lack of clarification on tax issues; 4) lack of accessibility to onshore FX/rates hedging
tools. Back from our 2016 China Conference, we believe allowing foreign private
investors to access onshore repo, onshore FX swap and forwards would be the next
steps to follow.
1 Our dependent variable is the weekly changes of SDR/EM; our independent variables are the weekly changes in the
SDR/EUR, SDR/CNY, SDR/USD and the VIX index, and a constant. Natural logarithms were taken for all variables and our
sample period is Jan’14-Nov’16, when the start of the RMB depreciation trend. We base our currencies against the SDR
to define their value (See Assessing China’s Exchange Rate Regime, Frankel and Wei (2007) for a detailed explanation.).
To compute the forecast change in each currency, we use our global FX forecasts to obtain our independent variables.
34 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
The most influential global bond index is believed to be the Citibank World Government
Bond Index (Citi WGBI), which is used as the benchmark for more than $2tn of AUM. The
most influential EM bond index is the JPM Government Bond Index – Emerging markets
Global/Diversified (JPM GBI-EM Global/Diversified), which is used as the benchmark for
about $200bn AUM and caps each country’s share to 10%. A caveat, however, is that
the actual size of indexed money or ETFs should be smaller. The most crucial country
criteria of Citi WGBI is “fully accessible to foreign investors,” which makes China less
likely to be included by far given its accessibility to only medium- and long-term
investors. Even if China is being considered, the assessment usually takes a long time.
So we believe the case for China to be included into Citi WGBI in 2017 is unlikely.
By contrast, JPM GBI-EM Global/Diversified only requires accessibility to the majority of
foreign investors and does not factor in tax hurdles in eligibility. We believe China has
better chance to be included into the JPM GBI-EM Global/Diversified index. While the
exact timing is hard to predict, an optimistic scenario possibly leaves 2H17 on the table.
Usually when a big country is being included, bonds are introduced slowly over many
months to enable clients to rotate without too much disruption.
We would expect China’s inclusion to account for 10% of the JPM GBI-EM Global
Diversified index. Turkey, Malaysia, S. Africa, and Thailand would lose the largest shares
in the index, while the shares of Brazil, Mexico, Poland and Indonesia are expected to
remain given their large absolute size. Inflows to China could be around $20bn, or
equivalent to 1.5% of the aggregate central government bond market cap. Turkey,
Malaysia, S. Africa, Thailand and Columbia could see outflows of $2.4bn-3.3bn each,
with the most expected impact on Thailand given its lower relative foreign ownership.
We would expect China to account for 4.4% of the Citi WGBI index. The biggest losers
of market share will be the US, followed by Japan and Europe. Inflows to China could be
around $87bn, or 6.5% of its CGB market cap. This would present a very bullish scenario
for CGBs, and the curve will likely steepen.
MSCI inclusion – more about good will, then real flow
Another potential implication of China capital account opening is equity inflows. The
MSCI has been considering the inclusion of China A-shares in its index. These are shares
of local Chinese companies trading at the Shanghai and Shenzhen stock exchange,
whose trading is so far limited to local investors (China: Will A-shares be included in
MSCI in June this year?). The associated flows aren’t likely to be too large, so positive
price reaction is likely to come mostly from sentiment. The MSCI has discussed most
recently a 5% inclusion factor for A-shares, which would translate in an additional 1.1%
MSCI weight of China in the index. The scope for additional foreign capital looks small,
when considering that China already weighs 27% in the index. Our equity strategists
estimate the total AUM tracking MSCI EM to approximately USD1.6tn (total market cap
of the index is USD3.8tn), so that inflows upon inclusion would be roughly USD16bn.
The inclusion was delayed in June 2016, mainly due to obstacles regarding the quota
allocation process, capital mobility restrictions and beneficial ownership.
