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Rates: short inflation/long duration Positioning surveys generally indicate that the rates market is neutral or short duration amid rising inflation expectations. According to our rates & FX sentiment survey, clients are relatively short in relation to their average positioning across major fixed income markets including the EU, UK, and to a lesser extent the US (Chart 42). Such position indications suggest that contrarian investors should be long duration in Europe, the UK, and the US. These positions have been factored into some of our pre-existing fundamental views, which include receiving euro vs US rates and expecting UK supply/demand dynamics to be supportive of longer-dated Gilts going into year end. We are reluctant to recommend outright long duration positions in US rates at present given that the sharp election-induced selloff could extend over the coming weeks. Consensus expects rising inflation Instead, we focus on contrarian views regarding the outlook for inflation, which underpinned some of short rates positioning and is expected to increase with US fiscal policy expansion and base effects. According to our recent Global Fund Manager Survey taken prior to the election, global inflation expectations are on the rise, with 70% of survey respondents expecting higher global CPI readings in the near term. Headline CPI has been moving higher in the US, and Chinese PPI recently turned positive for the first time since 2012. Similarly, global market-based measures of inflation expectations have been rising, with 5y5y forward inflation swaps in the US, UK, and Europe all rising over recent months and US inflation protected funds receiving nearly $2 billion in inflows since the start of October. Disinflation may strike back Risks to the near-term outlook for inflation could rise if: (1) expectations for US fiscal stimulus disappoint as House deficit hawks insist on revenue-neutral tax cuts or spending measures; (2) Beijing pushes the RMB lower before President-elect Trump takes office leading to risk-off and imported disinflation; (3) commodity prices decline if an OPEC deal cannot be reached, the USD meaningfully appreciates, or if EM growth falters; or (4) EU slowdown fears rise should the ECB taper due to technical constraints. We recommend buying 3-year 0% inflation floors in the US, which currently demand only 9 basis of premium. These levels are low in relation to recent history and could increase if Beijing were to more rapidly weaken the RMB or if commodities falter (Chart 43). Investors seeking to offset the premium could consider selling longer-dated more deeply negative floors under the assumption that any near-term disinflation scare would be short-lived and likely be offset by more activist monetary policies thereafter. The risk to the trade is a spike in commodity prices or a continued rise in core inflation. Chart 42: Z-score of duration positioning: short except in Japan/Canada Chart 43: Cost of 3Y 0% deflation floor has spiked with weak RMB (bps) 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 EU Core UK EUPeriph US JP CA Note: negative z-score values indicate short positioning, positive z-score values indicate long positions; z-score taken from survey net exposure index with responses dating back to 1992 for US, CA, JP, UK & EU, EU periphery data available back to 2013. Source: BofA Merrill Lynch Global Research 60 50 40 30 20 10 0 2011 2012 2013 2014 2015 2016 Source: BofA Merrill Lynch Global Research, Bloomberg Bankof America Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 23 HOUSE_OVERSIGHT_014753