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Economists place great store in the importance of expectations and their impact on inflation. Chart 29 suggests an adverse feedback problem has emerged, with actual inflation an increasingly influential driver of 5y5y inflation (and economist long-term consensus expectations). With 10y20y inflation effectively at the ECB’s target, we favor short positions in 30y breakevens. In the case of the OATei 2047, the “observed” breakeven drastically understates what we would consider to be a fairer measure. The issue here is that the linker is almost 10 years longer than its nominal 2045 comparator in modified duration terms. On a duration basis, the linker lies in between the 2060 and 2066 nominal OATs and, of course, the 30s50s OAT curve is very steep. Trade: we recommended a more closely-matched breakeven trade, shorting OATei 2047s to buy OAT 2066s to give a breakeven of 163.3bp, targeting 130bp with a stop-loss at 180bp on October 14. The breakeven has risen, against our expectations, to 169.6bp currently and we regard this as an attractive entry level. We will nudge our stop-loss level higher to 185bp. The relative cheapness of the nominal 50y partly reflects the 31y maturity limit to ECB buying. We regard the ECB eligibility premium for bonds within the ECB’s buying range (like this linker) as material, so the trade should be a beneficiary in the event of an ECB “taper tantrum”. An important additional feature in these turbulent times is the greater dispersion of the nominal’s cash flows (in PV terms). This means the trade is significantly net long convexity. We see the risks to the trade being a strong Eurozone recovery causing a general repricing of breakevens higher and the possibility of further heavy issuance of 50-year bonds across the Eurozone. EM linkers: feeling the contagion for higher breakevens The prospect for higher yields in the US clearly affects the appetite for Emerging Market (EM) assets including inflation-linked bonds. The discussion is about not only EM becoming less attractive on a relative basis, but also how the higher yields in the US affect the dollar and thus EM currencies. Fiscal stimulus prospects in the US should continue to drive some correction across EM assets, but at this point, there is still too much uncertainty on the actual reach of such stimulus. Investors faced strong returns in EM this year and because of the calendar effect, this puts pressure to square positions and reduce risk. While this correction may last for a while, it is clearly creating more value in some assets. For now, the discussion will be about re-sizing positions rather than valuation. Only when volatility declines and yields stabilize in the US will we be able to resume discussion on valuation and the level of yields across EM. Liquidity is a key issue when looking into EM linkers, in particular across EMEA, but we find some interesting opportunities in Asia and LatAm.. Currency weakness ends up adding risks for higher inflation in some countries but FX pass-through varies a lot depending on output gap. In general, we believe there is room for higher breakevens in EM, with key highlight for Thailand and 10y in Mexico. Attractive breakevens in Thailand and Mexico In Asia, we believe breakevens are pricing in too much complacency on the inflation outlook. With prospects for higher oil prices, it makes sense to position for higher breakevens in both Thailand and Korea in our view. Breakevens appear cheaper in Thailand as inflation is already increasing, while breakevens have clearly lagged the movement. In EMEA, linkers are mostly illiquid and/or expensive so there is more to do in nominals and/or FX in our view. Yet, the currency move has triggered a widening in breakevens in some countries like South Africa. We expect this movement to continue for now. Bankof America Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 15 HOUSE_OVERSIGHT_014745