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Cause and Effect
Fade the Trump risk premium – buy USD
13 February 2017
Concerns over stagflation return
In our view, the most interesting and important development in the global financial
market so far this year has been the divergence between rising US inflation breakevens
and falling US real yields. Rightly or wrongly, investors appear to have become
concerned about upside risk to inflation and downside risk to growth.
The Trump risk premium
Informal surveys of our clients suggest that stagflation concerns are being fed by
growing pessimism about the new Trump administration. Investors seem to think that
potential trade wars and a border adjustment tax (BAT) would boost inflation while
repealing Obamacare and the controversy regarding the BAT could delay the highly
anticipated tax reform.
Perception versus reality
In this report, we argue why the Trump risk premium may be too high. The
administration’s dealing with both China and Mexico in recent weeks suggests to us that
the near-term risk of open trade wars has abated. We are also less concerned that
Obamacare will take precedence over tax reform.
FX and Rates
Global
David Woo
FX, Rates & EM Strategist
MLPF&S
+1 646 855 5442
david.woo@baml.com
Global Rates & Currencies Research
Most crucially, we think the overall tax reform is less dependent on the BAT than usually
thought. Our scenario analysis shows that what has been getting priced into the market
since January (higher inflation, lower USD) may be actually the least likely path for the
BAT. In more plausible scenarios, the USD does quite well and inflation breakevens
should be either unchanged or lower.
How to trade it?
We could get details on the tax reform as early as the new president’s speech to joint
session of Congress on February 28, 2017. We think this could validate our view of a
stronger USD.
Unauthorized redistribution of this report is prohibited. This report is intended for kaasha.saini@baml.com
Taking advantage of clean positioning and the decline in implied FX vol lately, we
recommend buying a 6w ATM EUR put/USD call (spot reference at 1.0615), costing
1.1% EUR. A 6-week option will cover also the March Fed meeting and the Dutch
election (both on March 15) that could also work in favour of the trade. A risk to the
trade is that is weak February data takes the possibility of a March Fed hike off the
table completely.
A list of open trades and those closed in the last 12 months can be found in our Global
Liquid Markets Weekly.
Trading ideas and investment strategies discussed herein may give rise to significant risk and are not
suitable for all investors. Investors should have experience in FX markets and the financial resources to
absorb any losses arising from applying these ideas or strategies.
BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a
result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report. Investors should consider this report as only a single factor in making
their investment decision.
Refer to important disclosures on page 9 to 10. Analyst Certification on page 8. 11710696
Timestamp: 13 February 2017 06:00AM EST
Concerns over stagflation return
On the surface, this has been an uneventful year for the US rates market so far. At the
start of January, the market was pricing two Fed hikes for the year. Six weeks later, the
market is still pricing only two Fed hikes for the year. The yield on the bellwether 10y
US Treasuries started the year at 2.44%. Six weeks later, it is at 2.41%, unchanged for
all practical purposes.
As usual, the surface view is deceiving. The seeming collapse in volatility belies the
dramatic changes in the composition and term structure of rates. Since the December
FOMC meeting, real yields and inflation breakevens have diverged in remarkable fashion.
Year to date, 5y real yields have declined by 16bp while 5y inflation breakevens have
risen by 12bp (Chart 1); the 5s-30s real curve is 10bp steeper while the breakeven curve
is 10bp flatter.
Chart 1: 5y real yields and 5y inflation breakevens (%)
2.5
2
1.5
1
0.5
0
-0.5
-1
10/1/2016 10/26/2016 11/20/2016 12/15/2016 1/9/2017 2/3/2017
5y real yields (%) 5y infl BE (%)
Source: BofA Merrill Lynch Global Research
The effect of the divergence between real yields and inflation breakevens has been felt
across financial markets. For example, the USD, which trades with real rather than
nominal yields, has declined in tandem with real yields (Chart 2). In contrast, gold, which
usually thrives on inflation concerns, has been surging lately.
Chart 2: DXY and 5y real yields (%)
104
103
102
101
100
99
98
97
96
95
94
10/1/2016 11/1/2016 12/1/2016 1/1/2017 2/1/2017
DXY (LHS)
Source: BofA Merrill Lynch Global Research
5y real yields (RHS)
0.3
0.2
0.1
0
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
Chart 3: 5y real yields versus 5y inflation breakevens (%)
4
3
2
1
0
QE1
QE2 OT QE3
-1
-2
-3
3/1/2009 3/1/2010 3/1/2011 3/1/2012 3/1/2013
5y real yields (%) 5y infl BE (%)
Source: BofA Merrill Lynch Global Research
We have seen price action like this before. Indeed, it was quite common during the QE
period (Chart 3). However, QE is neither on the horizon nor on investors’ minds right
now. So what is really going on? Under normal circumstances, inflation breakevens are a
reflection of investors’ inflation expectations while real yields a proxy for their growth
2 Cause and Effect | 13 February 2017
expectations. The divergence between inflation breakevens and real yields seem to
suggest that investors have become more concerned about upside risk to inflation but
downside risk to growth.
