Australia

Highlights Dear Client, This is the final Global Fixed Income Strategy report for 2018. We will return with our first report of the new year on January 8th, 2019. Our entire team wishes you a very happy holiday season and a prosperous new year. Best regards, Rob Robis, Chief Strategist 2019 Model Bond Portfolio Positioning: Translating our 2019 key global fixed income views into recommended overall positioning within our model bond portfolio yields the following: target a modest level of active portfolio risk, with below-benchmark duration and only neutral exposure to corporate credit. Country Allocation: Government bond allocation should continue to reflect relative expectations for monetary policy changes. That means an overweight in countries where central banks will have little scope to increase rates (core Europe, Japan, the U.K., Australia, New Zealand) and an underweight where central banks are likely to tighten more than markets currently discount (U.S., Canada, Sweden). Corporate Credit: We currently prefer U.S. corporate bonds to European and EM equivalents based on better U.S. profit prospects, which enhances debt serviceability. However, we will look to pare U.S. exposure as the Fed shifts to a more restrictive stance later in 2019. Feature Last week, we published our 2019 “Key Views” report, outlining the thematic implications of the 2019 BCA Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations for next year. We also recommend changes to the allocations in the Global Fixed Income Strategy model bond portfolio to reflect our 2019 themes. The main takeaway is that 2019 will be another year of poor returns, with increased volatility, for most global fixed income markets. The greater pressures should come in the latter half of the year, after the U.S. Federal Reserve delivers additional rate hikes and decisive signs of a slowing U.S. economy unfold. Investors should maintain a defensive strategic posture on fixed income markets throughout the year, both for interest rate duration and credit exposure. Selling into market rallies, rather than chasing them, will prove to be the prudent strategy. Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from last week’s Key Views report were the following: Late-cycle pressures will keep bond yields elevated. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for both government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay modest in 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. We now present the specific fixed income investment recommendations that flow from those themes in the following categories: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Risk: DEFENSIVE Government bond yields enter 2019 at very low (i.e. expensive) levels across the major developed markets, even after the cumulative rise in U.S. Treasury yields seen over the past twelve months. Real yields remain below trend real GDP growth rates, a consequence of central banks keeping policy rates below neutral levels as measured by concepts like the Taylor Rule (Chart of the Week). In addition, credit spreads remain near the low end of long-run historical ranges in all markets. Without the initial starting point of cheap valuations, fixed income return expectations in 2019 should be severely tempered (Charts 2& 3).   Chart 2Low Yields = Low Expected Returns For U.S. Corporates …   Chart 3… And European Corporates Volatility measures like the VIX index will remain elevated until markets begin to sniff out a bottoming of global growth. Much will depend on developments in China, but our expectation is that policymakers there will only act to stabilize the economy rather than provide large, 2016-scale stimulus. That may be enough to create a tactical “risk-on” trading opportunity by mid-year but we recommend using any such rally to reduce credit exposure given the risk of a more lasting global economic downturn in 2020. Importantly, cross-asset correlations should continue to drift lower without broad support from coordinated global economic growth or expanding monetary liquidity via central bank asset purchases (Chart 4). Without those rising tides lifting all boats, more active security selection by country, sector and credit rating should help portfolio managers outperform their benchmarks in what is likely to be another down year for absolute returns. Chart 4High Volatilities With Low Correlations That combination of diminished return prospects and elevated volatility means investors should maintain a defensive bias in fixed income portfolios heading into 2019. Within our own GFIS recommended model bond portfolio, this means keeping our tracking error (the relative expected volatility versus our custom benchmark performance index) well below our maximum target level of 100bps (Chart 5). Chart 5Maintain Moderate Overall Portfolio Risk Overall Duration Stance: BELOW BENCHMARK We do not think that global bond yields have peaked for this business cycle. The current period of softening global economic momentum will not turn into a prolonged period of sub-trend growth that would push up unemployment rates in the major developed economies. With the global output gap nearly closed, and monetary policymakers firmly believing in the Phillips Curve framework (lower unemployment leads to higher inflation) to forecast inflation, a more dovish stance from the major central banks seems unlikely. As we discussed in last week’s report, global bond yields are in a process of normalization away from the depressed levels seen after the 2008-09 global financial crisis and recession (Chart 6). Term premia, inflation expectations and real yields all have upside potential as central banks slowly back away from quantitative easing and low interest rate policies. Thus, we continue to recommend a defensive, below-benchmark strategic stance on overall portfolio duration exposure (Chart 7). Chart 6Bond Yields Will Continue To Normalize In 2019   Chart 7Stay Below-Benchmark On Duration Risk Government Bond Country Allocation: Underweight U.S., Canada, Sweden, Italy. Overweight Germany, France, U.K., Japan, Australia, New Zealand At the country level, we recommend underweighting government bond markets where central banks will be more likely to raise interest rates (because of firm domestic economic growth and building inflation pressures), but where too few rate hikes are currently discounted in money market yield curves. The U.S., Canada and Sweden fit that description (Chart 8). The U.K. would also be part of this group, but the Brexit uncertainty leads us to maintain an overweight stance on U.K. Gilts entering 2019. Chart 8Monetary Policy Expectations Drive Country Allocations By the same token, we are recommending overweights in countries where rate hikes are unlikely to occur in 2019 because of underwhelming inflation, like core Europe, Japan and New Zealand. We are currently overweight Australian government bonds, but we expect to cut that exposure in 2019 as pressure builds for a rate hike in the latter half of the year as inflation picks up. Italian government bonds represent a special case of a developed market trading off sovereign credit risk rather than interest rate or inflation risk. We continue to treat Italian government bonds the same way we view corporate debt, as a growth-sensitive asset. On that basis, we will remain underweight Italian government bonds until Italy’s leading economic indicator bottoms out, mollifying concerns about debt sustainability. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will sustain wide differentials between Treasuries and non-U.S. bond yields (Chart 9). Chart 9ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets The greatest potential for spread widening will be for Treasuries versus JGBs, with no changes in the Bank of Japan’s monetary policy expected due to stubbornly low inflation. The 10-year Treasury-Gilt spread could also widen if the Bank of England stays on the sidelines for longer until Brexit uncertainty is resolved. The 10-year U.S.-New Zealand spread should also widen with the Reserve Bank of New Zealand staying on hold for a while due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be rangebound, with the Bank of Canada likely to match, but not exceed, Fed tightening in 2019. There are some markets, though, where yields could rise a bit more than Treasury yields due to shifting monetary policies. While the ECB will refrain from raising rates next year, there is a potential for the U.S. Treasury-German Bund spread to narrow marginally if the end of ECB new asset purchases lifts Bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads. After keeping monetary policy very loose for a long time, the beginning of rate hikes next year by the Reserve Bank of Australia and Riksbank could put meaningful upward pressure on deeply depressed longer-maturity Australian and Swedish yields. Yield Curve Positioning: Favor Bearish Steepeners Everywhere In The First Half Of 2019, Then Switch To Bearish Flatteners In The U.S., Canada, Australia And Sweden We expect some bearish steepening pressures to appear in most countries in the first quarter of 2019 with inflation breakevens likely to rebound if the bullish oil forecast of BCA’s Commodity & Energy Strategy team comes to fruition (Charts 10 & 11). The end of the net new buying phase of the ECB’s Asset Purchase Program in January will also put upward pressure on longer-dated European yields through a worsening supply/demand balance for European government bonds and a wider term premium, helping keep European yield curves steep. Chart 10Inflation Expectations & Bond Yields Will Rebound In 2019 …   Chart 11… As BCA’s Bullish Oil View Comes To Fruition Importantly, it is too soon to worry about an inversion of the U.S. Treasury curve, as we discussed in last week’s report, with the fed funds rate not yet at a restrictive level (i.e. real rates above measures of neutral like R-star). That outcome should occur by the end of 2019, when we expect the Treasury curve to move towards a true monetary policy-induced inversion. Similar patterns – steepening first from rising inflation expectations, flattening later from more hawkish central banks delivering rate hikes – should unfold in Canada, Australia and Sweden. Applying Our Global Golden Rule To Government Bond Allocations Back in September, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.”2 This is an extension of a framework introduced by our sister service, U.S. Bond Strategy, that links U.S. Treasury returns to changes in the fed funds rate that are not discounted in money markets (using our 12-month Discounters derived from Overnight