree on a transition deal The UK and EU have reached a broad deal on Brexit transition terms, as we had expected.  Positive for UK growth: Our above consensus growth forecast for the UK in 2018 (1.8% vs consensus 1.5%) was partly based on a status quo transition period being agreed with the EU. Today’s deal provides confidence to our growth forecast.  Two BoE hikes in 2018: This should also clear the way for the BoE to hike rates in May and this week’s BoE meeting (22 March) should firm up those expectations. We expect 2 BoE hikes in 2018 (one in May and other in November).  Points to soft Brexit: Today’s deal adds conviction to our call that the UK is heading towards a soft Brexit.

20 March 2018

Early Morning Reid Macro Strategy

Deutsche Bank 19 March 2018

Special Report - Assessing the upcoming 10y TIPS reopening The US Treasury will conduct a reopening auction for the TIIJan28, the onthe-run 10y Treasury inflationprotected security, on March 22nd. As expected, the offering amount will be of $11bn, which will add to the TIIJan28’s current inflation-adjusted outstanding value of $15bn (Figures 1 and 3). The past 10 reopenings in the 10y sector show that 10y TIPS start cheapening, on average, about 12 business days prior to the auction with yields increasing about 8bp as the auction approaches (Figure 3). Looking at movements within the 40-day window of the auction, the yield of the TIIJan28 has so far been moving sideways.

19 March 2018

Fed Watcher - FOMC preview: Dots drifting higher The FOMC meeting will be the main event this week. Given that the Fed is widely expected to raise the funds rate another 25bps, the main focus will be the latest Summary of Economic Projections (SEP), along with Fed Chair Powell’s inaugural post-meeting press conference. In a close call, we expect the Fed to converge to our forecast of four rate hikes in 2018, driven by an increase of twotenths in the median projection for 2018 growth to 2.7%, with a corresponding one-tenth fall in the unemployment rate to 3.8% and a one-tenth increase in inflation to 2.0%. Importantly, we expect the entire path of rate hikes to shift up modestly, with the median dot for 2019 rising two-tenths to 2.9% and the terminal rate forecast rising to 3.3% in 2020. For a detailed discussion of this week’s Fed meeting along with a complete recap of our expectations for the SEP, please see our latest Fed Note.

…That tech tantrum seemed to ricochet across other markets with the likes of the S&P 500 (-1.42%) down for the fifth time in the last six sessions, and the Stoxx 600 (-1.07%) and DAX (-1.39%) also down prior to this in Europe. The VIX also spiked above 20 at one stage before paring back at the close to finish just above 19, albeit up 3pts from Friday. Credit indices weren’t immune either with CDX IG and iTraxx Main about 1.5bps wider while 10y Treasuries rallied nearly 5bps from early highs and Gold was up about +0.70% from the lows as safe havens were quick to outperform. So some decent moves. Yesterday might well be an isolated case but it fits in with our view that we are likely to see more tantrums in markets this year, certainly relative to the incredible calm that was 2017. Indeed, it’s fairly amazing that the S&P 500 has now seen 16 days of plus or minus 1% moves in either direction since the start of February, which compares to only 10 occasions through the 13 months ending in January.

19 March 2018

UK economic notes - Brexit update: transition agreed and progress made on Northern Ireland This morning EU Brexit negotiator Barnier confirmed that a 21 month status quo Brexit transitional deal had been reached with the UK. This would begin at the Brexit date of 30th March 2019 and end on 31st December 2020. In reaching the transition, the UK also agreed to the principle of the EU's backstop solution for Northern Ireland after Brexit. This is a bigger surprise, and while details have yet to be agreed, enhances the credibility of today's deal. Northern Ireland backstop agreed in principle Three weeks ago the EU released its draft legal text for the Brexit withdrawal agreement and transition. The most controversial aspect concerned the status of Northern Ireland. The EU's draft protocol specified that Northern Ireland would remain part of a joint regulatory area after Brexit in areas that affect the functioning of the Good Friday Agreement, meaning the North would effectively remain part of the EU's Single Market and customs union and raising the prospect of a hard border between Northern Ireland and the rest of the United Kingdom.

We wrote at the time that Northern Ireland was most likely to derail a transitional deal this month, and Prime Minister May ruled out signing the EU's legal text immediately after its release. Today, the UK has backed down, agreeing to the principles of the EU's backstop option for Northern Ireland, although not all of its operational implications. UK Brexit Secretary Davis reiterated at today's press conference that the UK's preferred solution to the Northern Ireland border remains a close enough future UK/EU relationship that no hard border is needed, or technological solutions. Despite this, today's developments are a positive. We had expected a generic commitment to transition from the EU but with the status of Northern Ireland and the draft legal text deferred until later in talks. By contrast, today's commitment to the legal text lends more credibility to the transitional deal. In terms of other aspects of the transition, the UK has agreed to most substantive EU demands including citizens rights, which will be extended in full to December 2020, the 21 month length of the transition (the UK had sought two years) and the continuing role of the EU acquis and ECJ, although some governance issues remain to be decided. In return, the EU has agreed to allow the UK to sign third country free trade deals during the transitional period as well as help the UK to roll over its existing trade agreements…

