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All three would argue for the decline in rates to be led by breakevens leaving a real rate short with little downside (real rates moved higher by 50bp post China deval in Aug-15). Trade: We recommend selling 10y real rates at 35bp with a target of 1% and a stop loss of Obp. Risk: A reflationary sell-off without re-pricing the Fed is a risk to the trade. FX: GOP sweep emboldens core USD/JPY view Higher US real rates, higher intermediate (5-10y) nominal rates combined with a potential USD tailwind from a second Homeland Investment Act (HIA), leave USD/JPY as our top directional FX trade for 2017. We have maintained a core view that USD/JPY would move higher in 2017, as the factors weighing on the pair this year, namely speculative JPY buying and increased FX hedging by domestic investors (S/¥’s eventual surge), would subside. We like the trade for the following reasons. « USD/JPY most sensitive to fiscal-stimulus-driven rise in US yields: Of all G10 FX pairs, JPY is most vulnerable (versus the USD) to a fiscal-driven rise in US yields. First, the pair’s correlation with rate differentials is the highest in G10 at 60%. But, more importantly, USD/JPY is also the most sensitive to the shape of the US 2s10s curve (Chart 18). The shift from loose monetary/tight fiscal to a tight monetary/ loose fiscal policy regime will support such a steepening as supply is concentrated in the intermediate part of the curve, and the positive growth shock allows the Fed to hike faster, supporting an increase in real yields, also a key 2017 call. « BO) yield target is bearish for JPY: The BO)’s implementation of a yield target at its September meeting has caused a break in the correlation between 10Y JGBs and USTs (Chart 19). First, given USD/JPY’s significant correlation with 10Y yield differentials (>60%}, the anchoring of 10Y yields will further weigh on the Yen as US Treasury yields rise. Second, further Japanese fiscal stimulus will successfully lower real yields through higher breakeven rates of inflation while nominal yields will remain unchanged. As our JPY strategist argues, to the extent that a Trump victory has weakened Abe’s diplomatic success, not least from likely TPP failure, and residual macro uncertainty makes it increasingly likely the government will seek to draft a supplementary budget sooner than anticipated. « _HIA and domestic flow picture a JPY-negative: The flow picture also turns JPY- negative in 2017. USD/JPY’s underperformance during Asia trading hours in 2016 highlights that domestics used any rally in the pair to hedge (by selling USD/JPY) existing investments. This flow will likely subside in 2017. The compression in FX- hedge-adjusted yield pickup from a Japanese investor’s standpoint will likely shift Chart 18: USD/JPY and Japanese equities Chart 19: Correlation breakdown Chart 20: 2005 HIA repatriation flows vs perform well in US 2s-10s curve steepening 05 40Y UST 04 USD/JPY 5 140,000 40 23 ——/‘0Y JBG (RHS) , 2.1 0.2 120,000 56 1.9 100,000 0 . 17 0 80,000 . 60,000 : "s -0.2 00 oc. “ 13 40,000 ) gE g 00 oF * s Ss s Ss s s 1.1 -0.4 20,000 a a 80 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 99 00 01 02 03 04 05 06 07 tt US Multi-national repatriation... ee USD/JPY spot (RHS) Source: BofA Merrill Lynch Global Research, Bloomberg Note: curve and average cross-market reaction (past 40 quarter Source: BofA Merrill Lynch Global Research, Bloomberg, BEA simple average) RS iBear Steep mBearFlat mBullSteep Bull Flat Source: BofA Merrill Lynch Global Research, Bloomberg Bank of America Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 9 Merrill Lynch HOUSE_OVERSIGHT_014739