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2. Learning from Japanese fiscal stimulus Ultimately, fiscal stimulus is not the long-term answer to flat curves or low neutral rates Qapan being the prime example). Fiscal stimulus merely captures some low-hanging fruit that extends the business cycle by a couple of years and provides the central bank an opportunity to get further away from the ZLB. Said simply, fiscal stimulus raises the terminal rate in the current business cycle while doing little for the long-run neutral rate — this by definition should be more bearish for intermediate rates than 30y rates. 3. Additional deficit issuance With the average maturity of UST debt already standing at record highs (7Omonths), Treasury showing an inclination to cut long-end issue sizes in 2016, and the supply shortfall in the front end of the UST curve post MMF reform, we also believe that the US Treasury will finance the increased deficit using the belly of the UST curve as opposed to the long end Trade: We recommend a 3m5y OTM payer 25 delta, strike = 2.05% for a gross payoff ratio of 3.4: 1. See the Best Vol Trades section for more details and risks. But focus on being short real rates now After spending much of 2016 successfully being long real rates, we recommend switching to a real rate short for 2017. We think the consensus was too slow to get on the real rate train and is now too long relative to benchmark. As described in the detail here, fiscal stimulus is likely to leave government and private companies competing for a shrinking pool of savings, driving the real cost of debt higher. We highlight three reasons why short real rates provides better risk-reward now (Chart 15). « _ Anti-globalization = higher real rates: Few appreciate that one of the biggest beneficiaries of globalization has been US real rates. Globalization was undoubtedly good for EM growth and reserves. As these reserves found their way back into the US, US real interest rates were held lower. As the global savings glut unwinds, real rates have the most room to re-price. Chart 16 offers compelling proof. - — Risk parity unwind = higher real rates: Exposure to any heightened concern about a risk parity deleveraging trade in a high vol environment is best found in asset classes where their footprint is large relative to market liquidity. TIPS is a prime example of one such asset class. The influence of a multi-asset strategy on real rates is clear from Chart 17. - Lower rates = lower breakevens: If the recent euphoria unwinds, it is likely due to a1) RMB deval; 2} commodity collapse post OPEC; or 3) equity market correction. Chart 15: Real rates vs. breakevens: A real Chart 16: Foreign official holdings of UST vs. Chart 17: BAML multi asset strategy index vs short offers better risk reward than nominal real rates real rates short 600 -1.25 590 -0.2 2 0.8 400 0.75 580 0 1.8 570 0.2 0.3 Le - 200 0.25 560 04 02 0 0.25 550 0.6 14 -200 - 0.75 540 0.8 1.2 af 400 1.25 i a a a a 10 11 12 13 14 15 16 ¢ ® ¢ & ¢ & ¢ { 12 38282438 Ww wo re] wo co co co co eae === 6m change in foreign official holdings of USTs —— 5y5y breakevens (LHS) == 6m change in 30y real rates (RHS, inverted == USGGT10Y Index (R1) 5y5 | rates scale, %4} yoy real ra Source: BofA Merrill Lynch Global Research, US Treasury The BAML multi asset strategy index is not representative of all isk-parity funds. Si : BofA Merrill Lynch Global R h Source: BofA Merrill Lynch Global Research ae rere eee eer ee OT ETT HRCI ODaNNeseare 8 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America Merrill Lynch HOUSE_OVERSIGHT_014738