Interestingly, this shift in investor sentiment runs counter to incoming data which are
painting a picture of benign inflation but growth acceleration. Indeed, wage growth
remains lackluster while the Fed’s favorite measure of inflation core PCE has slowed to
the lowest level in more than a year (Chart 4). In contrast, both employment data and
survey data suggest economic growth is on a tear (Figure 5). The Atlanta Fed’s GDPNow
model is currently tracking 2.7% GDP growth for Q1.
If it is not the data, what is driving the market’s apparent increased concerns about
stagflation? Whatever these concerned may be, are they justified? We seek to answer
these two critical questions in this report.
Chart 4: Core PCE (3m/3m, SA, AR, %)
2.5
2.3
2.1
1.9
1.7
1.5
1.3
1.1
0.9
0.7
Jan-10
Jun-10
Nov-10
Apr-11
Sep-11
Feb-12
Jul-12
Dec-12
May-13
Oct-13
Mar-14
Aug-14
Jan-15
Jun-15
Nov-15
Apr-16
Sep-16
Source: BofA Merrill Lynch Global Research
Chart 5: GDP growth and aggregate hours worked (Q/Q, SA, AR, %)
6
4
2
0
-2
Mar-10 Jul-11 Nov-12 Mar-14 Jul-15 Nov-16
Source: BofA Merrill Lynch Global Research
real GDP growth (AR, %)
aggregate hours worked (AR, %)
aggregate hours worked, Jan (AR, %)
The Trump risk premium
Our informal survey of clients in the past two weeks suggests that stagflation concerns
are being fed by growing pessimism about the new Trump administration. Clients tell us
that their pessimism reflects four main concerns:
Downside risk to growth
1. Many investors are concerned that the new administration will get bogged
down by its promise to repeal and replace Obamacare, resulting in a significant
delay in pushing through fiscal reform
2. This concern is reinforced by the perception that the GOP is divided over the
proposed border adjustment tax (BAT), a key element of the tax reform
proposal
Upside risk to inflation
3. A growing number of investors are worried that potential trade wars with
Mexico and China could lead to tariffs and higher prices
4. Many investors are also concerned that the BAT will force retailers to raise
prices
With many investors having loaded up on Trump trades after the elections (The battle
lines are drawn, January 23, their willingness to continue to give the benefit of doubt to
the new administration appears to be wearing thin. We would advise patience as there
Cause and Effect | 13 February 2017 3
are reasons to think that the worst may be already behind us and that the higher
rates/higher USD trades will soon resume. We make our case in the following sections.
Trade wars: near-term risk drops
Developments over the past three weeks have led us to conclude that the risk of trade
wars with Mexico and China has abated significantly, at least for the short-term:
• China: We take some comfort in the fact that the only item in his 100 day plan that
President Trump has reneged on is his promise to label China as a currency
manipulator on his first day as president (Table 1). In his interview with the WSJ on
January 13, Trump said that he “would talk to them first”. He added: “Certainly they
are manipulators. But I’m not looking to do that.” This and the fact that Trump
changed tack on Taiwan last week by telling the Chinese president he would honor
the “One China” policy suggest to us a pragmatic approach to dealing with China.
• Mexico: We are relieved by the climbing-down by the administration after the
Mexican president cancelled his trip to Washington over Trump’s insistence that
Mexico pay for the wall. Reince Priebus, the influential White House Chief of Staff,
suggested that there is a “buffet of options” to pay for the wall, including by going
after the drug cartels. The Mexican foreign minister welcomed the overture by
saying that “It's a signal that … must be welcomed because we are already seeing
how the discussion is changing”.
Table 1: Trump’s 100 day plan (On the first day of my term of office, my administration will immediately pursue the following):
A hiring freeze on all federal employees to reduce the federal workforce through attrition
A requirement that for every new federal regulation, two existing regulations must be eliminated.
A five-year ban on White House and Congressional officials becoming lobbyists after they leave government service.
A lifetime ban on White House officials lobbying on behalf of a foreign government.
I will announce my intention to renegotiate NAFTA or withdraw from the deal under Article 2205
I will announce our withdrawal from the Trans-Pacific Partnership.
Lift the Obama-Clinton roadblocks and allow vital energy infrastructure projects, like the Keystone Pipeline, to move forward.