20 March 2018

UK Strategy – Transition The confirmation that a status quo transition deal has been reached between the EU and UK, with positive details concerning the Northern Ireland border, significantly reduces the risk of a cliff-edge Brexit Decreased probability of a no transition outcome should be associated with higher UK real rates thanks to the BoE's ability to remain hawkish and reduced likelihood of inflation passthrough due to sterling weakness Valuations for the BoE's terminal rate appear excessively rich at 1% below neutral at the 3Y1Y point. Positive progress on transition, resilient UK data and rich valuations suggest the UK terminal rate can reprice. We enter a paid position in 3Y1Y Sonia Into this week's BoE meeting, focus will be on the extent to which the BoE presignal a further removal of stimulus "over the coming months." Though May is now 85% priced, the MPC may err on the side of caution and include such language if they do expect to hike in May Transition supports the view that shorter dated Gilts can continue to cheapen on ASW. The 5Y area of the curve was well supported by foreign reserve manager rebalancing flows following sterling's post referendum depreciation. Transition reduces the likelihood of similar GBP weakness and suggests a moderation in the momentum of rebalancing flows The UK long end has led the global compression of term premia over recent weeks, with the 5s30s beta adjusted slope back in line with end 2017 lows. The recent cheapening of long end cash to sonia coupled with sharp Libor-Sonia basis widening points to a specific long end sonia receiving flow driving the current move

We enter a paid position in 3Y1Y Sonia and maintain Feb-19May-19 MPC steepeners. As a hedge to a shift in the market's precise scheduling of near term MPC hikes we stay received Nov18 vs Aug18 and May19 MPC dates. We stay short 5Y cash on ASW vs Sonia, but exit our UKT 5s10s flattener vs Sonia following the recent performance. Further out the curve, we exit the GBP 5s30s steepener (70% 5s) and at the ultra long end maintain UKT 30s50s steepeners.

March 19, 2018

Monday Morning Outlook The Powell Fed: A New Era In the history of the NCAA Basketball Tournament, a 16th seed has never, ever, beaten a one seed...until this year. But, on Friday, the University of Maryland, Baltimore County (UMBC) beat the University of Virginia – not just a number one seed, but the top ranked team in the USA. We don't expect the unexpected, however, when the Federal Reserve finishes its regularly scheduled meeting on Wednesday. Based on the federal funds futures market, there is a 100% chance that the Fed will boost the federal funds rate by 25 basis points, to a new range of 1.5% to 1.75% The markets are even giving a roughly 20% chance that the Fed raises rates 50 basis points. That's better odds than UMBC had, but we suspect it's highly unlikely given that this is Jerome Powell's first meeting as Fed chief. …In December, the median Fed forecast was that the jobless rate would reach 3.9% in the last quarter of 2018 and remain there in 2019 before heading back to 4.6% in following years. We're forecasting the unemployment rate should get to 3.3% by the end of 2019, which would be the lowest since the early 1950s. Beyond 2019, it's even plausible the jobless rate goes below 3.0%, as long as we don't lurch into a trade war or back off tax cuts or deregulation. We doubt the new Fed forecast gets that aggressive, but with the jobless rate already at 4.1%, faster economic growth should push Fed forecasts well below 3.9% in spite of faster labor force growth. For the Fed, lower unemployment rates mean faster wage growth and higher inflation. This may force a change in the Fed's "dot plot," which puts a dot on each member's expected path of short-term interest rates. Back in December, the dot plot showed a median forecast of 75 basis points in rate hikes this year –

basically, three rate hikes of 25 bps each. Four Fed officials expected four or more rate hikes in 2018, while twelve expected three or fewer. This time, we expect the dots to show a much more even split between "three or fewer" and "four or more." At present, the futures market is pricing in three rate hikes as the most likely path this year, with a 36% chance of a fourth rate hike (or more). Look for the market's odds of that fourth rate hike to go up by Wednesday afternoon, which means longer-term interest rates will also likely move higher. In addition, the markets will be paying close attention to Jerome Powell's performance at his first Fed press conference. With journalists planning "gotcha" questions, some negative headlines could result. If so, and if equities drop, the smartest investors should treat it as yet another opportunity to buy. Since 2008, the Fed has embarked on unprecedented monetary ease. Rather than boosting the actual money circulating in the economy, however, quantitative easing instead boosted excess bank reserves, which represent potential money growth and inflation in the years ahead. The Fed has decided that it can pay banks to hold those reserves, and not push them into the economy. Four rate hikes in 2018 mean the Fed will be paying banks 2.5% per year to hold reserves. Never in history has the Fed tried this. The jury is out. The Fed thinks it will work, we're not so sure. The odds of rising inflation in the next few years, because of those excess reserves, are greater than the chance of a number 16 seed beating a number one seed. Granted, that's not high odds, but we suggest investors, especially in longerdated fixed income securities, should be worried. Stay tuned.

