Global Liquid Markets Weekly

Global Liquid Markets Weekly Bitcoin: a new liquid market? Bank of America e-a Merrill Lynch 24 July 2017 1 je aa 5 The View: Bitcoin: a new liquid market? Is bitcoin a currency? A commodity? Neither? A proper store of value like the EUR. T- bills, or gold is measured by 3 factors: safety, liquidity, and return. Diversification is a plus. Bitcoin remains very volatile. But it has experienced a surge in liquidity in the last six months, surpassing $2bn a day. Moreover, bitcoin is uncorrelated to any financial asset, commodity, or currency we study in this note. The flipside of extreme diversification is that there is no way to explain let alone predict returns. Could bitcoin see a virtuous cycle of increased liquidity, lower volatility, attractive returns. and wider acceptance? Possibly, if regulated financial institutions move to allow bitcoin as pledgeable collateral. However, large inherent risks to digital tokens such as fraud, hacking, theft, new protocol adoption, limited acceptance, and that it is not legal tender many places in the world make it an unlikely development. — F Blanch 610 FX: Despacito until the fall More short-term EUR upside, balanced JPY risks, downside for GBP, prepare for higher FX vol this fall, hedge long EM. — A. VarnvakIdls; R. Gal Rates: Trading the central bank aftermath We review yesterday's ECB meeting and its impact on EUR rates. With the tapering discussion implicitly pushed back, the ECB have given the green light to carry trades. With our econ team pushing the first hike to Spring 2019, we stay long Mar19 Euribors. — S. Salim R. Hounhane; E Satko; 6 Moec EM: The girl with the dovish tattoo With the Fed moving to a more dovish stance, solid growth in China and lower geopolitical tensions, inflows into EM continue and despite tight valuations. We like receiving rates in the belly in Brazil, long Indonesia and Turkey local debt and TRY/2AR. We like long EUR/PLN call spread and JPY/KRW as efficient risk off hedges. — C. lrigoyen Commodities: Get ready for a nat gas rally The recent drop in US nat gas prices hard to justify and the underlying fundamentals are painting a far more positive picture. We expect the inventory surplus to be gone early August and end of October stocks at just 3.5 tcf, the tightest since 2008. We re-iterate our bullish call for 2018 US natural gas prices to average 53.50/MMBtu, significantly above the current forward. — S. Schels; F. Blanch 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 Lyndt 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 26 to 28. 11766548 Timestamp: 24July 2017 0131AM EDT Liquid Markets Weekly Global Francisco Bland. Commodity & Dertv Strategist MLPF&S See Team Page foe Ust of Analysts EFTA00788475 Our medium-term views Rationale GIOFX USD is likely to continue to face near-term headwinds as central banks move in tandem towards poky normalisation. eroding the US Wad advantage. Our expectations fora stronger USD by yearend are being challenged as the GOP has not repealed Obamacare. The path of least resistance remains for a weaker JPY as the Bei continues to anchor YCC towards 0%. The ECB has taken the director) of going further towards poky nonalsafion and the risks are building that EURIJSD ends the year closer to $1.20. GBP is stuck in a range and remains a trade on the Brexit deal. Data continues to play a secondary role but we ream a structurally higher vol bias. Scandnavian FX should beneft from a more constructive ECB and we remain directionally long NOK and long SEK volatility. G10 Rates With game' risks fading, we expect EUR duration to move more in line with the (improving) economic data and the effective reduction in the amount of duration the ECB absorbs in Buts through OE (compared to late last year). We see toy term premium as having the potential to rise by another 10-15bp. Very few Technical hkes" are priced in the very fronlend so we Ike paying Jan18 Eonia. However, we view the 30bp of hkes priced by 1019 to be excessive. With tapering inevitable. hvd guidance on rates• beyond any potential technical move early in 2018. would have to be strengthened. We are bearish Gifts on stretched crossmarket valuations and