Index Swap curves). In Table 1, we show the expected returns generated by the Global Golden Rule (shown hedged into U.S. dollars) for the countries in our model bond portfolio custom benchmark, based on monetary policy scenarios that we deem to be most plausible for 2019. In Table 2, we show the returns on a duration-adjusted basis (expected total return divided by duration). We then rank the return scenarios for overall country indices, aggregating the returns of the individual yield curve maturity buckets shown in those two tables, in Table 3. Table 1Global Golden Rule Return Forecasts For 2019   Table 2Global Golden Rule Duration-Adjusted Return Forecasts For 2019 The shaded cells in Table 3 represent our base case forecasts for policy rate changes in each country. On this basis, the better return prospects for 2019 will be in markets where central banks will stand pat throughout the year (Germany, Japan). Conversely, the weaker returns will occur where we expect more rate hikes than currently discounted by markets (U.S., Canada). These returns fit with our recommended country allocation outlined above. Table 3Ranking The 2019 Return Scenarios Corporate Credit Allocation: Neutral Overall, But Overweight In U.S. Investment Grade And High-Yield Relative To European And Emerging Market Equivalents. Look To Cut The U.S. To Underweight In The Latter Half Of 2019. We enter 2019 maintaining our recommended overall neutral exposure to corporate debt. As discussed earlier, we expect to see some stabilization of global growth in the first half of 2019. This will create a playable “risk-on” rally for growth sensitive assets like corporates, but we anticipate selling into that rally by downgrading our recommended U.S. credit allocations to underweight. Within U.S. credit markets, we are recommending a less aggressive medium-term stance, staying up in quality within investment grade debt (single-B and single-A rated names versus BBBs) and high-yield (BB-rated vs CCC-rated). With 50% of the investment grade benchmark index now rated just above junk, there is a growing risk of “fallen angel” downgrades to junk status in the event of a material slowing of U.S. economic growth. At the same time, default-adjusted spreads on U.S. high-yield debt only appear attractive if the current exceptionally low default rate backdrop persists (Chart 12). In other words, both U.S. investment grade and high-yield corporate debt are vulnerable to any major slowing of U.S. economic growth and slump in corporate profits. Chart 12U.S. Corporates Vulnerable To Slower Growth The confluence of above-trend U.S. growth and still pro-cyclical Fed policy will support U.S. credit in the near-term, but that will all change later in 2019. We expect the Fed to deliver at least 75bps of rate hikes in 2019 – perhaps only pausing from the current 25bps per quarter pace at the March meeting – which will push the funds rate into restrictive territory and invert the Treasury curve sometime in the 4th quarter of the year. This will cause investors to start to discount a deep growth slowdown in 2020, which will trigger systemic credit spread widening (Chart 13). We expect our next move on U.S. corporate debt to be a downgrade to underweight, likely sometime around mid-year. Chart 13Growth Differentials Continue To Favor U.S. We still prefer U.S. corporates to European or Emerging Market (EM) equivalents, however, thanks to the likelihood of better near-term growth prospects in the U.S. We are concerned about how the European corporate bond market will perform without the support of ECB asset purchases, which leads us to underweight both investment grade and high-yield European corporates (Chart 14).3 Chart 14Stay Overweight U.S. Corporates Vs European Corporates EM corporates will continue to suffer from the toxic combination of rising U.S. interest rates, a stronger dollar and global growth concerns. Our political strategists remain skeptical on the prospects for a permanent deal on thorny U.S.-China trade issues, leaving EM assets exposed to slowing momentum in China’s economy. We continue to prefer owning U.S. credit, given how the relative performance of EM and U.S. credit has not yet converged to levels implied by U.S./EM growth differentials (Chart 15). Chart 15Stay Overweight U.S. Corporates Vs EM Corporates Model Portfolio Adjustments To Begin 2019 In terms of our model bond portfolio, we recommend a few changes to our current allocations to reflect our 2019 outlook and key views (see the table below). We make a few adjustments to our individual country duration allocations, given our expectations of some re-steepening of global yield curves. We also bump up our allocation to core European debt given our expectation that the ECB will keep policy rates on hold throughout 2019. We fund that increase in European exposure from U.S. Treasuries, where too few Fed rate hikes are now discounted. Finally, we make a modest adjustment to our U.S. high-yield allocations, cutting CCC-rated exposure and upgrading B-rated credit.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “2019 Key Views: Normalization Is The “New Normal””, dated December 12th 2018, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “The Global Golden Rule Of Bond Investing”, dated September 25th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “Stubbornly Resilient Bond Yields”, dated November 13th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The dollar will continue to rally despite the trade truce agreed upon last weekend between U.S. President Donald Trump and China President Xi Jinping. Not only is this truce far from a permanent deal, but global growth continues to slow. Moreover, if the truce were to generate a genuine improvement in global growth conditions, this would likely result in a much more hawkish Federal Reserve than the market is currently pricing in. This would lead to a further deterioration in global liquidity conditions, causing additional growth problems for the world. Buy EUR/CHF, as the Swiss National Bank will soon have to intervene in the market. Sell AUD/NOK, as oil should outperform metals and the Norges Bank is better placed to tighten policy than the Reserve Bank of Australia. Feature Presidents Donald Trump and Xi Jinping have agreed to freeze additional new tariffs on Chinese exports to the U.S. for three months. This means that as of January 1, 2019, U.S. tariffs on US$200 billion of Chinese exports to the U.S. will remain at 10%, and will not jump to 25%. Meanwhile, China has agreed to immediately resume its imports of soybeans and LNG from the U.S. Moreover, China has also agreed to begin talks to open up Chinese markets to U.S. exports as well as to address U.S. worries regarding intellectual property theft. The world has let out a collective sigh of relief. A potent narrative exists that fears of a trade war have been the root cause of the slowdown in global growth witnessed this year. Consequently, since the dollar performs well when global industrial activity slows, this also means that ending the trade war could be key to abort the dollar’s bull market. We are doubtful this narrative will pan out, and we do not think that the Buenos Aires truce will lead to the end of the dollar rally. This also means that the G-20 armistice is also unlikely to reverse the underperformance of commodity and Scandinavian currencies. First, this truce does not mark the end of the trade war. It is only an agreement to delay the implementation of U.S. tariffs. Come March, the Trump administration may well sing a very different tune. The U.S. domestic political climate has not changed one iota, and protectionism, particularly when directed at China, still wins votes (Chart I-1). Meanwhile, the concessions China is willing to give are long-term in nature; however, Trump wants visible wins well ahead of the 2020 elections. This mismatch creates a real danger that the White House imposes new tariffs again beyond the three-month armistice agreed at the G-20. The news yesterday afternoon that the CFO of Huawei was indicted in Vancouver already casts doubts on the deal. Chart I-1Americans Will Remain Tough On China Second, the dollar has been strong, and risk assets have been weak for more reasons than the trade war alone. As shown by the slowdown in Japanese or Taiwanese exports, as well as by the contraction in German foreign orders and in the CRB Raw Industrial Index’s inflation, global trade and global growth are slowing (Chart I-2). This development is likely to last until mid-2019, as our global leading economic indicator continues to fall. This deterioration in the global LEI does not look set to stop soon, as normally any improvement in the global LEI is first telegraphed by a stabilization in the Global LEI Diffusion Index – an indicator that is still falling (Chart I-3). Chart I-2Global Growth Continues To Slow Chart I-3No Bottom In Sight For The Global LEI China is not yet coming to the rescue either. The slowdown in Chinese economic activity continues, and in fact, the paucity of a rebound in Chinese credit growth despite injections of liquidity by Beijing suggests that a bottom is not yet in sight (Chart I-4). Hopes that were raised by increased bond issuance from local governments have also been dashed as this proved to be a very temporary phenomenon (Chart I-5). What is more worrisome is that so far Chinese exports have held their ground; however, the decline in the new export orders of the Chinese PMI suggests that this support to growth is likely to taper sharply in the coming months (Chart I-6). Chart I-4Credit Growth Decelerating Despite Stimulus   Chart I-5Chinese Infrastructure Push Looks Transitory   Chart I-6Chinese Exports: The Last Shoe To Drop Finally, despite the cloudy outlook for global growth that built up this year, U.S. yields had risen 80 basis points by November 8, adding stress to economies already negatively impacted by weakening manufacturing activity. This increase in global borrowing costs has worsened the already noticeable decline in U.S.