Unauthorized redistribution of this report is prohibited. This report is intended for [email protected] Cause and Effect Fade the Trump risk premium — buy USD Concerns over stagflation return In our view, the most interesting and important development in the global financial market so far this year has been the divergence between rising US inflation breakevens and falling US real yields. Rightly or wrongly, investors appear to have become concerned about upside risk to inflation and downside risk to growth. The Trump risk premium Informal surveys of our clients suggest that stagflation concerns are being fed by growing pessimism about the new Trump administration. Investors seem to think that potential trade wars and a border adjustment tax (BAT) would boost inflation while repealing Obamacare and the controversy regarding the BAT could delay the highly anticipated tax reform. Perception versus reality In this report, we argue why the Trump risk premium may be too high. The administration’s dealing with both China and Mexico in recent weeks suggests to us that the near-term risk of open trade wars has abated. We are also less concerned that Obamacare will take precedence over tax reform. Most crucially, we think the overall tax reform is less dependent on the BAT than usually thought. Our scenario analysis shows that what has been getting priced into the market since January (higher inflation, lower USD) may be actually the least likely path for the BAT. In more plausible scenarios, the USD does quite well and inflation breakevens should be either unchanged or lower. How to trade it? We could get details on the tax reform as early as the new president’s speech to joint session of Congress on February 28, 2017. We think this could validate our view of a stronger USD. Taking advantage of clean positioning and the decline in implied FX vol lately, we recommend buying a 6w ATM EUR put/USD call (spot reference at 1.0615}, costing 1.1% EUR. A 6-week option will cover also the March Fed meeting and the Dutch election (both on March 15) that could also work in favour of the trade. A risk to the trade is that is weak February data takes the possibility of a March Fed hike off the table completely. A list of open trades and those closed in the last 12 months can be found in our Global Liquid Markets Weekly. Trading ideas and investment strategies discussed herein may give rise to significant risk and are not suitable for all investors. Investors should have experience in FX markets and the financial resources to absorb any losses arising from applying these ideas or strategies. BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 9 to 10. Analyst Certification on page 8. 11710696 Timestamp: 13 February 2017 06:00AM EST Bankof America Merrill Lynch 13 February 2017 FX and Rates Global e e The First Days David Woo FX, Rates & EM Strategist MLPF&S +1 646 855 5442 [email protected] Global Rates & Currencies Research HOUSE_OVERSIGHT_014721

Concerns over stagflation return On the surface, this has been an uneventful year for the US rates market so far. At the start of January, the market was pricing two Fed hikes for the year. Six weeks later, the market is still pricing only two Fed hikes for the year. The yield on the bellwether 10y US Treasuries started the year at 2.44%. Six weeks later, it is at 2.41%, unchanged for all practical purposes. As usual, the surface view is deceiving. The seeming collapse in volatility belies the dramatic changes in the composition and term structure of rates. Since the December FOMC meeting, real yields and inflation breakevens have diverged in remarkable fashion. Year to date, 5y real yields have declined by 16bp while 5y inflation breakevens have risen by 12bp (Chart 1); the 5s-30s real curve is 1O0bp steeper while the breakeven curve is 10bp flatter. Chart 1: 5y real yields and 5y inflation breakevens (%) 2.5 2 1.5 1 0.5 0 0.5 10/1/2016 10/26/2016 += 11/20/2016 += 12/15/2016 + —1/9/2017 2/3/2017 = 5y real yields (%) = ===~=5y infl BE (%) Source: BofA Merrill Lynch Global Research The effect of the divergence between real yields and inflation breakevens has been felt across financial markets. For example, the USD, which trades with real rather than nominal yields, has declined in tandem with real yields (Chart 2). In contrast, gold, which usually thrives on inflation concerns, has been surging lately. Chart 2: DXY and 5y real yields (%) Chart 3: 5y real yields versus 5y inflation breakevens (%) 104 0.3 4 103 0.2 102 01 3 101 0 2 "0 4 { E1 2 OT QE3 98 Oe 0 o7 -0.3 96 -0.4 “1 95 -0.5 -2 94 -0.6 3 10/1/2016 = 11/1/2016 §= 12/1/2016 ~— 1/1/2017 2/1/2017 3/1/2009 3/1/2010 3/1/2011 3/1/2012 3/1/2013 a==———DXY (LHS) = ===5y real yields (RHS) a= 5y real yields (%) = ====5y infl BE (%) Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research We have seen price action like this before. Indeed, it was quite common during the QE period (Chart 3). However, QE is neither on the horizon nor on investors’ minds right now. So what is really going on? Under normal circumstances, inflation breakevens are a reflection of investors’ inflation expectations while real yields a proxy for their growth 2 Cause and Effect | 13 February 2017 BankofAmerica <2” Merrill Lynch HOUSE_OVERSIGHT_014722