Begin the process of selecting a replacement for Justice Scalia from one of the 20 judges on my list
Cancel all federal funding to sanctuary cities.
Suspend immigration from terror-prone regions where vetting cannot safely occur. All vetting of people coming into our country will be considered “extreme vetting.”
Begin removing the more than two million criminal illegal immigrants from the country and cancel visas to foreign countries that won’t take them back
I will direct the Secretary of the Treasury to label China a currency manipulator.
I will direct the Secretary of Commerce and U.S. Trade Representative to identify all foreign trading abuses that unfairly impact American workers and direct them to use every tool under
American and international law to end those abuses immediately.
Propose a constitutional amendment to impose term limits on all members of Congress.
A complete ban on foreign lobbyists raising money for American elections.
Cancel billions in payments to U.N. climate change programs and use the money to fix America’s water and environmental infrastructure.
I will lift the restrictions on the production of $50 trillion dollars’ worth of job-producing American energy reserves, including shale, oil, natural gas and clean coal.
Source: Donaldtrump.com/contract; BofA Merrill Lynch Global Research
ACA reforms: not before fiscal reforms
In an interview on February 5, Trump walked back his promise to replace Obamacare in
short order, saying that the process is “complicated” and “maybe it’ll take till sometime
into next year.” In contrast, asked if Americans should expect a tax cut this year, he said:
“I think before the end of the year I would like to say yes.”
Done
Done
Done
Done
Done
Done
Done
Done
Done
Done
Done
Not Done
Not Done
Not Done
Not Done
Not Done
Not Done
In our view, the prevailing pessimism that Obamacare will take precedence over tax cuts
is not consistent with three key facts on the table:
• The Republicans, with only 52 seats in the Senate, do not have the votes to replace
Obamacare.
• It is by now a broadly shared view among Republican leadership that to repeal
Obamacare without replacing it would be very risky politically.
• There is no consensus among Republicans about how to replace Obamacare. For
example, 31 states took up federal funding to expand Medicaid under Obamacare
4 Cause and Effect | 13 February 2017
and 119 House Republicans represent these states. Repealing Obamacare without
replacing it would entail either a significant cut in the funding of the program or
that the state tax payers will have to pick up the bills. Either is likely to hurt
Republican support in these states.
Tax reform: BAT won’t kill it
The proposed border adjustment tax in the Ryan-Brady plan has been attracting a lot of
attention lately. Although we have concerns about some specific aspects of the proposal
(which we will discuss later), the popular view that it could be a deal breaker for the
whole tax reform initiative seems to us difficult to substantiate.
Below are some key facts that are worth noting:
• It has been thirty years since the US last overhauled its tax code. Most mainstream
economists agree that it needs a serious update.
• Tax reform requires strong political consensus. The Republicans, by gaining control
of the Presidency and retaining their control of both houses of Congress in the
November elections, are in a strong position to push through major tax reform.
• The tax reform proposal from House Republicans has already gone through
extensive consultations and enjoys broad support within the House Republican
Conference.
• One of the key commitments of the Trump campaign is tax cuts and simplification
to boost growth.
• The US today has the highest marginal corporate income tax rate among OECD
countries.
• Another major difference between the US and other major economies is that US
corporations are taxed on their world-wide income as opposed to territorial income.
In 2000, 17 out of the current 34 OECD members had a world-wide system. By
2010, only 7 did.
• The combination of high corporate income tax rate and a world-wide income tax
system has two unintended consequences. One, US companies currently hold more
than $2trn in capital overseas. Two, an increasing number of US companies are
acquiring smaller foreign companies with the purpose of relocating their
headquarters outside the US (ie, inversion). Between 2003 and 2011, there were
only 7 such transactions. From 2012 and 2015, 27 such transactions were
completed.
• The valued added tax (VAT) system has been gaining popularity over the past
twenty years. Today, more than 160 countries have a VAT. The U.S. is the only
OECD country that doesn’t.
• The fact that the US does not have a VAT system puts US produced goods at a
disadvantage. VAT is “border adjusted” - meaning that when a good is exported the
producer gets a rebate while imports are subject to VAT.
These facts together make it very apparent that both the case for tax reform and
support for tax reform are very strong. Paul Ryan said on January 26 after the
Republican retreat in Philadelphia that they “aspire” to pass tax reforms by August.
Cause and Effect | 13 February 2017 5
4 BAT scenarios
To us, the key question is not when tax reform will pass (likely sooner than what is
priced in). Far more important for financial markets in our view, especially for the rates
and FX markets, is what tax reform means for inflation. The recent divergence between
inflation breakevens and real yields reflects to a large part to the increasing consensus
that tax reform will be stagflationary.