19 March 2018 | 11:26AM EDT

Global Markets Daily: Post-VIX postscript: Is Liquidity the New Leverage? (Himmelberg) 

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Where is there complacency in this expansion? And where might complacency be hiding unappreciated risks? We see clues in Monday, Feb. 5, when the VIX had its largest one-day move in its history. We suspect the Feb. sell-off is symptomatic of rising “financial fragility”, meaning price volatility that arises not from changes in fundamentals, but rather from breakdowns in markets themselves.

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Specifically, we worry that trading liquidity may be worse than it looks because trading volume in many major markets is increasingly dominated by more speed and less capital. So far market breakdowns have been short-lived, but like the unwind of financial leverage in the last cycle, we worry that future liquidity disruptions may amplify price declines when the current cycle turns.

Market Views A fast start for the Powell Fed. We expect a fairly hawkish hike from the Fed on Wednesday. The SEP is likely to show higher GDP growth projections for 2018, 2019, and longer-run, as well as a lower unemployment path and a modest inflation overshoot in 2020. We expect the median dot to show four hikes in 2018, up from three at the December meeting. Additional hawkish changes—a move to three hikes in 2019 or an increase in the longer-run funds rate estimates—are also possible but not our base case. The Fed’s “fast pace” shouldn’t disrupt markets. While we expect the Fed to continue tightening once a quarter through end-2019, this “fast pace” is still half as fast as most historical hiking cycles. Rising rate expectations notwithstanding, the risk of inflation is still not high enough to justify “murdering” this expansion. Thus, while we expect more hikes in the next two years than the market is pricing, we also expect the pace of growth will be sufficient to allow markets to absorb the expected pace of rate hikes without disruption (“No Motive for Murder: One Less Risk to Markets”, Global Markets Daily, Jan. 12, 2018). 19 March 2018 | 7:08PM GMT

GOAL Kickstart: Near-term worries and their hedges Some near-term risks to our pro-risk asset allocation are: (1) a sharper growth slowdown than we expect, (2) material trade war escalation beyond our base case and (3) rising rates becoming more disruptive to risky assets. We are staying Overweight equity amid these risks given we expect the growth level to remain strong, even if growth momentum fades. But we would actively hedge these risks. (1) Growth slowdown: Given diversification desperation taking hold across asset classes, it is likely that hedging growth risk will increasingly need to be done by directly hedging downside risk in the growth asset equities. As we wrote last week, we would buy correction hedges at

times when vol resets lower (for example, S&P 500 97/93 put spreads we have discussed in the past). Our options colleague has also highlighted equity vol appears low in Europe (Exhibit 31). For example, VSTOXX is now at one of its lowest levels ever compared with the VIX (Exhibit 3). (2) Trade war: It is difficult to hedge a trade war via sectors or regions because the exact nature of the escalation isn't known in advance, and hedges often hurt in the base case. For example, while EM has the largest beta to global trade and may suffer most in escalation, in our base case we expect EM to outperform. One trade war hedge we like is long breakeven inflation. In the case of trade war escalation, inflation expectations could rise as supply chains and competition are disrupted, and uncertainty about inflation could rise, increasing inflation risk premium as well. Given late cycle pressures our base case expectation for breakeven inflation is also to the upside (Exhibit 3). Also, for those already underweight nominal bonds, we recommended being long TIPs to hedge.

(3) Rising rates: We think further rate repricing will cause tighter financial conditions and hence lower long-term growth expectations. As a result, rising rates could be disruptive to risky assets, depending on how they rise. Rate volatility continues to appear too low to us, particularly for intermediate maturity bonds (Exhibit 31). After the pick-up in rate volatility in January, rate vol has again returned to levels it was at towards the end of last year (Exhibit 4). As a result, we would position for 10-year yields rising above the forwards and for rate vol to rise, which could weigh on risky assets. 19 March 2018 | 4:20PM EDT

Wage Survey Tracker:

19 March 2018 | 1:27PM GMT

European Economics Daily: Sizing the first rate hike out of negative territory 

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USA: GS Economic Indicators Update Wage Tracker:

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Our base case for the size of the first two increases in the ECB's Deposit Facility Rate (currently at 0.40%) is 20bp. We expect 25bp standard-sized hikes subsequently (once the zero-threshold is reached). We do not expect the first 20bp hike to come until the second half of 2019. We see a case for ECB keeping the size of its first rate hikes as close to normal as possible and to thus stay on hold until conditions warrant a normal-sized hike: the ECB's ability to steer the short-term rate path relies on the effectiveness of its forward guidance. The most powerful element of this is its sequencing commitment that policy rates will remain at present levels 'well past' the end of net asset purchases. Once a hike is implemented, this part of the forward guidance is no longer valid. This favours close-to-normal sized (late) initial hikes rather than small-sized (early) hikes. Our base case expectations reflect this thinking. Our second preference is for the first rate hike to be 15bp in size, followed by 25bp hikes. The drawback is that (i) the first hike is small and therefore should come earlier, and (ii) that the difference in size between the first two rate hikes makes it more difficult for markets to anticipate both the size and timing of ECB policy changes. The advantage is that the standard 25bp step size it attained earlier. We see less of a case of having four initial hikes of 10bp each to reach the zero-threshold. This approach implies a large shift in the size of each hike when eventually moving on to standard-sized (25bp) hike path. This complicates communicating the forward path to the market. The logic of making small cuts when the effective lower bound is unknown within negative territory does not apply to hikes.