expectations. The divergence between inflation breakevens and real yields seem to suggest that investors have become more concerned about upside risk to inflation but downside risk to growth. Interestingly, this shift in investor sentiment runs counter to incoming data which are painting a picture of benign inflation but growth acceleration. Indeed, wage growth remains lackluster while the Fed’s favorite measure of inflation core PCE has slowed to the lowest level in more than a year (Chart 4). In contrast, both employment data and survey data suggest economic growth is on a tear (Figure 5). The Atlanta Fed’s GDPNow model is currently tracking 2.7% GDP growth for Q1. If it is not the data, what is driving the market’s apparent increased concerns about stagflation? Whatever these concerned may be, are they justified? We seek to answer these two critical questions in this report. Chart 4: Core PCE (3m/3m, SA, AR, %) Chart 5: GDP growth and aggregate hours worked (Q/Q, SA, AR, %) 2.5 R 2.3 4 2.1 1.9 2 1.7 1.5 0 1.3 1.1 2 0.9 Mar-10 Jul-14 Nov-12 Mar-14 Jul-15 Nov-16 0.7 2S®eSOrT THT NNNMMATH HW HW © = eal GDP growth (AR, %) e¢¢ he 5 heb He Soest FS Sot te tga === aggregate hours worked (AR, %) SSe2Ze2F8S687Z83323 ——= aggregate hours worked, Jan (AR, %) Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research The Trump risk premium Our informal survey of clients in the past two weeks suggests that stagflation concerns are being fed by growing pessimism about the new Trump administration. Clients tell us that their pessimism reflects four main concerns: Downside risk to growth 1. Many investors are concerned that the new administration will get bogged down by its promise to repeal and replace Obamacare, resulting in a significant delay in pushing through fiscal reform 2. This concern is reinforced by the perception that the GOP is divided over the proposed border adjustment tax (BAT), a key element of the tax reform proposal Upside risk to inflation 3. A growing number of investors are worried that potential trade wars with Mexico and China could lead to tariffs and higher prices 4. Many investors are also concerned that the BAT will force retailers to raise prices With many investors having loaded up on Trump trades after the elections (The battle lines are drawn, January 23, their willingness to continue to give the benefit of doubt to the new administration appears to be wearing thin. We would advise patience as there Bankof America <> Merrill Lynch Cause and Effect | 13 February 2017 3 HOUSE_OVERSIGHT_014723

are reasons to think that the worst may be already behind us and that the higher rates/higher USD trades will soon resume. We make our case in the following sections. Trade wars: near-term risk drops Developments over the past three weeks have led us to conclude that the risk of trade wars with Mexico and China has abated significantly, at least for the short-term: ¢ China: We take some comfort in the fact that the only item in his 100 day plan that President Trump has reneged on is his promise to label China as a currency manipulator on his first day as president (Table 1). In his interview with the WS) on January 13, Trump said that he “would talk to them first”. He added: “Certainly they are manipulators. But I’m not looking to do that.” This and the fact that Trump changed tack on Taiwan last week by telling the Chinese president he would honor the “One China” policy suggest to us a pragmatic approach to dealing with China. ¢ Mexico: We are relieved by the climbing-down by the administration after the Mexican president cancelled his trip to Washington over Trump’s insistence that Mexico pay for the wall. Reince Priebus, the influential White House Chief of Staff, suggested that there is a “buffet of options” to pay for the wall, including by going after the drug cartels. The Mexican foreign minister welcomed the overture by saying that “It's a signal that ... must be welcomed because we are already seeing how the discussion is changing”. Table 1: Trump’s 100 day plan (On the first day of my term of office, my administration will immediately pursue the following): A hiring freeze on all federal employees to reduce the federal workforce through attrition Done A requirement that for every new federal regulation, two existing regulations must be eliminated. Done A five-year ban on White House and Congressional officials becoming lobbyists after they leave government service. Done A lifetime ban on White House officials lobbying on behalf of a foreign government. Done I will announce my intention to renegotiate NAFTA or withdraw from the deal under Article 2205 Done | will announce our withdrawal from the Trans-Pacific Partnership. Done Lift the Obama-Clinton roadblocks and allow vital energy infrastructure projects, like the Keystone Pipeline, to move forward. Done Begin the process of selecting a replacement for Justice Scalia from one of the 20 judges on my list Done Cancel all federal funding to sanctuary cities. Done Suspend immigration from terror-prone regions where vetting cannot safely occur. All vetting of people coming into our country will be considered “extreme vetting.” Done Begin removing the more than two million criminal illegal immigrants from the country and cancel visas to foreign countries that won't take them back Done | will direct the Secretary of the Treasury to label China a currency manipulator. Not Done | will direct the Secretary of Commerce and U.S. Trade Representative to identify all foreign trading abuses that unfairly impact American workers and direct them to use every tool under American and international law to end those abuses immediately. Not Done Propose a constitutional amendment to impose term limits on all members of Congress. Not Done Acomplete ban on foreign lobbyists raising money for American elections. Not Done Cancel billions in payments to U.N. climate change programs and use the money to fix America’s water and environmental infrastructure. Not Done | will lift the restrictions on the production of $50 trillion dollars’ worth of job-producing American energy reserves, including shale, oil, natural gas and clean coal. Not Done Source: Donaldtrump.com/centract; BofA Merrill Lynch Global Research ACA reforms: not before fiscal reforms In an interview on February 5, Trump walked back his promise to replace Obamacare in short order, saying that the process is “complicated” and “maybe it’ll take till sometime into next year.” In contrast, asked if Americans should expect a tax cut this year, he said: “| think before the end of the year | would like to say yes.” In our view, the prevailing pessimism that Obamacare will take precedence over tax cuts is not consistent with three key facts on the table: * The Republicans, with only 52 seats in the Senate, do not have the votes to replace Obamacare. ¢ It is by now a broadly shared view among Republican leadership that to repeal Obamacare without replacing it would be very risky politically. e There is no consensus among Republicans about how to replace Obamacare. For example, 31 states took up federal funding to expand Medicaid under Obamacare Bankof America 4 Cause and Effect | 13 February 2017 Merrill Lynch HOUSE_OVERSIGHT_014724