We are less sure this will be the case and this is why. In our view, there are four possible
paths in terms of how the border adjustment tax proposal could play out:
• Scenario 1: This is the baseline of the Republican architects of the proposal
who see a 25% appreciation of the USD to offset the 20% new tax on imports.
In this scenario, because of the USD appreciation the inflationary impact of the
border adjustment tax will be limited. In fact, it is very likely in this scenario
that the second round effects of the USD appreciation (for example on
commodity prices and emerging markets) will stoke deflationary fears.
• Scenario 2: In this scenario, we would get the BAT as proposed but the USD
does not go up because the new administration sees a strong USD as
incompatible with its trade policy. We suspect this scenario has become the
baseline for the market. We disagree this is the most probable outcome. In our
view, it would be difficult if not impossible for Republican leadership to push
through tax changes that would lead to potentially very unpopular price hikes
ahead of the mid-term elections next year.
• Scenario 3: In this scenario the BAT would not make it into the tax reform and
the proposed corporate tax cut is financed by running up the fiscal deficit. This
could be easier to sell politically than Scenario 2, especially given that the
Republicans plan to deliver personal income tax cuts at the same time. In this
scenario, the USD will rally as the Fed continues to hike and rate differential
drives the USD higher.
Chart 6: The four different fates of the border adjustment tax proposal
Scenario 1: Ryan-Brady proposal
+25% USD increase = Little increase
in inflation
Medium probability:
USD↑↑↑, BE↓↓
Scenario 2: Ryan-Brady proposal +
little USD increase = Big increase in
inflation
Low probability:
USD↑↓, BE↑↑
BAT
Scenario 3: No BAT + bigger fiscal
deficit = Little increase in inflation
Medium probability:
USD↑, BE↓
Scenario 4: VAT instead of BAT =
Smaller increase in inflation
Medium probability:
USD↑↑, BE↑↓
Source: BofA Merrill Lynch Global Research
6 Cause and Effect | 13 February 2017
• Scenario 4: The current BAT proposal has some obvious issues. Because
wages are deductible from taxable income, it essentially taxes domestically
produced goods as a share of value added but taxes imports as a share of their
total value. This is a clear discrimination that would certainly invite WTO
dispute and that could potentially give future non-Republican administrations
the excuse to overturn the tax reform. Moreover, the fact that under the
current proposal some exporters will potentially pay no taxes does not seem
fair to us. Remember, in most countries with a VAT system, there is also a
corporate income tax. In this scenario, we assume that after negotiations we
get a true VAT that is both WTO compliant as well as being revenue neutral.
The USD would do better in this scenario compared to Scenario 3 because the
VAT would help level the playing fields between US and foreign produced
goods and the US trade balance should improve.
How to trade it?
We view the recent weakening of the USD and rising inflation breakevens as mutually
inconsistent, since we think Scenario 2 is not a viable political outcome. The fact that all
other scenarios are associated with a stronger USD and lower to flat inflation
breakevens is supportive of our bullish USD view.
The market needs more clarity on the details of the fiscal reform proposal to determine
the outlook for the USD and rates. It is possible that details may be unveiled as early as
the president’s speech to the joint session of Congress on February 28, 2017. We think
it could validate our view of a stronger USD.
Taking advantage of clean positioning and the decline in implied FX vol lately, we
recommend buying a 6w ATM EUR put/USD call (spot reference at 1.0630). A 6-week
option will cover also the March Fed meeting and the Dutch election (both on March 15)
that can both potentially work in favour of the trade.
We think the market is underpricing the risk of a Fed hike in March and better-thanexpected
results by the Freedom Party in the Dutch election could intensify concerns of
a second-round Le Pen win in May. The latter suggests that over the next 2-3 months it
may be easier to buy the USD than to pay US rates and easier to sell EUR/USD than to
buy USD/JPY.
Cause and Effect | 13 February 2017 7
Options Risk Statement
Potential Risk at Expiry & Options Limited Duration Risk
Unlike owning or shorting a stock, employing any listed options strategy is by definition
governed by a finite duration. The most severe risks associated with general options
trading are total loss of capital invested and delivery/assignment risk... all of which can
occur in a short period.
Investor suitability
The use of standardized options and other related derivatives instruments are
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with a FINRA Registered Options Principal.
For detailed information regarding risks involved with investing in listed options:
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Analyst Certification
I, David Woo, hereby certify that the views expressed in this research report accurately
reflect my personal views about the subject securities and issuers. I also certify that no
part of my compensation was, is, or will be, directly or indirectly, related to the specific
recommendations or view expressed in this research report.
8 Cause and Effect | 13 February 2017
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Cause and Effect | 13 February 2017 9
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10 Cause and Effect | 13 February 2017