-dollar based liquidity (Chart I-7). This decline in liquidity has been a great source of concern as EM economies, the source of marginal growth in the global economy, have large dollar-denominated debt loads, and thus need abundant dollar liquidity in order to support their economies (Chart I-8). Chart I-7Slowing Dollar Liquidity Explains Weak Global Growth... Chart I-8...Because There Is A Lot Of Dollar Debt Where Growth Is Generated This last point is especially unlikely to change in response to the Buenos Aires truce. Since November, 10-year U.S. yields have fallen around 25 basis points, and now fed funds rate futures are only pricing in 45 basis points of rate hikes over the coming two years, including the December hike. If business sentiment improves because of a trade truce, and consequently U.S. capex proves more resilient than anticipated by market participants, the Federal Reserve will increase rates by much more than what is currently priced into the futures curve (Chart I-9). Chart I-9U.S. Rates Have Plenty Of Upside, Even More So If The Trade Truce Becomes A Peace Treaty This will lift yields, resuscitating one of the first reasons why markets have been weak this fall. This risk is even greater than the market appreciates. After Fed Chair Jerome Powell gave what was perceived as a dovish speech last week, markets were further emboldened to bet on a Fed pause. However, Fed Vice-Chairman Richard Clarida and New York Fed President John Williams have both argued since that the U.S. economy will continue to run above trend and warrants further gradual increases in interest rates. A truce in Buenos Aires may only provide them with more ammunition to implement those hikes. Global liquidity conditions are unlikely to improve significantly anytime soon. Moreover, the truce could also change the calculus in Beijing. Much of the stimulus implemented since last summer in China has been to limit the negative impact of a trade war. However, if a trade war is not in the cards, Beijing has fewer reasons to abandon its deleveraging campaign. It thus raises the possibility that with a risk to China evaporating, the Xi Jinping administration would instead not do anything to limit the slowdown in credit. This implies that Chinese capex would stay weak and that China’s intake of raw materials and machinery would not pick up. This means that the euro area and countries like Australia will continue to lag behind the U.S.  Ultimately, the market speaks louder than anything else. The incapacity for risk assets to catch a bid in the wake of what was good news is disconcerting. It suggests that the combined assault of slowing global growth and a tightening Fed remains the main problem for global financial markets. Hence, in this kind of deflationary environment, the dollar reign supreme – even if U.S. growth were to slow (Chart I-10). Chart I-10A Strong Dollar Is Not A Function Of Strong U.S. Growth Bottom Line: A trade truce in Buenos Aires could have aborted the bull market in the dollar. So far, it has not, and we do not think it will be able to end the dollar’s rally. First, this truce remains flimsy, and does not guarantee an end of the trade war between China and the U.S. Second, global growth continues to exhibit downside. Finally, the Fed is unlikely to change its course and pause its hiking campaign. In fact, if a trade truce is so good for trade, it will give more reasons for the Fed to hike and may even incentivize Chinese authorities to abandon their efforts to cushion the Chinese economy against slowing global trade. Stay long the dollar and keep a defensive exposure in the FX market, one that favors the yen and the greenback at the expense of Scandinavian and commodity currencies. Buy EUR/CHF Despite our view that global growth is set to slow, we are inclined to buy EUR/CHF this week. We expect the Swiss National Bank to stop sitting on its hands as a stronger CHF is becoming too painful. First, as we highlighted last week, aggregate Swiss economic activity is slowing sharply.1 What is more concerning is that consumer spending is also suffering, as shown by the contraction in real retail sales (Chart I-11). This implies that despite record-low interest rates, Swiss households are feeling the pinch of the tightening in Swiss monetary conditions created by the stronger CHF. Chart I-11Swiss Households Are Feeling The Pinch Second, the franc remains a problem for Swiss competitiveness. As Chart I-12 shows, Swiss labor costs are completely out of line with its competitors. This phenomenon worsened significantly after 2008 due to the Franc’s strength vis-à-vis the euro. Despite the weakness in the franc from mid-January 2015 to April 2018, Swiss unit labor costs remain uncompetitive. This means that going forward, either the SNB will have to tolerate a further contraction in wages, something unpalatable as Swiss households have a debt load equal to 212% of disposable income, or the franc will have to fall. Chart I-12The CHF Makes Switzerland Uncompetitive Third, the franc’s recent strength is only accentuating the deflationary impact of softer global growth on the local economy. As Chart I-13 illustrates, the recent strengthening in the trade-weighted CHF portends to a potentially painful contraction in import prices, while core inflation is already well off the SNB’s 2% objective. Moreover, as the second panel of Chart I-13 shows, our CPI model suggests that Swiss inflation is about to fall into negative territory again. This would imply that not only will the Swiss economy suffer from the recent strengthening in the franc, but also that Swiss real interest rates are about to increase by 100 basis points, the last thing a slowing economy needs. Chart I-13Swiss Deflation Will Return This economic backdrop suggests to us that after 16 months where the SNB played nearly no active role in managing the CHF exchange rate, the Swiss central bank is about to come back to the market in order to limit the downside in EUR/CHF. This makes buying this cross attractive, as it offers a favorable asymmetric payoff. EUR/CHF generates a small positive carry, has limited downside and offers ample upside if the SNB intervenes – all while offering low volatility. Meanwhile, if global growth picks up, EUR/CHF should also rebound. In fact, the pro-cyclical behavior of EUR/CHF, as well as its asymmetric payoff, increases the attractiveness of this trade within our broadly defensive portfolio stance: It hedges us against being wrong on the global growth outlook and the importance of the trade truce. Furthermore, any resolution to Italy’s battle with Brussels will also boost this cross. Bottom Line: EUR/CHF normally depreciates when global growth slows. While this pattern materialized in 2018, we anticipate EUR/CHF to stabilize and potentially rally, even if global growth slows. The strong CHF is now causing serious pain to the Swiss economy, and the SNB will have to prevent any deepening of the malaise. The SNB is thus set to begin intervening in the market. Additionally, if we are wrong and global growth does not slow further, being long EUR/CHF provides a hedge to our defensive market stance. AUD/NOK To Be Knocked Down An attractive opportunity to sell AUD/NOK has emerged. First, on the back of the weakness in oil prices relative to metals prices, AUD/NOK has caught a furious bid in recent weeks (Chart I-14). However, we expect the underperformance of oil relative to metals to peter off. The main factor that has weighed on petroleum prices is that Saudi Arabia has kept extracting oil at full speed, expecting a shortage of oil in global markets once U.S. sanctions on Iran kicked in. Chart I-14AUD/NOK Strength: A Reflection Of Weak Crude Prices However, with President Trump greatly softening his stance and allowing exemptions for some countries to import Iranian oil, the crude market instead has experienced a mini unforeseen oil glut. OPEC 2.0, just agreed to essentially remedy this problem by limiting their oil output. This should boost oil prices. Meanwhile, slowing global growth centered on slowing Chinese capex will have a much deeper impact on industrial metals prices than on oil. This represents a negative terms-of-trade shock for Australia vis-à-vis Norway. Second, domestic economic conditions also favor betting on a weaker AUD/NOK. Australian nominal GDP growth often weakens when compared to Norway’s ahead of periods of depreciation in AUD/NOK. Today, Australia’s nominal GDP growth is sagging relative to Norway’s, and the contraction in Australia’s LEI relative to Norway suggests that this trend will deepen (Chart I-15). A rebound in oil prices relative to metals prices will only reinforce this process. Chart I-15Domestic Economic Conditions Point To A Lower AUD/NOK Third, AUD/NOK seems expensive relative to the anticipated path of policy of the Reserve Bank of Australia relative the Norges Bank (Chart I-16). Moreover, the Norwegian central bank has begun lifting rates, and since real interest rates in Norway are still negative, it will continue to tighten policy next year. Meanwhile, the RBA remains reticent to increase interest rates as Australian inflation and wage growth are still tepid. The recent deceleration in Australian GDP growth as well as budding problems in the Aussie real estate market will only further cajole the RBA in its reluctance to lift the cash rate higher. Hence, the real interest rate differentials will continue to point toward a lower AUD/NOK. Chart I-16AUD/NOK At A Premium To Expected Rates Fourth, AUD/NOK is once again very expensive, trading at a 12% premium to it purchasing power parity equilibrium (Chart I-17). It only traded for an extended period of time at a richer premium when Brent was free-falling to US$25/bbl. Since we anticipate oil to rebound, such a premium in AUD/NOK is unwarranted. Chart I-17AUD/NOK Is Pricey Finally, all our technical indicators show that AUD/NOK is massively overbought (Chart I-18). The study on momentum we conducted last year showed that out of 45 G-10 FX pairs tested, after AUD/SEK, AUD/NOK was the second worst one to implement momentum-continuation trades.2 As a result, we would anticipate that the recent period of overbought conditions will lead to a period of oversold conditions. Chart I-18The Mean-Reverting AUD/NOK Is Overbought Bottom Line: Selling AUD/NOK today makes sense. BCA anticipates oil prices to rebound relative to metals prices, the Australian economy is slowing relative to Norway’s, monetary policy is moving in a NOK-friendly fashion, AUD/NOK is expensive, and the cross is well-placed to experience a large episode of momentum reversal.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com  Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “2019 Key Views: The Xs And The Currency Market”, dated November 30, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The price component of the ISM manufacturing survey underperformed expectations, coming in at 60.7. This measure also declines sharply from the previous month. However, the headline ISM Manufacturing survey surprised to the upside, coming in at 59.3. Total vehicle sales also outperformed expectations, coming in at 17.50 million. The DXY U.S. dollar Index was flat for the past two weeks. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and falling inflation has historically been very positive for this currency. Moreover, the fed will likely hike more than anticipated by the market, providing another tailwind for the dollar until at least the first quarter of 2019. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in Europe has been mixed: Retail sales growth underperformed expectations, coming in at 1.7%. Moreover, core inflation also surprised to the downside, coming in at 1%. However, market services and composite PMI surprised positively, coming in at 53.4 and 52.7 respectively. EUR/USD has been flat for the past two weeks. We are bearish on the euro, given that we expect Chinese tightening to continue to weigh on global growth. Furthermore, recent disappointment in euro area inflation confirms our view that it will be very difficult for the ECB to tighten policy. This means that rate differentials will continue to move against EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Nikkei manufacturing PMI outperformed expectations, coming in at 52.2. Moreover, housing starts yearly growth came in line with expectations, at 0.3%. However, Markit Services PMI came in at 52.3, decreasing from last month’s number. USD/JPY has decreased by -0.4% these past two weeks. We are positive on the yen for the first quarter of 2019. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which should keep decreasing as markets continue to sell off. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Nationwide housing prices yearly growth came in at 1.9%, outperforming expectations. Moreover, Markit manufacturing PMI as well as construction PMI both surprised positively, coming in at 53.1 and 53.4 respectively. However, Markit Services PMI underperformed expectations, coming in at 50.4. GBP/USD has decreased by 0.7% these past two weeks. The pound continues to be a complex currency to forecast. While the pound is cheap and makes for a potentially attractive long-term buy, current political risk continue to make a shorter-term position very risky. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.8%. Moreover, building permits month-on-month growth also surprised negatively, coming in at -1.5%. Finally, construction done also surprised to the downside, coming in at -2.8%. AUD/USD has decreased by -0.5% these past two weeks. We believe that the AUD is the currency with the most potential downside in the G10. After all, the Australian economy is the economy in the G10 most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: Building permits month on month growth outperformed expectations, coming in at 1.5%. However, retail sales as well as retail sales ex-autos both declines from the previous quarter, coming in at 0% and 0.4%. NZD/USD has increased by 1% these past two weeks. After being bullish in the NZD for a couple of months, we have recently turned bearish, as we believe that this currency is very likely to suffer in the current environment of declining inflation and global growth. With that said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: Retail sales month on month growth outperformed expectations, coming in at 0.2%. Moreover, headline inflation also surprised to the upside, coming in at 2.4%. Finally, the BOC core inflation measure increased from last month’s number, coming in at 1.6%. USD/CAD has risen by 1.7% these past two weeks. A lot of this weakness was caused by the dovish communication of the Bank of Canada following their announcement to keep rates on hold at 1.75%. This change in stance is likely a response to the collapse in oil prices in the past months. With that in mind, we are inclined to believe that the CAD might be reaching oversold levels, as oil is likely to stabilize and the economy continue to show signs of strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.4%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 99.1. Finally, headline inflation also surprised negatively, coming in at 0.9%. EUR/CHF has decreased by 0.5% these past two weeks. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover, registered unemployment also surprised negatively, coming in at 2.3%. Finally, the credit indicator came in line with expectations at 5.7%. USD/NOK has been flat these past two weeks. We are shorting AUD/NOK this week, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency shows one the most mean reverting tendencies in the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence underperformed expectations, coming in at 97.5. Moreover, retail sales growth also underperformed expectations, coming in at -0.1%. Finally, gross domestic product yearly growth also surprised negatively, coming in at 1.6%. USD/SEK has fallen by roughly 1% these past two weeks. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank continues to be too dovish given the current inflationary backdrop. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights The Reserve Bank of Australia (RBA) may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band.  Reflation in China could also embolden the RBA to tighten monetary policy – though the odds of a more aggressive stimulus package will decline as long as China’s overall economy remains stable and the U.S. maintains its tariff ceasefire. The Labor Party is favored to win the federal election, which is most likely to occur in May. This is a low-conviction view, as polls are tight and economic improvement will help the ruling Liberal-National Coalition. Feature 2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. One country that has bucked the trend to some degree is Australia. The nation has famously avoided a recession since 1991 and last saw a tightening of monetary policy in 2010. While the recession streak is unlikely to be broken in 2019, there are growing risks that the era of interest rate tranquility will soon end. In this Special Report, jointly published with our colleagues at BCA Geopolitical Strategy, we update our views on Australia for 2019 – a year when the investment backdrop has the potential to become far more interesting, and volatile, due to election year uncertainty and a potential shift to a more hawkish bias for monetary policy. The Bond Outlook: What To Watch To Turn Bearish BCA Global Fixed Income Strategy has maintained an overweight stance on Australian government bonds since the end of 2017. That high-conviction view stemmed from our expectation that the Reserve Bank of Australia (RBA) would keep policy rates on hold for longer due to sluggish economic growth and underwhelming inflation. This recommendation has performed well, with Australian government bonds returning 2.4% (currency-hedged into U.S. dollars) in 2018 year-to-date, beating the Bloomberg Barclays Global Treasury index by 190bps. The benchmark 10-year Australian government is now yielding 36bps below the equivalent 10-year U.S. Treasury yield, the tightest spread since 1980 (Chart 1). Chart 1Australian Bonds Have Outperformed Looking ahead, we still have a positive opinion on Australian debt relative to its global peers over the next six months. The RBA is unlikely to make any adjustments to the Cash Rate - which remains at a highly-accommodative level of 1.5% - without seeing some signs of accelerating inflation in both the Q4 2018 and Q1 2019 CPI reports. This is especially true given the political uncertainty with another federal election due by May 18,1 which could change the outlook for fiscal policy (as we discuss later in this report) and impact the RBA’s economic projections. In our view, the RBA will only be able to seriously consider an interest rate hike, warranting a downgrade of our recommended overweight stance, if all three of the following conditions occur: Australia’s underemployment rate falls below 8% China’s economy shows convincing evidence of reacceleration, especially in commodity-intensive industries like construction Core CPI inflation rises back to at least the midpoint of the RBA’s 2-3% target band We will now discuss each of these in turn. Underemployment Australia is a fairly open economy with a large export sector, but consumer spending is still the largest share of GDP (60%) so it matters most for growth. On that front, real consumption has grown in a narrow and uninspiring range between 2-3% over the past five years. Anemic wages and disposable incomes have been the problem, with the growth of both (in nominal terms) struggling to grow faster than low realized inflation, which now sits below the RBA’s inflation target range of 2-3% (Chart 2). Households have been forced to deploy a greater share of that modest income growth just to maintain spending, with the savings rate plunging from 8% at the end of 2014 to 1% this year and consumer debt piling up. Chart 2An Income-Fueled Pickup In Consumer Spending The dynamics may be changing in a more positive direction, however. Growth rates of nominal wage (+2.3%) and disposable income (+3.1%) have accelerated this year to a pace faster than inflation. With real incomes perking up, the year-over-year growth rate of real consumer spending growth accelerated to 3% in Q3/2018, driving real GDP growth to similar levels. A sustained pickup in wage growth is necessary before the RBA would even contemplate a rate hike. For that to occur, there must be decisive evidence of a tightening Australian labor market and increased resource utilization. While the headline unemployment rate of 5.0% is below the OECD’s estimate of the full employment NAIRU for Australia (5.3%), broader measures of labor market slack are still at elevated levels. Specifically, the “underemployment” rate, which includes workers who are working fewer hours than they would like or at jobs below their skill levels, is still at an elevated 8.3% (Chart 3). That is down from the peak of just below 9% seen in early 2017, but well above the 2012 trough near 7% (when wage growth was close to 4%).  Chart 3UNDERemployment Rate Matters More For Australian Wages Australian wage growth tends to correlate more with the underemployment rate than the traditional unemployment rate (middle panel). This suggests that the recent blip higher in wage growth could be the beginning of a new trend, given that it has occurred alongside the recent drop in underemployment. Already, underemployment is back below the levels that prevailed when the RBA did its last interest rate cut back in 2016 (bottom panel).  