Chart 60: Estimated loss of share if China is included in JPM GBI-EM
Global Diversified
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
0.0% 0.0% 0.0% 0.0%
BRL
MXN
PLN
IDR
Source: BofA Merrill Lynch Global Research
-1.3%
-1.2%
-1.6%
-1.5% -1.5%
TRY
MYR
-0.9% -0.9%
-0.1% 0.0%
-0.3%
-0.5%
ZAR
THB
COP
HUF
RUB
RON
PEN
PHP
CLP
Chart 61: Estimated loss of share if China is included into Citi WGBI
0.0%
-0.5%
-1.0%
-1.5%
-2.0%
-1.5%
USD
-1.2%
-1.1%
JPY
EUR
Source: BofA Merrill Lynch Global Research
-0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
-0.3%
GBP
CAD
AUD
MXN
MYR
DKK
CHF
PLN
SEK
SGD
ZAR
NOK
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 35
Best Carry Trades
Claudio Irigoyen
MLPF&S
claudio.irigoyen@baml.com
Mai Doan
MLI (UK)
mai.doan@baml.com
Rohit Garg
Merrill Lynch (Singapore)
r.garg@baml.com
Vadim Iaralov
MLPF&S
vadim.iaralov@baml.com
Carry trades and blond swans
• We do not expect traditional carry trades such as ARS and BRL to perform well in a
strong USD and increasing interest rates environment, so we focus on USD neutral
carry trades.
• We like short EUR/RUB, short SGD/INR and long PEN/CLP. For more neutral
commodity exposure we like baskets of EUR, CAD, COP and CLP, AUD to fund RUB
and PEN trades respectively.
Carry is in the eye of the beholder
To focus on identifying best carry trades in the current environment of rising US
interest rates sounds counterintuitive at least. It is well know that carry trades perform
nicely in risk-on periods as well as in a low volatility environment, which is the opposite
of what we expect in the coming months. However, once proper factor exposure of
currency returns is considered, smart carry reemerges as an interesting proposition. As
we have documented (Forecasting with Compass30), most of the variation in currency
returns can be explained by the first two principal components, which can be labeled as
dollar and carry factor respectively, as they are highly correlated with USD and carry
performance.
Expected returns of carry strategies are defined by interest rate differentials (ie, carry),
assuming no change in spot exchange rates. Uncovered interest parity states that the
carry should be offset by a change in the spot of equal magnitude. However, empirical
evidence (so called forward premium puzzle) clearly shows that carry trades are
profitable on average, which indicates the presence of currency risk premium. Since
both dollar and carry, are priced factors, any sensible carry strategy in an environment in
which US rates are rising needs to hedge the USD exposure. This is just a necessary
though not a sufficient condition, since the carry factor is also correlated with global
measures of risk. Interestingly, post-election currency losses is not as highly correlated
with carry, indicating that carry trades were not as a strong investment theme as it was
the case during the taper tantrum episode (Chart 62).
Chart 62: Carry didn’t drive currency reaction to US elections
25
1m carry (annualized)
Currency depreciation since Nov8 (rhs)
20
15
10
5
0
-5
ARS
IDR
BRL
RUB
ZAR
PHP
TRY
INR
COP
PEN
MXN
MYR
CNY
CNH
CLP
NZD
AUD
PLN
THB
KRW
TWD
NOK
SGD
RON
HKD
CAD
HUF
GBP
ILS
CZK
JPY
EUR
SEK
CHF
Source: BofA Merrill Lynch Global Research, Bloomberg
15
12
9
6
3
0
-3
Chart 63: Asia and LatAm display the highest risk-adjusted carry
3
2
1
0
-1
IDR
ARS
PHP
CNY
INR
CNH
BRL
TRY
RUB
PEN
MYR
ZAR
COP
CLP
MXN
THB
NZD
AUD
PLN
KRW
TWD
NOK
SGD
CAD
RON
HUF
GBP
JPY
CZK
SEK
EUR
ILS
CHF
HKD
Source: BofA Merrill Lynch Global Research, Bloomberg
1m carry (annualized) / 1m implied ATM vol
1m carry (annualized) / max 1m DD (5y, rhs)
36 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
Characterizing carry
Efficient carry strategies involve buying and selling dynamic portfolios of currencies
with certain risk characteristics. Carry strategies are supposed to work better over long
investment horizons, so that the cushion provided by the carry compensates for the
currency volatility through mean reversion.
Here, we analyze carry from a different perspective, as our goal is to identify standalone
attractive carry opportunities. We define the investment horizon to end 1Q17. We sort
currencies based on risk-adjusted carry. We then characterize the factor exposure of
currency returns, isolating global and idiosyncratic sources of risks, in order to identify
smart carry trades that are not highly exposed to a massive re-pricing of global factors,
such as US rates, USD, commodity prices and global risk aversion. We identify carry
trades that have low exposure to global factors, in particular the USD factor, and offer
attractive risk-rewards.