March 19, 2018

JEF Economics

Monday Morning Recon …This week is all about FOMC and Powell’s first news conference. Powell was very upbeat and optimistic during HH so we will see if he continues that tone in the press conference. We will be watching the Fed dots closely and especially the 2018 and 2019 dots to see if the median gets increased. Treasuries are very range bound so hopefully Powell shakes things up. Any hawkish tune and we should push higher in yields and flatter on the curve… …The Week Ahead in the Bond Market: Treasury This Week ,,,Coupons: Treasury will announce 2-, 5-, and 7-year note auctions at 11:00AM on Thursday. We expect that the size of the 2-year auction will be bumped up to $30 bln from $28 bln last month while the 5- and 7-year auctions will be unchanged at $35 bln and $29 bln, respectively. The auctions will pay down $3.5 bln in cash when they settle on April 2nd, though there will be a total of $16.6 bln in Fed add-ons.

March 19, 2018

US Economics & Rates Strategy: Treasury Market Commentary, March 19 UK yields push higher following positive headlines on a Brexit transition deal but the move is short lived as political uncertainty weighed heavily on US equity markets. Long end European periphery continue to perform led by Spain. US 2s30s Yield Curve flattens as 10y rises 1bp to 2.855%.

… US rates traded heavy across the curve in the early morning as the 10y yield pushed 3.5bp higher to 2.88% on positive Brexit headlines. The move was short lived, however, as yields declined as much as 5bp from the peak into the early afternoon before pushing gradually higher in yield in line with the better equity market close. The 10y rose 1bp to 2.855% while the 2s30s and 5s30s Yield curves closed slightly flatter on the day at 77bp and 43bp, respectively. The Fed remain priced for 3 full hikes through the end of January 2019 heading into Wednesday’s FOMC decision.

…GDP tracking We continue to track 1Q GDP at 1.7%.

March 20, 2018

FX Morning Hans W Redeker … A difficult Fed job. Against this background, the Fed's task of ensuring price stability and employment will not get easier. Theoretically, trade duty-related price increases should be transitory, suggesting the Fed would concentrate on weaker growth and its long-term impact on price stability. Nonetheless, dealing with deflationary and inflationary shocks simultaneously can lead to policy errors. Remember in the early 1970s, the oil price shock which made the Fed overestimate the US economy's growth potential allowed the otherwise transitory oil price increase to develop cost push inflation. Import tariffs work like a supply restricted oil price increase, with the only difference being that tariff revenues support the US fiscal position while the oil related price shock allowed mainly Middle Eastern oil producers to increase their savings which, in the form of petrodollars, were recycled back into global markets and economies. JPY reaction function changing…

….is why USDJPY has held up. Exhibit compares the evolution of Japan's net investment into foreign long-term debt with net money market flows from Japan. The bond sell-off witnessed over recent months came alongside a volatility spike in equities and bonds. Japan was selling some of its bond holdings into this volatility spike, but cautiously took advantage of higher rate differentials, pushing funds into non-JPY-denominated money markets. Interestingly, money market flows seem to lead bond flows by a year. Should volatility stay muted within the current risk sell-off, the US bond market could see inflows from Japan, weakening the JPY.

Money market flows suggest Japanese investors could buy US bonds again

US Rates Strategy • With fewer dots contributing to the calculation of the median (15 dots for the 2018~20 period and 14 dots for the longer run), the movements of each dot become more important for projecting the median. As a result, we encourage investors to place more emphasis on movements in the mean of the dots in each year and the longer run instead of movements in the medians. • We continue to suggest UST 2s30s flatteners. If the dot plot shows a much larger increase in the 2018 and 2019 mean dots than in the 2020 and the longer-run mean dots, as our economists expect, then we expect the yield curve to flatten in response

March 15, 2018

FOMC Preview: A Hike and Hawkish Bias | US Economics & Rates Strategy We expect the Fed to hike its target range by 25bp at its March meeting with a hawkish bias in its projections. While too early to call for 4 hikes this year, the FOMC moves decisively in that direction. Our strategists suggest maintaining UST 2s30s curve flatteners. At the conclusion of the March 20-21 meeting, we expect the FOMC to: • Raise the target range of the federal funds rate to 1.50-1.75%. • Acknowledge fiscal stimulus while continuing to see "near-term" risks to the outlook as "roughly balanced". It will also continue to stress it is monitoring inflation data "closely", given the continued shortfall vs. goal. See our side-by-side mock-up of potential changes to The March FOMC Statement. • Change the SEP to include faster growth with corresponding lower unemployment rate, but leave core inflation unchanged. We also look for the median assessment of longer-run unemployment to move lower. • Show a pronounced upward drift, but leave the median number of hikes at 3 this year, raise the median path to 3 in 2019 and leave 2020 at 1. We think the longer-run neutral rate remains unchanged, though it is a close call.