A further dip lower in the underemployment rate to below the 8% threshold would likely confirm that wage growth has more upside. That outcome would give the RBA greater confidence that consumer spending will gain more strength even with a low savings rate, and that CPI inflation will return back into the target range – both outcomes that would justify some removal of the RBA’s highly stimulative monetary accommodation. China Stimulus The main connection from China’s economy to Australia is through Chinese demand for Australian exports. There is also an indirect, but very important, link between Chinese demand boosting industrial commodity prices. The latter boosts Australian growth through positive terms-of-trade effects and increased capital spending in commodity-related sectors like mining. Iron ore is the most important of those commodities, representing 18% of total Australian goods exports, with 85% of those iron ore exports going to China. Australian export growth has decelerated during 2018 from the very robust 15% year-over-year pace to a still solid 10% rate. This has mirrored the trends seen in many other economies, where exports have slowed alongside diminished demand from China. If Chinese authorities change their current policy trajectory, and embrace more aggressive fiscal and credit stimulus, then they will reaccelerate the country’s flagging demand, which should benefit Australian exporters. If the increase in spending occurs in commodity-intensive parts of China’s economy, like construction, then Australia can also benefit from a terms-of-trade impact if commodity prices rise. However, BCA’s Geopolitical Strategy and China Investment Strategy remain skeptical that China will launch a major economic stimulus package along the lines of what occurred in 2015-16. That surge not only boosted Chinese GDP and import demand but also triggered a boost to global industrial commodity prices that benefitted many commodity exporters, including Australia. In recent months, there has been a pickup in overall Chinese import growth, as well as some acceleration of higher frequency growth indicators like the Li Keqiang index (Chart 4). Australian exports to China have not picked up though, and Chinese iron ore imports are contracting. Part of that is due to the elevated levels of Chinese iron ore inventories. More likely, there is little demand for additional iron ore given China’s reform agenda and the struggles of its construction sector (which accounts for roughly 35% of Chinese steel demand). Chart 4China Stimulus Not Helping Australia...Yet? Our colleagues at BCA China Investment Strategy2 have noted that both weakening sales and tighter funding sources for real estate developers point to declining growth in property starts and construction. This will be negative for construction-related commodity markets and construction-related machinery. This is coming at a time when the Chinese government is trying specifically to address over-indebted industries like construction. As for the U.S.-China trade truce, a permanent de-escalation of tensions – which has not yet occurred – could provide a boost to Australian export demand, as with other export-focused countries. But the negative impact of bilateral U.S.-China tariffs on the global economy is much smaller than that of China’s attempt to limit indebtedness. Moreover, a trade truce will remove China’s primary incentive to adopt more aggressive stimulus. Nevertheless, from the RBA’s perspective, any boost to China’s construction-related activity would have a big impact on Australia’s economy and would strengthen the case for a rate hike in 2019.  Core Inflation Australia’s headline CPI inflation has struggled to hit even the bottom end of the RBA’s 2-3% target band since 2015, reaching only 1.9% in Q3 of this year (Chart 5). The story is even worse for inflation excluding food and energy, with core CPI inflation now only at 1.2% after having drifted lower in two consecutive quarters. Both market-based and survey-based measures of inflation expectations are also hovering near 2%. Chart 5Australian Inflation Well Below RBA Target When breaking down the CPI into tradeables (i.e. more globally-focused) and non-tradeables (i.e. more domestically-focused), the two types of inflation have not been accelerating at the same time since the 2009-11 period. Since then, faster tradeables inflation has occurred alongside slowing non-tradeables inflation, and vice versa.  While volatility on the tradeables side should be expected given the correlation to swings in commodity prices and the Australian dollar, the weakness in non-tradeables is more directly related to the spare capacity in the domestic economy. Therefore, if wage growth continues to pick up as the labor market tightens, then non-tradeables inflation should follow suit and boost Australian CPI inflation back towards the RBA target range. The implication for the RBA is that a move in core CPI inflation back towards 2.5% (the midpoint of the RBA band), occurring after an acceleration in wage growth as described above, would give the central bank confidence that a higher Cash Rate is required. Bottom Line: The RBA has kept interest rates on hold for over two years, but may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band. A more aggressive fiscal and monetary stimulus package in China, while not our base case, would also embolden the RBA to tighten monetary policy. Risks From Australian Banks? Throughout 2018, the Australian financial industry has had to endure the slings and arrows of a government inquiry into its questionable business practices and misconduct. Revelations of bribery, fraud, the charging of fees for no service and from the accounts of deceased people, as well as board-level deception of regulators, have roiled Australia's financial sector since the explosive inquiry began in February. The final report of the Australian Financial Services Royal Commission will be published in February, but the impact is already being felt throughout the industry. Bank CEOs have been publically shamed, while other senior financial sector executives have been forced from their jobs. The chairman of National Australia Bank stated before the inquiry that customers’ trust in lenders had been “pretty well eroded to zero”, and that it could take as long as a decade to successfully overhaul the culture within the banks. The biggest impacts from the Commission will come through hits to banks’ earnings and funding costs, as well as the potential impact on lending standards for new loans. Australian banks will be less profitable because of fines, customer refunds, setting aside provisions for potential misconduct penalties and the government wanting increased competition. If banks also choose to be more conservative with the marking of loans, then higher loan-loss provisions could be an additional drag on bank earnings. Already, Australian bank stocks have severely underperformed the overall domestic market, and there has been some slowing of domestic credit growth (Chart 6). There are also signs of bank funding stresses from contracting bank deposit growth (second panel) and wider offshore funding costs like relatively elevated LIBOR-OIS spreads (bottom panel). Considering how heavily Australian banks rely on offshore funding, any squeeze in those markets could severely influence the availability of credit within the Australian economy. Chart 6Australian Banks Under Some Stress... Looking ahead, if banks do tighten up their lending standards in response to the criticism and findings of the Commission, that will be from a starting point of very accommodative levels. In other words, getting a loan will likely still be “easy”, rather than “incredibly easy”. The reason is that Australian bank balance sheets remain in excellent condition. Credit crunches begin when banks are undercapitalized and are forced to retrench new loan activity as losses on existing loans pile up. That is not the case in Australia, where the major banks have Tier 1 capital ratios in the 10-12% range and non-performing loans are a tiny share of total lending. In our view, a true credit crunch would likely only occur after the Australian housing bubble bursts and the economy enters a severe downturn. That outcome would most likely be triggered by monetary policy tightening via multiple RBA rate hikes. Importantly, some of the steam has already been taken out of Australian house prices thanks to changes in regulations on new lending (Chart 7), potentially reducing some of the immediate risks to growth from a sharp plunge in home values.  Chart 7...But No Credit Crunch Expected Bottom Line: In 2019, the Australian government and its key financial regulators will have to work together to enforce responsible lending without triggering a catastrophic property market unwind. RBA policymakers are less likely to hike rates given their desire to maintain financial stability in the aftermath of the Commission – or at least until the inflation story forces their hand, as outlined in this report. The Federal Election: Polling Slightly Favors Labor Scandals in the financial sector are of utmost importance to the other major factor that could make 2019 a year of significant change in Australia: the federal election that looms most likely in the spring. Parliament is balanced on a knife’s edge, with the Australian Liberal Party’s loss of former Prime Minister Malcolm Turnbull’s parliamentary seat in a Sydney by-election on October 20. The ruling Liberal-National Coalition no longer has a majority and must rely on independent MPs to survive any no-confidence vote. This precarious situation suggests that the election could come even sooner than May and that the slightest twist in the campaign could deliver at least a small majority to either of the top two parties. Indeed, at this early stage, a high-conviction view on the election outcome is not warranted. After all, the 2016 election was decided in the Coalition’s favor only after a shift in opinion in the final month! Chart 8Labor Party Narrowly Leads All-Party Opinion Polls Nevertheless, with all due caveats, our baseline case is for a Labor majority in 2019, however slim it may be.3 Labor is slightly ahead of the Coalition in the primary opinion polling, which includes all parties (Chart 8). In two-party preference polling, Labor has gradually widened its general lead since the July 2016 election and now holds a 10% advantage in the federal polls – albeit only a 6% lead when a moving average is taken (Chart 9). Labor is also winning or tied in every major state. Chart 9Labor Has Large Lead In Two-Party Preference Polls The dramatic shift in polling since August is significant because that is when the knives came out and the Coalition ousted Turnbull in favor of the current Prime Minister Scott Morrison. The purpose of this move was to give the party a facelift