and 119 House Republicans represent these states. Repealing Obamacare without replacing it would entail either a significant cut in the funding of the program or that the state tax payers will have to pick up the bills. Either is likely to hurt Republican support in these states. Tax reform: BAT won’t kill it The proposed border adjustment tax in the Ryan-Brady plan has been attracting a lot of attention lately. Although we have concerns about some specific aspects of the proposal (which we will discuss later), the popular view that it could be a deal breaker for the whole tax reform initiative seems to us difficult to substantiate. Below are some key facts that are worth noting: « — It has been thirty years since the US last overhauled its tax code. Most mainstream economists agree that it needs a serious update. * Tax reform requires strong political consensus. The Republicans, by gaining control of the Presidency and retaining their control of both houses of Congress in the November elections, are in a strong position to push through major tax reform. * The tax reform proposal from House Republicans has already gone through extensive consultations and enjoys broad support within the House Republican Conference. e One of the key commitments of the Trump campaign is tax cuts and simplification to boost growth. « The US today has the highest marginal corporate income tax rate among OECD countries. « Another major difference between the US and other major economies is that US corporations are taxed on their world-wide income as opposed to territorial income. In 2000, 17 out of the current 34 OECD members had a world-wide system. By 2010, only 7 did. e | The combination of high corporate income tax rate and a world-wide income tax system has two unintended consequences. One, US companies currently hold more than $2trn in capital overseas. Two, an increasing number of US companies are acquiring smaller foreign companies with the purpose of relocating their headquarters outside the US (ie, inversion). Between 2003 and 2011, there were only 7 such transactions. From 2012 and 2015, 27 such transactions were completed. « The valued added tax (VAT) system has been gaining popularity over the past twenty years. Today, more than 160 countries have a VAT. The U.S. is the only OECD country that doesn’t. « — The fact that the US does not have a VAT system puts US produced goods at a disadvantage. VAT is “border adjusted” - meaning that when a good is exported the producer gets a rebate while imports are subject to VAT. These facts together make it very apparent that both the case for tax reform and support for tax reform are very strong. Paul Ryan said on January 26 after the Republican retreat in Philadelphia that they “aspire” to pass tax reforms by August. Bankof America <> Merrill Lynch Cause and Effect | 13 February 2017 5 HOUSE_OVERSIGHT_014725