16 MARCH 2018

Financial Market Weekly CHRISTOPHER S. RUPKEY, CFA

FED’S 2018 INTEREST RATE FORECAST DEAD AHEAD: TWO HIKES, THREE HIKES, FOUR HIKES OR MORE? The million dollar question for Powell’s first Federal Reserve meeting as Chairman in March is whether the economy is still strengthening enough for policymakers to raise the interest rate hike forecast from three times in 2018 to four times. The market thought it heard Fed Chair Powell say he would raise rates four times this year, one step beyond the Yellen Fed’s three rate hike forecast made last December, when Powell gave his Monetary Policy Report testimony before the House on Tuesday, February 27. The second million dollar question is why the 3-month Libor yield, the only shortterm “money market” yield that real people pay, is soaring ahead of the Fed’s widely expected 25 bps rate hike to 1.75% on March 21. Three-month Libor was 1.60% on December 14 the day after the Fed raised rates to 1.50%, a 10 bps spread, which okay, it is what it is. But now 3-month money is already 2.20% just before the March Fed meeting which is ahead of the game and will be an even wider spread of (2.20-1.75) 45 bps even after they indeed pull the trigger and raise rates 25 bps to 1.75% on March 21. In other words, investors are interested in, or at least market commentary and financial news coverage is focused on three or four rate hikes this year, but the greater concern should be what the heck is going on with soaring short-term borrowing/funding costs as represented by 3-month Libor. Didn’t we put the Libor trader criminals in jail already? Then why are short-term borrowing costs still moving up? Natural market forces not dealer manipulation? Whatever. Higher short-term rates certainly are not going to make America great again and lead companies to borrow and invest more in

our future. 3-month Libor closing the week at 2.20% we mean. Three or four hikes in 2018 means the 1.5% Fed funds rate ends the year at 2.25 or 2.50 percent. Important news certainly, but the valuation of 10-yr Treasury yields might depend more on where the Fed sees rates at the end of 2020. 2020 being closer to the final maturity date of the current 10-yr Treasury in February 2028. The December median forecast said the Fed funds rate would be 3.1% at the end of 2020, which is 3.25% more or less. Bond yields cannot rise too far beyond this level even with the talk of the Treasury needing to auction as much as $1.5 trillion in “bonds” in fiscal year 2019 starting on October 1. We are still forecasting four rate hikes this year. This seems to be the most sensible course, raising rates at each of the four regularly scheduled Fed press conference meetings, eliminate the guessing game about which meeting they would take a pass, and just bring rates up to more normal levels at a measured pace. If they do move it up four times in 2018 to 2.5% it leaves them in a bit of a pickle about what to do in 2019? We don’t think the too-low inflation, go-slow on rate hikes crowd at the Fed was completely scattered by Powell’s 4-hikes, “the economy is strengthening,” testimony in February. Although we were a little taken aback by Fed Governor Brainard’s more hawkish comments at Money Marketeers on March 6, which seemed to signal a change in her view that falls more into line with the Fed Chair’s testimony. She said the strong headwinds against the economic recovery had “weighed down the path of policy,” but that now the headwinds have turned into tailwinds. Sounds like she would not be against a faster pace of policy normalization…. …MARKETS OUTLOOK A quiet week despite the flow of news, perhaps waiting for the Fed decision on Wednesday, March 21. Yields were already falling for the week ahead of the 0.2% core CPI number with its unchanged 1.8% year/year rate on Tuesday. Maybe bonds rallied further, though that’s a stretch, on a second month of weaker retail sales for February on Wednesday morning. Dow industrials fell 248 points on Wednesday, closing up just 0.2% year-to-date, and bonds finished the day at 2.82% the low close for the week.

Desk Strategy

US Markets Closing Notes, March 16th 2018 Cross Asset | Strategy Daily 19 Mar 2018 Recap and Comments: … it’s worth highlighting that the prevailing question through today’s price action was about the lack of clear “risk off” price action in both Treasuries and FX markets in response to the US equity weakness. To be fair, Treasuries did rally off their morning lows, though the move certainly feels muted relative to the moves across US equity indices today. One possible reason for this relates to the FOMC decision on Wednesday, as sectorspecific weakness (even if pronounced) seems unlikely to derail the FOMC from tightening this week or signaling further tightening to come. Fed Chair Powell and his colleagues made clear through their commentary in February, most notably in Powell’s semi-annual Congressional testimony on Feb. 27th, that the FOMC did not see the jump in volatility in equity markets as posing a clear risk to the economic outlook (and, in turn, the appropriate path of rates.) In fact, one line that stood out to me in Powell’s testimony at the time was that the financial stability picture “shows, at most, modest risks.” So barring a substantial and severe shock, an unlikely event in the next two days, the current weakness is unlikely to move the needle for the Fed.

