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Chart 34: EUR/JPY and real GDP growth Chart 35: EURJPY and relative central bank balance sheets Chart 36: EUR and JPY market positions relative to the last 12 months 80 r 70 60 50 40 30 35.0 5 20 10 00 90 et Pp On OWMRorNMT IO i ) Oona NwAe & Row 4S Ss S55 5 Ss 55 SE 55 SSSstSSS2S2S2S2522225 EURJPY (LHS) Real GDP growth difference (RHS} 6% 6 Y oe 6 % cya ig, “My, “, %,, % % Me BoJ-ECB balance sheets (GDP shares, LHS) EURJPY (RHS) Source: BofA Merrill Lynch Global Research. Source: BofA Merrill Lynch Global Research. EUR rates are probably more vulnerable against US rates movements, as the market questions whether the next ECB move will be expansion or tapering. On the other hand, Japanese rates are insulated from foreign movements as the Bo) directly targets the 10yr yield. Japanese fiscal easing is also a possibility in light of reduced odds of TPP implementation and a potential snap election. Any positive impact of Japanese fiscal easing on growth is likely to manifest in higher inflation expectations under the Bo)’s yield-targeting regime, which means Japanese real interest rates could actually fall. Based on these considerations, we recommend buying a 6M EUR/JPY 122/130 call spread for 1.2312% EUR (spot ref. 116.84). Risks to our trade include a severe global shock that could strengthen the JPY, or the return of the Eurozone crisis; for example, if the government in Italy falls after Renzi loses the referendum in December or Le Pen wins the elections in France. Long RUB/KRW Post US elections and the improved outlook for fiscal expansion in the US, we see more upside in being long oil and reflation sensitive Russia than short technology and interest rate sensitive Korea. We recommend being long RUB/KRW heading into 2017 targeting a move to 19.4 (spot ref 18, stop 16.7). The trade is positive carry 2% per quarter. The rise in US breakeven inflation is positive for risky assets broadly but could be painful in the short term for highly indebted countries with low interest rates. Higher US breakeven inflation rates are historically associated with higher RUB/KRW (Chart 37). Higher US real rates are also less of a threat for Russia where local real yields are significantly higher than Korea (Table 2) and most EM peers. Korea also has relatively high private sector debt which could face pressure if BoK is forced to raise rates. Household debt has been rising at an alarming rate and domestic political turmoil facing the Park administration has also added to concerns. In our baseline scenarios, we expect a modest growth recovery for Korea but a stronger delta for Russia where the oil price collapse over 2014-15 led to a much sharper slowdown earlier and activity is now in recovery stage. The ToT trade shock that hit Russia in 2014 led to material underperformance in exports vs Korea. Over 2011-13, Russia and Korean exports were growing at about the same rates but since 2014 that gap widened has materially against Russia. Since early 2016, however, this has reversed with Russia catching up. In 2017, Russian exports growth could outperform Korea given the outlook for oil. Moreover, it is less reliant on China or Japan and more reliant on Europe. CNH/KRW as well as JPY/KRW remains near multi year 50.00 40.00 30.00 20.00 10.00 0.00 -10.00 -20.00 -30.00 -40.00 50.00 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 EUR JPY Source: BofA Merrill Lynch Global Research. For more details, see Liquid Cross Border Flows. Bankof America Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 19 HOUSE_OVERSIGHT_014749