ahead of the election. It is true that public opinion views Morrison as the preferred prime minister to Labor’s Bill Shorten. Shorten has a negative net approval rating and has never been viewed as an inspiring politician, while Morrison is just barely net positive. This perception works against Labor’s lead in the party polling – which is very competitive anyway – and suggests the election will be close. Critically, the Liberal-National Coalition’s polling as a whole has not benefited from the change in leadership. And in fact the data does not support the two major Australian parties’ abiding belief that a leadership coup will boost their popularity: Australia has seen four of these coups since 2010, two from Labor and two from the Coalition, and the party in question lost an average of 8% of the popular vote and 14 seats in parliament in the succeeding election (Table 1). Table 1Intra-Party Coups Don’t Win Votes Turnbull’s ouster also calls attention to another detrimental factor for the Coalition: the challenge on the right flank from minor and anti-establishment parties. Pauline Hanson’s One Nation has a relatively low support rate both historically and in today’s race, currently at 8%, but anti-establishment feeling may have forced the Coalition into an error. Judging by the party’s weak polling since August, the negative response to Turnbull’s ouster has been more detrimental than the nomination of Morrison, an immigration hardliner and social conservative, has been beneficial. Meanwhile, Labor’s momentum has been corroborated by a string of surprise victories in by-elections and a sweeping win in the Victoria state elections on November 24. In the latter case, the party not only defended its hold on government, as one might expect in this progressive state, but exceeded expectations to win 56 seats out of 88 in the lower House, while the Coalition lost nearly half of its seats, falling from 37 to 21. Still, Labor’s lead is by no means decisive. In the average of the various primary polls its edge over the Coalition is within the margin of error. Moreover, the Coalition holds more “safe” (uncompetitive) seats than Labor.4 The bottom line is that a small swing in either party’s favor can produce a thin majority. The Coalition’s best case is the economy. But as concerns about unemployment and job creation recede, voters will make other demands. The top issues in recent polling are the cost of living, health care, housing affordability, and wages. Some polls also emphasize social mobility and climate change and renewable energy. Will Shorten’s Labor Party be able to capture the median voter? It is highly significant that the party has taken a rightward turn on immigration and taxes even as it holds out a more left-wing agenda on health, education, regulation, and social benefits. Immigration has played a major role in Australian politics and Labor is currently positioned near the political center – in other words, if Morrison hardens his line to guard against populists, he risks over-hardening and moving away from the median voter (Chart 10). Shorten has proposed a large bipartisan task force to determine the proper limits to immigration and how to deal with congestion and infrastructure pressures. Shorten’s platform also calls attention to abuse of temporary visas by foreign workers. Chart 10Labor Is Not Too Soft On Immigration On taxes, Shorten has attempted to separate small and big companies, again in a bid for the political center. When Prime Minister Morrison sought to establish his anti-tax credentials (Chart 11), Shorten met him halfway and proposed relief for middle class families and small and medium-sized enterprises. Yet he doubled down on higher taxes for multinational corporations and high-income earners. Chart 11Liberal-National Coalition Cutting Corporate Tax Rates Critically, the latter redistributive stances are more in line with the median voter than the Liberal Party’s more conservative, supply-side, tax cut agenda. All of Australia’s parties, including the increasingly popular “minority parties,” have a more favorable attitude toward redistribution than the Coalition, which is the outlier (Chart 12). Indeed, the National Party is closer in line with the others than the Liberals, highlighting the divisions within the Coalition that have been jeopardizing votes. As for tax cuts on middle income earners and small businesses, Labor’s acceptance of them speaks to voter concerns about living costs, jobs, and wages. Chart 12The Coalition Is Out Of Synch On Taxes Labor is also closer to the median voter on the aforementioned financial sector scandals. The Coalition stands to suffer because it has developed a reputation for being too cozy with the banks (Chart 13). This is one of the biggest perceived differences between the two major parties – in addition to the negative perception of intra-Coalition betrayal – and it is possibly one of the most salient issues in the election. This presents a serious danger for the Coalition. Chart 13Banks: The Coalition’s Ball And Chain What would a Labor government bring? The market will be jittery about Shorten’s attempts to increase tax revenue, which threatens a non-negligible tightening of fiscal policy. Shorten wants to raise taxes on high income earners; remove or lower deductions and discounts (such as on capital gains); crack down on tax evasion; and tighten control over a range of tax practices specific to Australia (limiting “negative gearing” and cutting cash refunds for “franking credits”). He is also taking a tough position on banks and the energy sector. At the same time, it is clear from Labor’s proposals in 2016 (Chart 14) that there will be a hefty amount of new spending coming down the pike if a Labor government is formed – primarily on education, health, infrastructure and job training. The tax cuts that Shorten does support will go to those with a higher propensity to consume, as well as to SMEs that are responsible for job creation. Chart 14Labor’s Spending Plans Unlikely To Change Much Ultimately, Australia’s recent history, taken in consideration with the global business cycle, does not suggest that the Labor Party is all that much more fiscally profligate than the Coalition – but the current budget balance does suggest that there is substantial room to increase deficits, which is convenient for a government that is predisposed to give voters more services (Chart 15). Hence fiscal easing is the path of least resistance - one that could make the RBA even more comfortable in raising interest rates if the conditions laid out earlier in this report come to pass. Chart 15Australia's Next Government Will Have Room To Spend! Bottom Line: The Australian Labor Party is slightly favored to win the next Australian election. This is a low-conviction call given the tight competition in public opinion polling and other mixed indicators. Broadly speaking, Labor’s shift to the political center on immigration and some tax issues makes the party more electable relative to the Coalition; meanwhile its promise of more government services fits with voter demands. We do not accept the narrative that Shorten’s Labor Party will engage in substantial fiscal tightening. The path of least resistance is for tax cuts as well as revenue collection, and for greater government spending. On the other hand, if the Coalition capitalizes on the incumbent advantage and stays in power, larger tax cuts will be in store. Hence we expect Australia to see marginally larger-than-expected budget deficits and fiscal thrust as the one reliable takeaway of next year’s election. Fixed Income Investment Implications We continue to recommend an overweight stance on Australian government bonds in currency-hedged global bond portfolios. While we have laid out the conditions that would make us change that view in this report, it is still too soon to position for such a move. Our RBA Monitor, which measures the cyclical pressures on the central bank to change monetary policy settings, is modestly below the zero line (Chart 16). This indicates a need for easier policy, although the indicator is starting to rise driven by the inflation components in the Monitor (bottom panel). In terms of market pricing, there are only 15bps of rate hikes over the next year discounted in the Australian Overnight Index Swap (OIS) curve, so markets are exposed to any shift to a more hawkish bias by the RBA as 2019 progresses. Chart 16Our RBA Monitor Starting To Turn Less Dovish Looking purely at Australian government bond yields, the forward curves are priced for very little change in yields over the next year (Chart 17). This suggests that outright duration trades in Australia look uninteresting from a carry perspective of betting against the forwards. We continue to prefer Australian bonds on a relative basis to global developed market peers until there is more decisive evidence pointing to convergence of Australian growth and inflation to the other major economies (bottom panel). Chart 17Stay Overweight Australian Government Bonds Over the past year, Global Fixed Income Strategy has recommended tactical trades in Australian money market futures to fade the pricing of RBA hikes that we did not expect to materialize. Specifically, we entered a long position in December 2018 Australian 90-Day Bank Bill futures on October 17, 2017, then switched to a long October 2019 90-Day Bank Bill futures position on May 29, 2017. The latter contract is now trading at implied interest rate levels just above the RBA’s 1.5% Cash Rate (Chart 18), suggesting that there is no more value in this trade.  Chart 18Taking Profits On Our Long Bank Bill Futures Trade We therefore take a profit of 21bps on the Bank Bill futures trade, while awaiting evidence from the “RBA Hike Checklist” introduced in this report before considering trades that will benefit from a more hawkish central bank.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1      Technically the House of Representatives election could occur as late as November 2, while the half Senate election is due May 18, but the norm is to hold the election simultaneously. The 2016 election was a “double dissolution” involving the election of the entire Senate and House of Representatives.  2      Please see BCA China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018, available at cis.bcareserach.com. 3      We would slightly favor Labor leading a slim majority in the Senate as well as in the House. In the Senate, the half of the seats that are up for grabs are evenly split and the polling at this early stage favors Labor over the Coalition. The poor performance of the Greens, in recent polling and in the Victoria state election, suggests a positive development for Labor on the margin, whereas One Nation, whose polls are improving, poses a threat to the Coalition. 4      Labor is fighting for 15 “marginal” (hotly contested) seats and 28 “fairly safe” seats, while the Coalition is only fighting for 12 marginal seats and 14 fairly safe seats.  