Desk Strategy

The Velocity of Excess Dollar Liquidity FX | Insights 19 Mar 2018 We believe in cross asset funding cycles which connect G10 FX to the drivers of synchronised growth, EM-DM capital flow and global asset-liability effects (more here). These funding cycles are partly dependent on global

bank and corporate access to USD funding, which would be threatened at the margin (along with broader risk assets and financial conditions), by a deterioration in the velocity of excess dollar liquidity. The velocity of excess dollar liquidity is the pace at which reserve balances in the Federal Reserve System and currency in circulation are growing. That’s impacted by a range of factors discussed below and in turn it impacts the dollar via the ability of global growth to benefit from the drivers of the cross asset funding cycle (more here), as well as the tightness of USD funding markets including cross currency basis and FX forwards. We have constructed a measure of the velocity of excess dollar liquidity shown below, which leads the dollar. The velocity of excess dollar liquidity has been decelerating, led by the combined lagged effects of the Fed running down its balance sheet, increased treasury issuance, treasury cash balances rising, Fed SOMA (system open market account) holdings falling and quarter end funding. The monetary base is getting smaller and excess liquidity is declining, creating a shortage of USD in funding markets. This note is to highlight a short term risk to our longer term bullish EUR/USD view, which the recent widening in LIBOROIS has emphasised. We remain longer term EUR/USD bulls, as the multiplier effect (more here) supporting synchronised growth should be reasonably independent of the velocity of excess dollar liquidity. We entered long in October at 1.1840, with a 1.33 target and 1.1350 stop. Tactically we are wary of the potential for USD strength and higher FX volatility on the back of a sharp turn in the velocity of excess dollar liquidity. Cross border dollar funding, driving global growth, has been historically prevalent in Asia Pacific (more here). Therefore as a tactical hedge we enter USD/KRW longs in the 1 month NDF at 1072.50, target 1113, stop 1054.45. Recent widening of LIBOR-OIS has a mixed historical relationship with the dollar. Its impact depends on the drivers of the widening. Increased issuance has been partly responsible, which over a multi-quarter period is a US twin deficit story. Longer term, non-economic actors are building a structural USD short in funding markets, which is driving synchronised growth. This is something we analysed in our January FX Alpha note here. The biggest short term threat to this process is a slowdown in the velocity of excess USD liquidity.

Desk Strategy

The Fed Watcher

Economics | Policy Flash 19 Mar 2018

FOMC Preview Expect 25bp hike, close call whether 2018 median dot moves up The FOMC meets March 20-21 to debate monetary policy. Another 25 basis point hike in the funds target is widely expected. We expect the communique will have a similar tone to the prior edition. The greater uncertainty centers on whether the FOMC’s median year-end 2018 “dot” moves up, signaling that four (rather than just three) rate hikes are likely to be appropriate this year. Our base case is for no shift in the 2018 median dot at this time, but it’s a very close call. Even if the median 2018 dot does not change, we expect the year-end 2019 dot, which in December guided for two additional hikes next year, will increase in March to show that three hikes are now seen to be appropriate.

Desk Strategy

CFTC Commitment of Traders Analysis Cross Asset | Flows Flash 19 Mar 2018 •

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Velocity of excess USD liquidity is a leading indicator for the USD Source: NatWest Markets

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This week’s CFTC CoT report covers up to March 13th, which means that these data cover the BoE and ECB decisions as well as the February NFP. The data also pick up the final text and signing of the President’s steel and aluminium tariffs. In rates, speculators turned more positive on the longend of the curve. Indeed, speculators as a whole either trimmed shorts or added to longs in TYs and out in the latest week, most clearly in the US contract (+$14.75bn). In the belly, speculators also pared back short positions in the FV contract, where shorts had climbed to a record large last week. By investor type, levered fund positioning changes clearly favoured the long-end while asset managers cut longs in both TY and US contracts. The reduction in the asset manager TY long position ($5.92bn) comes after asset manager TY net longs reached their highest level since 2010 last week. In FX, speculative accounts continue to reduce their JPY short position, which was pared for a fourth consecutive week in the latest report. EUR longs, meanwhile, were extended this week and now sit just shy of the all-time large spec net EUR long position established in early February. Specs also increased

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net long positions in both GBP and MXN. Changes in spec positioning in the commodity dollars were modest, though specs did flip to (small) net shorts in both AUD and NZD this week. In both cases, those net shorts readings are the first since January. All interest rate future numbers in this report are in 10yr equivalents.

MARCH 20, 2018

GLOBAL EQUITY COMPASS STRONG 4Q17 REPORTING SEASON, BUT 2018 LOOKS SET TO BE HIT BY FX Invest with SG Earnings Momentum Strategy Basket Following the 4Q17 reporting season, we update our basket of 20 European stocks that had: i/ reported sales higher than consensus estimates, ii/ positive EPS momentum, and iii/ no increase in relative forward P/E. Since March 2017, our basket has outperformed the Stoxx 600 by 13% (see p.5). Positive but weak momentum in the US The 4Q17 reporting season did not disappoint, with 88% of US companies having reported EPS above or in line with consensus expectations (vs the historical average of 85%), a positive trend also confirmed at a sales level. Overall, EPS grew c.12% in 2017, and consensus now expects EPS to grow by 18% in 2018, courtesy of US Tax Reform. However, while consensus has revised up its 2018 EPS expectations 8% since mid-November, 2018e EBITDA was revised up only 0.5% vs the USD index down 3.2%. The Stoxx 600 has delivered its strongest earnings growth in seven years, with annual growth of 14% despite headwinds from a higher euro Due to recent strong upward revisions in 2017 EPS estimates, only 57% of Stoxx 600 companies published EPS in line with or above expectations (versus the 10Y average of 62%). Looking forward, the consensus only expects EPS to grow by 8%, as forex headwinds should build up. However, in contrast to the US, 2018e EBITDA has been revised up by 1.5% for the EuroSTOXX (SXXE) and 3.6% for the FTSE 100 since mid-November. We maintain our preference for eurozone equities over US equities, and favour equities exposed to the eurozone consumer. Japan looks set to register strong realised earnings Japan had a decent earnings quarter, with 55% of companies reporting above or in line with the consensus. While the number is higher than average (51%), EPS growth revisions for FY18 (March 18 ending) have been revised up, suggesting stronger earnings growth than the previous three fiscal years.

16 March 2018

Market Musings FOMC Preview: Too Soon for Four •

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Along with yet another 25bp hike, Fed officials should sound somewhat more upbeat at the March FOMC meeting, with the balance of risks now skewed to the upside. But the median dot is likely to remain at three hikes for 2018 in our view, even as the distribution drifts higher — which may be dovish for a market anticipating the Fed could indicate four hikes for this year. We do expect a higher median 2019 dot, rising to three hikes. We also see some risk for the median longer-run dot to shift up to 3%, but in our base case it remains as is. On the outside chance that Powell announces a press conference at every meeting, the knee-jerk market reaction would be sharply hawkish.

• Rates: Rates have fully priced in the March hike and a total of 3 hikes in 2018 and a neutral rate of 2.65%, which is not far from the Fed's median dots as of December. Given the sharp repricing higher of rate expectations in recent weeks, we think that an unchanged 2018 and long run dot should modestly bull steepen the curve. We are long 3y Treasuries and in 5s-30s steepeners. •

FX: Though the USD has lacked a major directional impulse recently, we think the USD stands to be tactically supported. We look for gains to be concentrated against the dollar bloc and the EUR, while the JPY may be the outlier.

19 March 2018

Global Credit Strategy Is US corporate leverage higher than reported? Matthew Mish, CFA Key questions The state of US corporate balance sheets and the outlook is one of the key debates for fixed income investors. The consensus is, while we are in the later stages of the US credit cycle, a recession is not on the horizon. We agree. But we believe identifying those pockets within credit markets where credit and leverage growth has been excessive is crucial to capturing a potential inflection point in the credit cycle early and to calibrating the extent of the fallout. Where are US corporate credit market excesses? A focus on loans Our view is there are three corporate credit market imbalances in this cycle. First, the rise in lower-rated, longer dated investment grade debt1; second, a 100% increase in the number of triple C rated issuers to over 1,400, many of which have floating-rate liabilities; and third, excessive debt growth in the technology, electronics and pharmaceutical sectors. Our focus here is on US leveraged loans (LL), where $1.1tn in lower rated, spec grade loans is more vulnerable to our house view for 7 Fed hikes and a material flatting in the US yield curve through '19. Leverage is high. After normalizing for addbacks, it is even higher. US leveraged loan gross issuance hit $500bn in 2017, with 60% used for M&A, LBOs or recapitalizations. Total leverage on new deals is 5x, and near 5x since 2014, while 1st lien leverage is 3.9x, the highest in two decades. But are these figures understated? EBITDA add-backs are rampant and material, averaging 20-21% for M&A related deals in 2017 and 26% for large sponsor deals YTD (largest in the tech, metals and food sectors). The jury is still out on add-back realization rates, but a conservative view would push average total/ 1st lien leverage to 6.2x and 5x, respectively, on M&A deals. What are the early warning signals and current prognosis? Corporate leverage is therefore a structural risk. But are we at an inflection point in the credit cycle? Leveraged loans (1.35%) have outperformed high yield bonds (0.52%) YTD even as LL default rates have risen