Not surprisingly, purely based on carry considerations, EM currencies appear more
attractive than DM ones, which are mostly candidates for funding currencies. However,
carry trades returns are highly volatile, exhibit negative skewness and fat tails. Even
controlling for different measures of risk such as volatility or maximum drawdown, and
according to this criteria only, we find that EM currencies are the most attractive, in
particular ARS, BRL in LatAm, RUB, TRY and ZAR in EEMEA and INR, IDR and CNY in
Asia (Chart 63).
Even though volatility and drawdowns can be useful measures of risk, they don’t say
much about the exposure to different risk factors. Since carry trade strategies are
usually very sensitive to global factors, we study the cross sectional exposure of
currencies to key global factors: commodity prices, global risk aversion and US yields (as
a proxy of global yields). We report the R2 of regressions of two years of weekly returns
on the above mentioned global factors, for the last two years and the years 2013-2014
for the sake of comparison (Chart 64).
We find that currencies in LatAm and EEMEA are more exposed to global factors than in
Asia. Interestingly, LatAm and EMEA currencies are more sensitive to shocks in
commodity prices and risk aversion, while in Asia the shocks to monetary policy are the
most important ones (Chart 65). Within DM currencies, AUD and NOK are the two
currencies most exposed to global factors. Ideally, we seek for currencies with high riskadjusted
carry and low exposure to global factors. Under such a metric, ARS, BRL, RUB
and INR stand out as the best investment currencies, while EUR, CHF, JPY, KRW and
TWD are the best funding currencies. However, this filter is not enough in the current
volatile environment.
Chart 64: LatAm is more exposed to global factors than Asia
0.6
Depend on global factors
0.5
0.4
RSQ '16 RSQ '14
0.3
0.2
0.1
Chart 65: Sensitivity to global factors across regions
0.8
Normalized beta of global factors
0.6
0.4
0.2
0
-0.2
Monetary
Commodities
Equities
0
COP
CAD
MXN
LATAM
EMEA
RUB
ZAR
JPY
NOK
CLP
AUD
BRL
IDR
TRY
MYR
CZK
INR
SEK
EUR
SGD
ASIA
NZD
THB
RON
PEN
HUF
PLN
PHP
CHF
ILS
KRW
TWD
GBP
HKD
CNY
ARS
-0.4
COP
CAD
MXN
LATAM
EMEA
RUB
ZAR
JPY
NOK
CLP
AUD
BRL
IDR
TRY
MYR
CZK
INR
SEK
EUR
SGD
ASIA
NZD
THB
RON
PEN
HUF
PLN
PHP
CHF
ILS
KRW
TWD
GBP
HKD
CNY
ARS
Source: BofA Merrill Lynch Global Research, Bloomberg
Source: BofA Merrill Lynch Global Research, Bloomberg
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 37
The role of fundamentals
From a purely mechanical perspective, we could stop the analysis here and choose those
currencies with better risk-reward prospects according to the metrics so far described.
However, in order to analyze carry trades with relatively short investment horizon, we
need to complement our analysis with our views on future exchange rates dynamics.
We expect US rates to continue moving higher and the USD to strengthen across the
board due to easier US fiscal policy and significant uncertainty regarding foreign policy.
In EM, we think LatAm is the region that will suffer the most in the new global scenario,
followed by Asia. We find EEMEA relatively more resilient to US driven shocks. We want
to avoid countries with high financing needs (i.e., high fiscal and current account
deficits). We also prefer trades with neutral commodity exposure. Since carry trades
tend to underperform when US rates are moving higher and the USD strengthens, we
want at least to avoid USD funded carry trades, crowded carry trades and currency
crosses highly exposed to the USD factor. Hedging the USD factor leaves us with the
pure carry exposure, which by being a price factor, is also related to standard measures
of risk, as well as idiosyncratic factors.
Best carry trade: Cherry picking among rotten cherries
Given our views, and focusing on those trades where ex-ante high carry is consistent
with ex-ante expected returns, we choose our best carry trades across EM and DM.
Since DM currencies offer very low carry vs the USD, there are not many attractive carry
opportunities in DM in a strong USD environment, so much so that the most attractive
carry proposition is simply to go long USD/JPY. Since this trade is mostly predicated on
a strong USD view and is being developed in other sections of this report we refer the
reader to those sections (please see: USD/JPY will the main beneficiary of Trump win,
FX: GOP sweep emboldens core USD/JPY view, Long EUR/JPYAsia: short JPY/KRW).
Therefore, we focus mostly on EM or EM/DM carry trades.
EEMEA: short EUR/RUB
We like selling EUR/RUB (spot 69.28, target 66.15, stop 71.02). We see EEMEA as
relatively more resilient to higher US rates, though with some heterogeneity within the
region. On the one hand, high current account deficit countries like Turkey or South
Africa should continue suffering from a re-pricing of risk. On the other hand, CEE
countries are expected to some more resilience. One currency we find particularly
attractive is the Russian ruble, which still offers an attractive risk-adjusted carry,
controlling for standard measures of risk such as implied volatility and maximum
drawdown. The outcome of the US election should remove some risk premium from
Russian assets as the geopolitical backdrop improves. Economic activity is expected to
pick up in 2017. A hawkish central bank, coupled with a favorable external position and
an energy-driven current account surplus will likely limit its exposure to a reversal in
capital flows.
On the geopolitical side, we expect Russian foreign policy to become more conciliatory
Chart 66: Oil prices are a major risk factor
Chart 67: Russia tends to be more market-friendly with lower oil
1.5
1.0
0.5
RUB/(EUR,CAD,COP) Jan 4 '13 =100
RUB/EUR Jan 4 '13 =100
Brent oil (RHS)
0.0
Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16
Source: BofA Merrill Lynch Global Research, Bloomberg
150
100
50
0
100
50
0
Oil price, $/bbl 10y MA
Privatization,
Georgia
Gaidar reforms war
Start of
Yukos
Perestroika
case
Afganistan war
Jan-70
May-72
Sep-74
Jan-77
May-79
Sep-81
Jan-84
May-86
Sep-88
Jan-91
May-93
Sep-95
Jan-98
May-00
Sep-02
Jan-05
May-07
Sep-09
Jan-12
May-14
Source: BofA Merrill Lynch Global Research, Bloomberg
Ukraine
crisis
US-Russia
“Reset”
38 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
and less disruptive for markets, in particular given the expected improved foreign
relations with the US (Chart 67). However, the currency remains overvalued and highly
exposed to global factors, in particular oil price, and positioning is crowded. Despite our
forecast is for USD/RUB to remain around 63 in 1Q17, we prefer to mitigate the abovementioned
risks by choosing a more favorable funding currency.
If liquidity is a major consideration, we prefer to use the EUR as a funding currency,
which offers negative carry vs the USD, and gives the ruble the best risk-adjusted carry
across all potential funding currencies. In addition to the already seen impact on US
rates, Trump’s victory implies that political risks are becoming increasingly important in
Europe, with the Italian referendum in December and elections in Netherlands, Germany
and France in 2017. This scenario strengthens our call for a six-month extension to ECB
QE at the current pace. We expect the EUR/USD to trade at 1.05 by end 1Q17.
Since short EUR/RUB is still exposed to much lower oil prices, an alternative way to
express the trade is to use a basket of euro, Colombian peso and Canadian dollar as
funding basket (Chart 66). The COP remains overvalued, the central bank is expected to
ease monetary policy as the economy decelerates and oil represents 35% of Colombian
exports. We expect the COP to depreciate 2.5% by end 1Q17. Carry, on the other hand,
is higher than EUR and CAD. The CAD offers very low carry and we forecast a 1.5%
depreciation by 1Q17 vs the USD. The economy keeps displaying weak growth and we
expect the Bank of Canada likely to cut rates and maintain the accommodative stance of
monetary policy.
Asia: short SGD/INR
We like short SGD/INR (spot 47.96, target 47, stop 48.44). While the performance of
Asia FX can be influenced by broader risk conditions, we expect most to weaken vs. the
USD. The Korean won and the Singapore dollar, as well as the Taiwanese dollar for
instance stand out as being the most sensitive to a stronger USD, as they act as a high
beta proxy for CNY, which we expect to continue depreciating in this new high US rates
environment. Others like Indonesian rupiah and Malaysian ringgit are more sensitive to
higher USD rates. Consequently, outflows from these countries will adversely impact the
respective FX. That said, Bank Indonesia has built good amount of reserves to prevent
rupiah from weakening excessively. Moreover, tax amnesty related repatriation flows
and global bond issuance is still expected to come in December, which should also
support the rupiah.