4 BAT scenarios To us, the key question is not when tax reform will pass (likely sooner than what is priced in). Far more important for financial markets in our view, especially for the rates and FX markets, is what tax reform means for inflation. The recent divergence between inflation breakevens and real yields reflects to a large part to the increasing consensus that tax reform will be stagflationary. We are less sure this will be the case and this is why. In our view, there are four possible paths in terms of how the border adjustment tax proposal could play out: e Scenario 1: This is the baseline of the Republican architects of the proposal who see a 25% appreciation of the USD to offset the 20% new tax on imports. In this scenario, because of the USD appreciation the inflationary impact of the border adjustment tax will be limited. In fact, it is very likely in this scenario that the second round effects of the USD appreciation (for example on commodity prices and emerging markets) will stoke deflationary fears. e Scenario 2: In this scenario, we would get the BAT as proposed but the USD does not go up because the new administration sees a strong USD as incompatible with its trade policy. We suspect this scenario has become the baseline for the market. We disagree this is the most probable outcome. In our view, it would be difficult if not impossible for Republican leadership to push through tax changes that would lead to potentially very unpopular price hikes ahead of the mid-term elections next year. e Scenario 3: In this scenario the BAT would not make it into the tax reform and the proposed corporate tax cut is financed by running up the fiscal deficit. This could be easier to sell politically than Scenario 2, especially given that the Republicans plan to deliver personal income tax cuts at the same time. In this scenario, the USD will rally as the Fed continues to hike and rate differential drives the USD higher. Chart 6: The four different fates of the border adjustment tax proposal Scenario 1: Ryan-Brady proposal Medium probability: +25% USD increase = Little increase USD{ 17, BEL | in inflatian Scenario 2: Ryan-Brady proposal + Low probability: little USD increase = Big increase in —_— USDt |, BET Tt Inflatinn BAT Scenario 3: No BAT + bigger fiscal Medium probability: deficit = Little increase in inflation | USD?, BE| Scenario 4: VAT instead of BAT = Medium probability: 41\\ Smaller increase in inflation > USD* 1, BET | Source: BofA Merrill Lynch Global Research BankofAmerica <2” 6 Cause and Effect | 13 February 2017 Merrill Lynch HOUSE_OVERSIGHT_014726

e Scenario 4: The current BAT proposal has some obvious issues. Because wages are deductible from taxable income, it essentially taxes domestically produced goods as a share of value added but taxes imports as a share of their total value. This is a clear discrimination that would certainly invite WTO dispute and that could potentially give future non-Republican administrations the excuse to overturn the tax reform. Moreover, the fact that under the current proposal some exporters will potentially pay no taxes does not seem fair to us. Remember, in most countries with a VAT system, there is also a corporate income tax. In this scenario, we assume that after negotiations we get a true VAT that is both WTO compliant as well as being revenue neutral. The USD would do better in this scenario compared to Scenario 3 because the VAT would help level the playing fields between US and foreign produced goods and the US trade balance should improve. How to trade it? We view the recent weakening of the USD and rising inflation breakevens as mutually inconsistent, since we think Scenario 2 is not a viable political outcome. The fact that all other scenarios are associated with a stronger USD and lower to flat inflation breakevens is supportive of our bullish USD view. The market needs more clarity on the details of the fiscal reform proposal to determine the outlook for the USD and rates. It is possible that details may be unveiled as early as the president’s speech to the joint session of Congress on February 28, 2017. We think it could validate our view of a stronger USD. Taking advantage of clean positioning and the decline in implied FX vol lately, we recommend buying a 6w ATM EUR put/USD call (spot reference at 1.0630). A 6-week option will cover also the March Fed meeting and the Dutch election (both on March 15} that can both potentially work in favour of the trade. We think the market is underpricing the risk of a Fed hike in March and better-than- expected results by the Freedom Party in the Dutch election could intensify concerns of a second-round Le Pen win in May. The latter suggests that over the next 2-3 months it may be easier to buy the USD than to pay US rates and easier to sell EUR/USD than to buy USD/JPY. Bankof America <> Merrill Lynch Cause and Effect | 13 February 2017 7 HOUSE_OVERSIGHT_014727

Options Risk Statement Potential Risk at Expiry & Options Limited Duration Risk Unlike owning or shorting a stock, employing any listed options strategy is by definition governed by a finite duration. The most severe risks associated with general options trading are total loss of capital invested and delivery/assignment risk... all of which can occur in a short period. Investor suitability The use of standardized options and other related derivatives instruments are considered unsuitable for many investors. Investors considering such strategies are encouraged to become familiar with the "Characteristics and Risks of Standardized Options" (an OCC authored white paper on options risks). U.S. investors should consult with a FINRA Registered Options Principal. For detailed information regarding risks involved with investing in listed options: http://Awww.theocc.com/about/publications/character-risks.jsp Analyst Certification |, David Woo, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. | also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report. Bankof America 8 Cause and Effect | 13 February 2017 Merrill Lynch HOUSE_OVERSIGHT_014728

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