Dear Client, Early next week, we will be sending you our BCA Outlook 2019 - our annual dialogue with the bearishly inclined Mr. X and his family. In this report, BCA editors will highlight the most impactful themes for the global economy next year, and the opportunities and risks they create for international asset markets. Next Friday, we will also send you our take on the implications of this discussion for the FX market. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A bearish consensus is forming around the dollar for 2019 as U.S. growth is falling prey to global economic deterioration. However, slowing global growth and inflation create the best environment for the dollar, suggesting the greenback could perform very well in early 2019. While EUR/USD should trade below 1.10 before mid-2019, the dollar should be strongest against the AUD, the NZD and the SEK. The yen faces a trickier picture. With a low degree of conviction, we anticipate USD/JPY to depreciate; but with a high level of confidence, we foresee additional strength in the JPY against the AUD, the NZD and the SEK; EUR/JPY should move below 120. Close short CAD/NOK. Feature The end of the year is approaching, which means that like BCA, banks and research houses around the world are rolling out their major forecasts for the upcoming year. The near-uniform bearishness toward the greenback of the current vintage of forecasts has struck us. Our contrarian streak inclines us to re-assert our bullish dollar stance, but being contrarian for the sake of it is often the perfect recipe to lose money. Welcome To The Jungle A bearish tone on the dollar appears justified right now. Speculators hold near-record long bets on the dollar, yet U.S. economic data seem to finally be succumbing to the gravitational pull of slowing global economic activity. U.S. core inflation has disappointed, orders have been weak, capex intentions have softened, the Conference Board's leading economic indicator has rolled over, and financial conditions have tightened as junk bonds have sold off. This combination could easily generate the perfect recipe for the dollar to sell off. The dollar's strength has been rooted in the divergence of U.S. growth from a weak world economy (Chart I-1). As the narrative goes, without U.S. strength, the Federal Reserve will not be tightening policy anymore, and the dollar will sag. Interest rate markets are already on this page, as after the December meeting they only foresee one more rate hike over the coming two years. Chart I-1Will The Dollar Lose A Key Support? Despite this tantalizing narrative, the dollar rarely weakens because of poor U.S. growth alone. To the contrary, dives in our diffusion index of 16 key U.S. economic variables are most often associated with a strengthening greenback (Chart I-2). The recent sharp fall in this diffusion index would actually point to an appreciating USD. Chart I-2The Plot Thickens This relationship is obviously paradoxical. It exists because the dollar is not a normal currency: it is the premier reserve currency of the world. Resting at the center of the global financial system, the dollar is more sensitive to global growth and inflation conditions than to U.S. growth and policy alone. As Chart I-3 shows, the dollar's behavior is a function of where we stand in the global economic and inflation cycle. We looked at the performance of G-10 currencies versus the dollar since 1986, decomposing the period in four samples based on trends in global activity and global headline inflation. We observed the following patterns: When global growth is accelerating but inflation is decelerating, the dollar tends to weaken, especially against the very pro-cyclical AUD, NZD and SEK (Bottom right quadrant). This is often an environment observed in the early days of a business cycle recovery. When global growth and global inflation are both accelerating, the dollar also tends to weaken, but the pattern is much less clear than in the previous stage (Top right quadrant). This is generally a mid-cycle environment. When global growth is decelerating but global inflation is accelerating, the dollar weakens much more clearly than in the mid-cycle stage (Top left quadrant). In this stage, global growth has begun to decelerate but is still elevated. Risk assets are doing well, but some clouds are gathering on the horizon. European currencies perform best. The most distinct change in the dollar's behavior happens when both global growth and global inflation are decelerating (Bottom left quadrant). In this context, the dollar is strong across the board. This is an end-of-cycle environment where global growth is poor and inflation sags. Investors become very risk averse and they favor the dollar. Commodity currencies and Scandinavian currencies are the worst performers, while the yen is the best. We were surprised that the yen did not manage to appreciate during the periods described by the bottom-left quadrant. However, this is due to the long sample used (since 1986). Prior to the mid-1990s, the yen was a decidedly pro-cyclical currency. This taints the study's overall results. If we only use a shortened time span, the yen in fact appreciates in the last stage of the global business cycle. The yen is the only currency to experience such a sharp regime shift in its relationship to the global business cycle. Chart I-3The Dollar And The Global Business Cycle Bottom Line: Dividing the business cycle into four periods shows that only when global growth and inflation are very weak can the dollar unequivocally rally. This is exactly what we would anticipate of a reserve currency. Investors flock to it when they are looking for safety. Moreover, since being the global reserve currency also means that most of the world's foreign-currency borrowing is in dollars, periods of tumult force debtors to repay their debt, prompting them to buy the greenback in the process. Finally, the low beta of the U.S. economy to the global industrial cycle only adds fuel to the fire, as it means that U.S. growth outperforms global growth when global activity deteriorates meaningfully. Paradise City Under this lens, the dollar's strength this year was rather impressive. We have seen global growth slow, but global inflation accelerate. This could have been a disastrous year for the dollar, but it was not. Markets have been sniffing out slower growth and its potentially deflationary impact; hence, the dollar has responded well. Moreover, the dollar started the year trading at a 5% discount to its fair value, and investors were massively short. Finally, as we have previously showed, the dollar is the epitome of momentum currencies within the G-10 space, and this year, our momentum measure flagged a very bullish signal for the dollar (Chart I-4).1 Chart I-4Momentum Has And Continues To Support The Greenback While the dollar has already been strong, the next three to six months could generate considerably more dollar strength. The dollar may not be cheap anymore, but as we argued last week, it is not expensive either.2 Moreover, while investors are already very long the dollar - a source of concern for us - momentum still favors the greenback. Finally, the global economy might spend some time in the bottom-left quadrant described above where global growth and global inflation both decelerate - the quadrant where the dollar strengthens. Thus, both momentum and economics could line up to enhance the dollar's appeal. First, we have already highlighted that global growth is in the process of weakening. Under the weight of China's deleveraging efforts, of uncertainty surrounding global trade under the Trump administration, and of the tightening in EM financial conditions, global export growth has been flailing.3 Now, our global economic and financial advance/decline line shows that enough variables are pointing in a growth-negative direction that global industrial production - not just orders and surveys - is set to deteriorate sharply (Chart I-5). Chart I-5Global Growth Will Slow Materially In The First Half Of 2019 This message is confirmed by the OECD's leading economic indicator, which is falling faster than it was in late 2015. Most crucially, the very poor performance of EM carry trades financed in yen, which have been a reliable forecaster of global industrial activity, point to a sharp deterioration of our Global Nowcast (Chart I-6), an indicator that measures the evolution of global industrial activity while bypassing the long publishing lags inherent in global IP statistics. Chart I-6The Canaries Are Suffocating Second, while global inflation has been on an uptrend, we expect it to soon relapse, potentially for six months or so. To begin with, we are already seeing some key global inflation measures soften. Recent U.S. core inflation releases have disappointed, Japan's GDP deflator has grown more negative, Germany's producer prices have decelerated, and both producer and core consumer prices in China are slowing sharply. If we are to believe financial markets, this development has further to run. The change in 10-year and 5-year/5-year forward U.S. inflation break-evens has collapsed, and the performance of U.S. industrial stocks relative to utilities suggest that global core inflation will soon decelerate noticeably (Chart I-7). Additionally, the annual total returns of EM equities relative to EM bonds, adjusted for their mutual volatility, has fallen, which normally also foreshadows a decline in underlying global inflation (Chart I-8). Chart I-7U.S. Financial Market Point To Slower Global Inflation... Chart I-8...So Do EM Stocks And Bonds The trend in some of the most important globally traded good prices is also very worrisome for inflation hawks, at least for the first half of 2019. Oil has fallen 26% since its October peak, but also, after rising nearly 90% from April to August, the Baltic Dry index has tumbled by nearly 45%. Another risk could exacerbate these deflationary forces: the Chinese yuan. The Chinese authorities are afraid of the potentially deeply negative impact on their economy of a trade war with the U.S. As a result, they have slowly been injecting monetary stimulus into the economy and are also adjusting fiscal policy to support the Chinese consumer. However, until now, these