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Chart 7: 5Y yields to continue to underperform Chart 8: Real rates likely to feel the pressure going forward 0.5 3.5 3 29 2 0.4 0.3 ——10y US TIP yield 0.2 15 0.1 1 0.5 0 0 -0.1 05 == 7s-5s-10s US fly 0.2 #] Jan-i4 Juket4.—s Jan-14$~—=Sts«Jue1§—~SOt«éan-106 Ss Je 16 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Bloomberg Source: Bloomberg Peak globalization/inequality means higher real rates - short 10Y US real rates Our fixed income team make the point that globalization has been a driving force behind lower real rates as it has been good for EM growth and reserves. Those reserves then found their way back into the US holding real rates lower. They argue that as the global savings glut unwinds real rates have room to re-price. Peak inequality also means an unwind of globalization as politicians seek to protect workers from the depressing effect on wages coming from overseas. Donald Trump has already said he intends to charge China with being a currency manipulator. Whether he does or not and what action he takes to accompany it remains to be seen, but artificially low currencies generating high current account surpluses are unlikely to go down well with the new administration. That lends weight to the fixed income team’s arguments. Peak inequality may also mean less migration across the world — think Trump’s arguments on illegal immigration from Mexico and Theresa May’s desire to limit migration into the UK post Brexit. Less migration likely means more upward pressure on wages, which is the inflation expectations side of the argument. But Michael Hartnett also thinks it means more action on fiscal policy. The UK government have implemented a £24bn infrastructure fund in the Autumn statement. Donald Trump wants to trigger up to $1tn of infrastructure spending in the US in addition to the tax cuts. The fiscal boost should push real rates higher (at least in the short term). Some Fed members have acknowledged this suggesting that equilibrium interest rate might be moved higher by fiscal stimulus. The rates team also rightly says while they want to be bearish rates given the speed of the move so far it is also right not to be foolish. Given how much inflation expectations have moved they think there is better risk reward in real rates. They argue the 10Y real rate is the most vulnerable to further moves higher in rates. Although they have already risen from around zero in the summer to ~50bp now they think 10Y real rates can reach 1%. So we add that trade to our 2-5-10s position. Implications for other asset classes: Stronger USD, weaker EM? The forces impacting on markets from the Trump victory have not been confined to rates markets, although it is probably fair to say that most (although certainly not all) of the impact stems from the move in rates. Higher US rates have meant a stronger USD, an outperformance of short duration over long duration equities, a hit to EM debt and all forms of carry trades. Bankof America 2 Global Cross Asset Strategy - Year Ahead | 30 November 2016 7 Merrill Lynch HOUSE_OVERSIGHT_014438