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Cause and Effect Bank of America Fade the Trump risk premium - buy USD ESL 13 February 2017 Concerns over stagflation return Re aes 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 e e and falling US real yields. Rightly or wrongly, investors appear to have become The First 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 Days 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 eli ary aN Gules: anticipated tax reform. MLPF&S +1 646 855 5442 david.woo@baml.com 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. 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. 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 Unauthorized redistribution of this report is prohibited. This report is intended for kaasha.saini@baml.com HOUSE_OVERSIGHT_014721