measures have not been enough to lift Chinese growth and investment. Chinese interest rates are thus likely to continue to lag behind U.S. rates. Deeper cuts to the reserve requirement ratio for commercial banks are also forthcoming. Historically, these developments have been associated with a weaker renminbi (Chart I-9). Chart I-9A Falling CNY Will Further Curtail Inflation A softening CNY is deflationary for the world for three reasons: It decreases the purchasing power of China abroad; it cuts Chinese export prices; and it forces competitors to China to also lower their prices and let their currencies depreciate in order to maintain their own competitiveness in international markets. In other words, a falling yuan unleashes China's own deflationary forces onto the rest of the world. Bottom Line: While momentum has already been a tailwind for the dollar, now the global economy is likely to enter the quadrant where both growth and inflation decelerate. This means the greenback is likely to pick up an additional strong tailwind. Stay long the dollar. Nightrain Based on this analysis, the first half of 2019 could be very positive for the dollar. The Bottom left quadrant of Chart I-3 implies that EUR/USD is unlikely to suffer the greatest downside. Nonetheless, based on our preferred fair-value model for the euro - which is based on real short-rate differentials, yield curve slope differences, and the price of lumber relative to copper - the common currency needs to move below 1.1 before trading at a discount (Chart I-10). We expect the euro will settle between 1.10 and 1.05. Chart I-10EUR/USD Will Fall Below 1.1 If business cycle analysis is any guide, the dollar should shine most brightly against commodity currencies - the AUD and NZD in particular - and Scandinavian currencies. We closed our long NZD trades last week, and this week's analysis implies completely curtailing our positive bias toward the kiwi. Positive domestic economic results have lifted the AUD, but slowing global growth and inflation will hurt this very pro-cyclical economy. A key support for the expensive AUD will dissipate as quickly as it appeared. We had sold CAD/NOK, but this trade is not panning out. Global business cycle dynamics suggest that we should terminate this bet. Slowing global growth and inflation historically hurt the NOK more than the CAD. As Chart I-11 shows, under these circumstances, CAD/NOK does not depreciate, it appreciates. However, we remain committed to our long-term short AUD/CAD trade. This cross performs poorly in this quadrant of the global business cycle. This view is reinforced by the fact that Robert Ryan, BCA's head of commodities, continues to favor energy over base metals. Furthermore, the Canadian government unveiled C$14billion of corporate tax cuts this week, creating a marginal additional positive for the Canadian economy. We therefore do not expect AUD/CAD to break above the important technical resistance it currently faces. Instead, it is likely to embark on the last leg of a downtrend started in March 2017, which could culminate with AUD/CAD trading between 0.88 and 0.86 (Chart I-12). Chart I-11The Global Business Cycle Votes Nay To Short CAD/NOK, But Yea To Long AUD/CAD Chart I-12Attractive Spot To Sell AUD/CAD The yen is potentially the trickiest of all the currencies. At face value, the global business cycle analysis suggests the yen could depreciate against the dollar, but as we argued, this is an artefact of the long sample used in this analysis. A shorter sample would show the yen appreciating against the dollar. We are inclined to agree with this conclusion. Slowing global growth and inflation as well as a strong trade-weighted dollar could very well put a bid under the price of Treasury bonds over the next few months, especially as speculators are still large sellers of the whole U.S. government bond universe (Chart I-13). Since the yen remains broadly inversely correlated to Treasury yields, it may appreciate against the dollar over the coming three to six months. Chart I-13Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Our view has been and remains that the yen offers its most attractive reward-to-risk ratio on its crosses, not against the U.S. dollar. The business cycle analysis confirms that the yen has upside against all the other currencies when both global growth and inflation slows (Chart I-3, bottom left quadrant). The yen should, therefore, offer plentiful upside against the AUD, the NZD, the SEK and the NOK. Moreover, since the beginning of the year, a core view of this publication has been that EUR/JPY would depreciate4 - a trend that has materialized, albeit in a volatile fashion. Since the global business cycle is likely to put downward pressure on global yields for another three to six months, it should also push EUR/JPY lower (Chart I-14). Hence, a move in EUR/JPY below 120 is likely over the coming months. Chart I-14...Which Will Hurt EUR/JPY Bottom Line: While EUR/USD could fall slightly below 1.1, the greenback is likely to experience its sharpest upside against the AUD, NZD, SEK and NOK. While selling CAD/NOK does not work when global growth and inflation decelerate, selling AUD/CAD does. The JPY is likely to experience more upside against the dollar, but the JPY is most attractive against commodity currencies and the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Six Questions From The Road", dated November 16, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Clashing Forces: The Fed And EM Financial Conditions", dated October 19, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "The Unstoppable Euro?", dated January 19, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity utilization came in above expectations, coming in at 78.4%. However, both initial jobless claims and continuing jobless claims surprised negatively, coming in at 224 thousand and 1.688 million. Finally, durable goods orders also disappointed expectations DXY has been roughly flat this week. Several indicators point to a slowdown on economic data. At face value this could imply that the dollar could fall. However, falling oil prices, point to a slowdown in global inflation. This factor, alongside slowing global growth has historically been very positive for the U.S. dollar. Thus, we maintain our long dollar position. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: Both core and headline inflation came in line with expectations, coming in at 1.1% and 2.2%, respectively. Headline inflation in Italy also came in line with expectations, at 1.6%. EUR/USD has risen by roughly 0.5% this week. Overall, we continue to be bearish on the euro, given that we expect an environment of declining growth and inflation, which usually is negative for EUR/USD. Moreover, large exposure to vulnerable emerging markets by European banks will continue to be a drag on how much the ECB can tighten policy. Report Links: Six Questions From The Road - November 16, 2018 Evaluating The ECB's Options In December - November 6, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The All Industry Activity Index monthly change underperformed expectations, coming in at -0.9%. Meanwhile, national inflation ex-fresh food came in line with expectations at 1%. Finally, national inflation also came in line with expectations, coming in at 1.4%. USD/JPY has been flat this week. We remain positive on the trade-weighted yen, given that the continued slowdown in global growth, fueled by the dual tightening of policy by Chinese authorities and the Fed, will help safe haven currencies like the yen. Moreover, the current selloff in U.S. markets could also provide a boon for this currency if it forces the Fed to tamper its hawkishness. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 GBP/USD has risen by 0.9% this week. The market reacted positively to the draft of the Brexit agreement. Even if risks have begun to decline, the all clear for the pound has not been reached as political risks will continue to regularly inject doses of volatility into British assets. Moreover, the strength in the dollar should continue to weigh on cable. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has been flat this week. We are most negative on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that global inflation will start to roll over. This deceleration in prices, coupled with slowing growth will provide a dangerous cocktail for this cross. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. While we were positive the NZD and capitalized on this view, we are becoming more cautious. We cannot rule out any further short-term upside, but on a six month basis, the NZD will likely experience heavy downside, as slowing global growth and inflation are major hurdles for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has risen by 0.6% this week. The weakness in oil prices have caused the Canadian dollar to be one of the worst performing currencies in the G10 in recent weeks. We are reticent to be too bullish on the CAD, given that markets are now pricing in a BoC that will be more hawkish than the Fed. Nonetheless the CAD tends to outperform other commodity currencies when the global business cycle slows. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen by 0.7% this week. While global volatility can temporarily support the swiss france versus the euro, w continue to be bearish on the franc on a 12 to 18 months basis, given that Swiss growth and inflation remain too tepid for the SNB to hike policy rates. This point is confirmed by the recent rollover in industrial production. Moreover, the SNB will also have to intervene in currency markets if the franc becomes more expensive in response to the current risk-off environment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by 0.4% this week. Overall, we expect for the krone to have further downside as oil continues to fall while U.S. rates continue to rise. Moreover, if the fall in oil prices causes a large fall in inflation the krone could depreciate even more against the CAD, as this cross has historically fallen when this particular set of circumstances occur. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has been flat this week. Overall, we are bullish on the krona on a long-term basis. After all, the Riksbank is on the verge of beginning a tightening cycle, as imbalances in the Swedish economy are only growing more dangerous. The optimism on domestic factors is tempered by global risks. The krona tends to perform very poorly when global growth slows, as Sweden is very exposed to the gyrations of the global economy. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades