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Chart 3: Change in structural budget balance /potential GDP (pp) Chart 4: Number of Senate seats up for grab in 2018 0.5 25 0.4 0.3 20 0.2 0.1 15 0.0 -0.1 10 0.2 -0.3 5 -0.4 0.5 0 Clean sweep Divided government Democrats Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research fiscal easing will likely place pressure on the Fed to normalize rates more quickly when internal dissent against near zero rates is growing. US rates have backed up quickly after the election, driven largely by a repricing of inflation expectations. With long-term inflation breakevens closing on their historical averages (Chart 5), we think the next phase of the rates move will be led by the belly of the curve. The market is only pricing in a one and a quarter rate hike in 2017, and another one and a quarter hike in 2018, with Fed Funds futures implying that the Fed Funds rates will be only at 1.25% at the end of 2018 (Chart 6). We think the 5y part of the curve offers the best risk-reward trade-off for investors with a 3-6 month horizon to position for a more aggressive Fed. As our leading indicator section suggests, global growth momentum is set to pick up in Q1, also supporting this view. For investors with a 1-3 month horizon, we would recommend shorting 10y real rates. This trade would benefit from higher rates in general, but more importantly, would also benefit from a sudden risk-off that could render vulnerable reflation trades that have gone a very long way since 9 November. This trade would also benefit from a grand bargaining that stabilizes long-term debt dynamics, cuts waste and supports investment and growth. 3. USD/JPY will the main beneficiary of Trump win While the US fixed income sell-off will likely continue to spill over to other bond markets, yield differentials are likely to move in favor of the USD. This will be especially Chart 5: US 10y inflation breakeven (%) Chart 6: Implied Fed Funds rates in 24 months (%) 3 2.8 2.6 24 2.2 2 1.8 1.6 1.4 1.2 1 2.5 1/7/2010 7/7/2011 1/7/2013 71712014 1/7/2016 1/1/2010 Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Bankof America 2 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014733