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its 2% core PCE target. Our economists think that the Fed may well aim a little high in the short term on inflation to ensure they have sufficient room to ease in the event of a downturn. However, it is unlikely that the Fed would tolerate a sustained overshoot of their inflation objective. That is particularly the case if the Fed under President Trump is made more hawkish as our economists think it probably will be (see Liquid Insight: Trump’s stamp on the FOMC). Chart 5: US 5Y5Y forward inflation back towards 2.5% Chart 6: Euro 5Y5Y forward inflation up to 1.6% 3.3 28 3.1 2.6 29 24 27 2.2 25 2 23 1.8 2.1 1.6 19 = US 5y5y fwd inflation swap 14 17 1.2 PEF ESE ee ee a a Source: Bloomberg Source: Bloomberg Equally, our economists in Europe are sceptical on the ECB’s ability to get inflation to rise significantly from current levels. Optically there is scope for European breakevens to head higher if the ECB were to be successful but investors are likely to want to see some evidence of rising inflation first before they price that in. We will return to this below. For now we agree with our fixed income strategists that the rise in inflation expectations is probably sufficient and that any rise in yields from here has to be one of higher real yields. They think such a rise as a tightening of monetary conditions which may be self-limiting in the short term, particularly as the fiscal boost in the US is likely to be back loaded in terms of 2017. If rates move too quickly and the USD follows before the fiscal stimulus kicks in they could actually dampen growth. Indeed, our US economists have shaved their near term growth forecasts already to reflect the current moves. They do not expect the fiscal stimulus to start to boost growth before the 3” quarter. Fiscal + hawkish Trump Fed means we stay short 5Y US via 2-5-10 butterfly Our fixed income team estimated how much fair values of the different parts of the curve would have to move were the market to move into line with the dot plot. Updating those estimates for the move since their publication we find 2Y rates can move another 11bp, 5Y 39bp and 10Y 33bp. They argue that given we are past the inflection point for rates, with fiscal policy being eased and now with a more hawkish Fed under Trump likely, the dot plot should form the floor not the ceiling for rate expectations. All of this translates into a view that 10Y yields can push to 2.65% by the second half of 2017. Given their views on the curve we continue to run the 2-5-10 butterfly. It has moved from around -10bp to +10bp since the election, and our fixed income strategists have moved their target to +20bp. BankofAmerica <2” 6 Global Cross Asset Strategy - Year Ahead | 30 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014437