moderately to 2.2% (from 1.4% in Q3 '17). First, we have created a proprietary non-bank LL liquidity indicator to assess if lenders are beginning to ration loan supply. This metric led spread widening in '15 and '07, but currently the indicator is at -2%, indicative of slight easing and a stable backdrop. Second, the key demand source for LL is collateralized debt obligations (CLOs), and portfolio concentrations are highest in technology (13-15%), healthcare (11-12%) and cable/media (8-9%). Our recent flows analysis suggests rising USD hedging costs and duration concerns are driving more foreign investors into loans. And while total returns in the above sectors are lagging the LL index, they remain in positive territory. How to position credit portfolios? Overall bank and non-bank lending standards are not showing signs of tightening credit, our credit-based recession gauge is at a modest 13% through Q3 '18 and broad US credit valuations are moderately overvalued. With the house view calling for materially higher short rates but a modest rise in long end yields and USD depreciation, we favour EM over DM corporate credit and US leveraged loans over US high yield. Our HY spread target remains 380bp vs 341bp current. We maintain the view that corporate credit markets can absorb the next several rate hikes, but spread tightening is over and investors should be more cautious as the hiking cycle matures. And we remain structurally underweight healthcare and tech across credit portfolios for 20182.

March 19, 2018

Rate Strategy

Rates Express

Government Bond Fund Flows Update •

Turbulent markets drive Treasury inflows in February. Investors poured $5.1 billion into Treasury-focused funds in February (Figure 1) as equities and other risk assets hit the skids and VIX surged over 3x. This was the highest net contribution since Sept. 2017. Inflows of $2.5 billion to the short end and $3.0 billion to the long end offset modest outflows of $300 million for intermediate-focused funds (Figure 3). Chunky inflows in the long end quickly helped to reverse the brief period of curve steepening earlier in Feb in response to strong CPI and NFP data. Strong demand in the front end is unsurprising with the

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2yr yields rising more than 100bps in recent months. TIPS demand moderates. Inflation-protected funds saw $1.4 billion in inflows in Feb, a notable slowdown from the $3.0+ notched in Jan (Figure 1). Both foreign and domestic investors tapped the brakes a bit (Figure 5). We view this as more of a return to “normal” flows, as the big jump in Jan would be hard to sustain. We continue to see demand for TIPS going forward consistent with recent inflation data, which points to a recovery in core CPI in the U.S. We view the latest CPI prints as supportive of breakevens (see March 14 “TIPS update”). Weekly data show continued demand into March. Demand remained relatively firm into the first half of March with $477 million in flows for the week ended March 14th (Figure 2). Short-end inflows of $486 million drove overall demand with inflows into intermediate offsetting long-term outflows (Figure 2). Weekly data point to continued demand for inflation protection with $203 million in inflows (Figure 2). Fed meeting set to shape landscape going forward. The market implies a rate hike on Wednesday is nearly certain, with OIS pricing about 3.5 hikes in total for 2018. We concur having recently updated our call to four rate hikes this year. All eyes will be on the SEP and the “dot plot” on Wednesday as markets brace for the opening act by new Fed Chair Powell and his FOMC.

March 19, 2018

Credit Strategy Research

Credit Hedge: FX Hedging Costs for Global Credit Investors Key Takeaway: USD hedging costs increased significantly last week for all but two currencies we track, though the RV impact to USD credit was partially blunted by wider spreads. Regions that have been some of the biggest buyers of USD credit are being impacted the most so overall foreign demand should remain somewhat muted in the near term. EUR credit remains ahead though, as EUR hedging costs continue to decline while spreads widened significantly last week on account of near record new issue volumes. As a result, a USD investor looking at EUR credit can now pick up 33 bps more than just a month ago (c.f. MoM row in section ‘change in row [C]’ on page 1) to buy into a credit market still directly supported by its central bank via ECB CSPP.

USD (Page One): A) Median hedging costs rose 4.3 bps last week. On a MoM basis, the three currencies that have seen hedging costs increase the most are TWD, EUR and CHF. B) Conversely, USD Credit RV increased 2.8 bps WoW, on account of wider spreads. C) The median USD yield bogey is currently 2.79%, down 1 bps WoW.

March 19, 2018

Economics Group Special Commentary

From Abundance to Scarcity: Which Industries Are Most Vulnerable to Rising Labor Costs? Executive Summary

Since employment bottomed in early 2010, businesses have added more than 18 million jobs in the United States, bringing the unemployment rate down to a 17-year low. With little slack remaining, labor cost pressures are building. Examining job openings and labor’s share of input costs, we look at which industries are most vulnerable to the wage pressures associated with the increasingly tight labor market. We find that at this point in the cycle, the retail and health care sectors look to be the most sensitive, while the information and durable manufacturing industries bear below-average exposure. While on balance the tight labor conditions will lead to compressed profit margins and/or higher prices for all industries, those with particularly elevated rates of job openings and higher reliance on labor stand to see the greatest cost pressure.