Historically, large US tax cuts have been followed by a widening of the US current
account deficit driven by higher imports. This supported Asia export growth and
exchange rates, especially after the Bush tax cuts. However, this time could be different
partly because US household spending has been shifting towards non-tradable services.
More importantly, Trump’s policy platform itself is geared towards reducing dependence
upon foreign goods and services (Chart 68).
Chart 68: Export exposure to the US across EM Asia
20
Exports to the US in 2015 (% of GDP)
15
10
5
0
Source: BofA Merrill Lynch Global Research, Bloomberg
Chart 69: S$NEER has depreciated 50bp below par since Oct MPS
130
125
120
115
110
105
Index
Apr-08
Oct-08
Apr-09
Oct-09
Apr-10
Oct-10
Apr-11
Oct-11
Apr-12
Oct-12
Apr-13
Oct-13
Apr-14
Oct-14
Apr-15
Oct-15
Apr-16
Oct-16
Source: BofA Merrill Lynch Global Research estimates, Bloomberg
BofA-ML SGD NEER
lower end of band
mid-point
upper end of band
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 39
At this juncture, the Indian rupee seems to be the only one in the region that is expected
to display a much lower sensitivity to US rates, outperforming others within Asia. We
expect the Monetary Authority of Singapore to keep the SGD NEER in the weaker side
of the band for the next few months, which reduces the downside risk for the trade
(Chart 69). We like the INR as the preferred long, followed by the IDR, as they offer high
risk-adjusted carry, central banks are interested in keeping their currencies stable,
current account deficits are bounded, and the currencies are not expensive relative to
long term fundamentals. The main risk of the trade is of higher oil prices, and
considerable reversal of capital flows. Apart from that, a change in the behavior of
Reserve Bank of India it terms of managing INR to accumulate international reserves is
also a risk.
LatAm: long PEN/CLP
We like long PEN/CLP (spot 195.7, target 200, stop 195.5). LatAm is the most
exposed region within EM to global factors. Traditional carry trade candidates like the
Brazilian real and the Argentina peso are no longer attractive given the still fragile fiscal
stance in both countries. Local positioning in BRL has proven to be heavier than
thought, and we expect the currency to continue weakening until we observe some
stabilization in US rates. The Brazilian real is still overvalued and the economy will be
negatively affected since its strategy to gradually reduce budget deficits is based on low
global rates, capital inflows and higher domestic growth. In the case of the Argentine
peso, despite showing some detachment from global factors and some positive inflows
due to the tax amnesty, we think the currency needs to weaken given the recent
depreciation of the BRL and its current overvaluation as well as the government fiscal
needs for 2017, which is an important electoral year. Therefore, we remain neutral on
these currencies.
A more modest but more interesting carry trade within LatAm in an environment of
higher US rates is to be long the Peruvian sol, funded with the Chilean peso, in order to
make the trade more neutral to commodity exposure. The Peruvian economy is expected
to continue growing at rates above 4% due to strong mining activity; the new
government will likely implement expansionary fiscal policy and has room to finance it.
The exchange rate is close to its equilibrium value based on terms-of-trade and
productivity. In fact, we expect the currency to appreciate in real terms if growth
recovers as predicted. The currency still offers a decent carry. We forecast a nominal
depreciation but below the forward. The central bank has a strong preference for low
currency volatility and would be ready to intervene in case of a disorderly depreciation,
as it has been already the case in the last few days with small interventions in the
forward market.
On the other hand, Chile’s growth remains anemic and the economy is expected to
continue growing sub 2% in 2017 (Chart 71). The CLP is overvalued but recent flows
Chart 70: Copper prices are a major risk factor
Chart 71: Relative growth to favor Peru going forward
400
350
300
250
Copper prices
200 CLP (rhs, Jan2012 =100)
PEN (rhs, Jan2012 =100)
150
2012 2013 2014 2015 2016
Source: BofA Merrill Lynch Global Research, Bloomberg
80
100
120
140
160
230
pen/clp growth diff (rhs)
220
210
200
190
180
170
160
150
2010 2011 2012 2013 2014 2015 2016
Source: BofA Merrill Lynch Global Research, Bloomberg, Haver
5
4
3
2
1
0
-1
-2
-3
40 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016

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