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Chart 30: Breakevens to increase in some EM Chart 31: In Brazil, high correlation between breakeven and BRL 10% Brazil 10% | Brazil breakeven 10yr. BRL - RHS 48 3.9 8% 4 3 8% 6% 3.5 2.1 9 3 4% 6% 2% 12 25 0% Do at taal 03 4% 2 2/28/2014 1/24/2015 12/20/2015 11/14/2016 2/28/2014 1/24/2015 12/20/2015 11/14/2016 Source: Bloomberg Source: Bloomberg Finally, in LatAm, we expect inflation to increase in Mexico, driving breakevens higher across the curve. Although FX pass-through is very low in the country, the ongoing MXN depreciation may add some pressure on inflation at the margin. In the case of Brazil, the central bank was very successful in anchoring long-term inflation expectations driving breakevens lower across the bond curve. For long-only investors, we believe linkers should be more resilient versus nominal bonds. While Brazil continues to have one of the highest nominal and real yields across the globe, further compression requires stabilization in US yields. As long as the Brazilian government is able to deliver on the reform front, approving a social security reform bill next year, we see room for real yield compression from levels above 5.5% right now. Buy USD/JPY, sell CHF/SEK Inflation may not be back yet but deflation risk is most likely gone in most regions in our view (the notable exception being the Eurozone, we believe, as discussed above). A year ago we argued that the market deflation position was stretched and that there was room for inflation surprises. Indeed, average inflation surprises in G1O economies have been increasing since then and are now Clearly in positive territory (Chart 32). Monetary policy in G10 economies is the loosest it has even been, suggesting that global inflation could continue rising (Chart 33). This is not necessarily bad news, as the threat of deflation is now gone. However, inflation rather than deflation trades are likely to become an important driver in G10 FX. We update a heatmap of inflation risks in G10 economies to determine how to position for such risks in FX. We have discussed the methodology in Inflation and FX: What if the dog starts barking?. The idea is to rank currencies based on a number of early warning inflation indicators. Using equal weights, if most indicators point towards higher inflation for a currency, we take this to suggest that investors should go long, against a currency for which most indicators point towards deflation, both in relative terms. Chart 32: G10 inflation surprises (average) Chart 33: G10 sum of spreads from Taylor rule 40.0 30.0 20.0 10.0 0.0 -10.0 -20.0 -30.0 jan-00 jan-01 an-02 an-03 an-04 Jan-05 an-06 an-07 an-08 an-09 2 2 ao S&S 2 2 o ©® u u an-10 jan-11 an-12 Jan-13 an-14 an-15 an-16 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11 Feb-12 Feb-13 Feb-14 Feb: Feb: Source: BofA Merrill Lynch Global Research. Source: BofA Merrill Lynch Global Research. 16 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America Merrill Lynch HOUSE_OVERSIGHT_014746