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Best Directional Trades David Woo Shyam S.Rajan MLPF&S MLPF&S david.woo@baml.com shyam.rajan@baml.com Jane Brauer lan Gordon MLPF&S MLPF&S jane.brauer@baml.com ian.gordon@baml.com Stay hungry, stay bearish (not foolish) For the year ahead, we recommend being bearish 5y US rates, long USDJPY and short a basket of LatAm long bonds (Mexico, Brazil and Colombia). « Butin the near term, we urge caution with the reflation trade. Short 10y US real rates offers the best risk-reward after recent moves. US rates back in the driver seat After three years of being the sideshow, US rates are back. The US rate outlook in no small part will drive the FX and EM outlook for 2017. Our strongest medium-term conviction on a Republican sweep was higher US rates (Mind the Sweep, 31 Aug 16). That conviction remains steadfast: US rates are headed higher to start 2017. But, this is not the time to be foolish — 5y and 10y rates have seen a 5 standard deviation move over the last week. So we recommend a near-term trade (bearish 10y real rates) that has the least to lose if the reflation theme unwinds while capturing most of the upside from a bearish move. Our medium-term directional view goes with the flow of recent price action: short 5y rates, long USDJPY and short basket of LatAm long bonds. Here we make the compelling case that recent moves have a lot further to go. Bearish 5y yields for the medium term Our bearish energy in US rates for 2017 will largely be focused on the 5y point of the curve. Despite the recent move, we see three clear reasons why the market still has to play catch-up from now, at least until inauguration day: 1. Comeback chart of 2017: market vs dots We prefer short 5y rates over the widely held view of short 30y rates given we think that fiscal stimulus will move the Fed before it shows up in fundamentals. We believe the Fed’s current dot projections will move from being a ceiling to a floor on the market. In this case, intermediate forwards like the 3y1 and 4yly have the most room to sell off, leaving the 5y point most vulnerable, (Chart 13). Our fair value framework indicates that if the market were to revert to the dots, 2y rates can move higher by 26bp, 3y rates by 45bp, 5y rates by 57bp and 10y rates by 48bp. Chart 13: After three years of treating the dots as a ceiling, they will Chart 14: Additional deficit needs are likely to be financed by increasing soon act as a floor for the market, in our view front-end auction sizes af 2y 3y 5y Ty 10y 30y 25 e 0 2.0 ry 4) 5 1.5 : ; 10 1.0 . 0.5 18 0.0 -20 beets oli ; Bee"l? HOS ee olllt-T8 ; sacle m Change in auction szies from the peak in 2010 ($bn) ——OlS implied FF target © FOMC median Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Bankof America 2 Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 7 HOUSE_OVERSIGHT_014737