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Best Relative Value Trades Athanasios Vamvakidis Erjon Satko MLI (UK) MLI (UK) athanasios.vamvakidis@baml.com erjon.satko@baml.com Arko Sen Shusuke Yamada, CFA >> MLI (UK) Merrill Lynch (Japan) arko.sen@baml.com shusuke.yamada@baml.com Relative value in a macro world « Long EUR/JPY: data and positioning supportive; the Bo) has more tools to address sustainability challenges than the ECB. « Long RUB/KRW: US fiscal expansion suggests more upside for reflation sensitive Russia than interest rate sensitive Korea. « Sell German 2y vs OIS, buy 10y vs OIS: fade the impressive richening of short- maturity German govies. Long EUR/JPY In a recent report we argued that EUR/JPY could appreciate in the months ahead as the Bo) gains credibility and the ECB has to deal with QE constraints. Since then, the EUR/JPY has appreciated by 3%, but we see more upside. Although we expect the ECB to extend QE by a further six months in December, we see more difficulties next year. Extending QE will require difficult decisions, such as relaxing the capital key or buying below the depo rate. QE tapering is therefore a risk and the market could start testing the ECB. Even if Draghi succeeds, the Euro could strengthen in the meantime. In contrast, the Bo)’s new framework should address the sustainability challenges that Kuroda faced this year, and allows more fiscal stimulus by keeping the government’s borrowing costs at zero. The ECB cannot do this, in our view. We have been short EUR/JPY this year, as we were expecting the ECB to extend QE, while the Bo) faced challenges. Data also suggests further EUR/JPY upside. Relative GDP growth would be consistent with a stronger EUR/JPY, as the Eurozone has been gaining momentum, while growth in Japan remains weak (Chart 34). Relative central bank balance sheets give the same signal (Chart 35). Positioning is also in support, as our analysis suggests a short EUR/JPY market position (Chart 36). If the external environment improves, we think Japanese investors are likely to be JPY sellers again as the hedge ratio and hedge costs have both risen. One of key factors of the yen’s appreciation this year might have been that, as the USD/JPY fell, institutional investors implemented additional FX-hedging to their existing forex positions as part of their risk management, which caused the USD/JPY to fall further and supply-demand to worsen in a vicious circle. However, this mechanism probably ran its course when the USD/JPY reached 100 on the Brexit vote as we argued in $/¥’s eventual surge: Buy Nikkei O06 September 2016. In fact, the USD/JPY has stopped falling during Tokyo trading hours since the summer. Based on the decline of foreign yields and higher hedge costs, hedged US Treasuries and German bunds had lost nearly all of their attraction for Japanese investors by the summer. US and German 10yr government bond yields sank to about 0% after being hedged to the JPY, reflecting that downward pressure on yields had reached the limit. Institutional investors are expected to increase their exposure to unhedged foreign bonds in H2 FY16. Investor behavior is especially liable to change in April, when the new fiscal year starts. BankofAmerica <2” 18 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 . Merrill Lynch HOUSE_OVERSIGHT_014748