challenging demand 8, sup* dynamics ahead. We like being shod 3y Gilts vs. OIS on Brexit risks and paying 1y2y forward yield in Gifts on midi:upload rate hke risks and RV anomalies. EM While we expect valuations to get more expert sigus long as the DXY is weak or stable. we are watchful of crowded positioning that could be vulnerable. Triggers for a correction could be weakness in the crowded and HY trades in the US. possbly from weaker corporate earnings or conceded ECPSFed tightening in the autumn. We prefer RV trades or idiosyncratic longs in pockets of remaining vake and take out inmate in options formal However. we remain structwally buyers of EM dips. as we believe that growth is likely to continue to outperform relative to DM for a while. Comedies With OPEC cuts working at a slower pace than we expected. we are adjusting our nventery projections. With output set to rise and oft demand disappointing. global balances point to deficits of 210 kbd in 2017 and 90 kbd in 2018. We lower our WTI forecasts to average $47 this year and $50.bbl next year. We cut Brent to $50 this year and $52bbl in 2018. We now beleve oil stays in contango by yearend. but see a WTI forward anchor al $45.50 and S5 backwardation by next summer. Our key forecasts 3017 4Q17 1Q18 2018 3m Libor 1.35 1.60 185 2.10 10y Thole 2.60 2.85 285 245 toy Efund 0.50 0.55 OR 0.60 EUR4JSD 1.10 1.08 1.10 1.10 USD4PY 119 117 117 115 LtSCi•CNY 6.95 7.05 7.10 7.15 USEIRRL 3.35 3.40 145 3.50 USDINR 66.50 66.80 66.30 66.00 USD•RUB 60.00 60.00 63.00 63.00 WTI Crude Oil 44.00 47.00 47.00 47.00 Gild 1.275 1.350 1.400 1350 Safe, gnfAhleff11t)n,h(iibYRef".. -sol rvermoilities Research What we like right now IX Buy 6M ATM EURSEK straddles: We see a number of key events for the rest of the year wtich should see EURSEK vol rise including ECB and Riksbank meetings as well as the announcement of a new Riksbark Governor. EUR?SEK vol looks cheap on our metrics. Buy EURAJSO out spreads: near.temi headwits for EUFL1JSD are moulting: the Fed remains hawkish & p3sitioring is a constraint. Risks to the trade are further deieriorat& in US data and Fed officials turning more dovish. Buy teionth 102/107 USCUPY out spreads: the upside for USD is likely fmited until there is greater clarity on tax reform. positioning is relatively clean and there are signs that Japanese investors have lately been soling USCL'JPY. Rates In EUR. we like gong long Mar19 Eunbors on ECB Sequencing. We also like peripheral hedges and shod breakevens. In the UK. we pay ty2y Gilt retds. EM Long JPYARW: long USDHKD forward: long INR and IDR against SGD: long OTIA USD callIDR put. long USDKRW 3m NDF points: long EURPLN 3m call. spreads. stay cautious RUB. long TRWZAR: long ARS: shod CLP: neutral BRL. MXN. PEN: long I rontend MXN volatility: construcfive on India: receive China rates: long 15y IndoGB: receive 1.2.5y MYR NDIRS. receive 1.2-5y INR NDIRS: pay Czech 5y. Nand 2yty IRS: long forward steepeners in Turkey swaps: receive Jans19 and Jan21 in Brazil: pay ly IBR and 2y inflation breakevens in Colontia: 2w5y TIIE sleepeners in Mexico: long end of Soberanos Curve. Convnothes We like buying the crude oil dips. We also see a continued run.te in copper. zinc and nickel paces. Still. gold prices could potentially drop further as the USD strengthens and US rates move higher. For a complete list of our open trade ideas and our trade ideas closed, please refer to pace 19. 2 Global Liquid Markets Weekly 124 July 2017 Bankof America 40' Merrill Lynch EFTA00788476 The View Francisco Blanch MLPF&S From metal-backed to fiat to aypto, money keeps evolving The world economy has used different types of currencies as a means of exchange for millennia. From commodity -backed to precious metal-backed to fiat to crypto. the meaning of currency has changed with varying economic needs, political trends, and technological change. For example, salt was once mined and treasured in the ancient world and used a means of exchange. However, commodity -backed currencies were often neither a practical nor a durable means of exchange. So the global economy moved on. Governments coined currency to create standard economic units of account using either precious metals like gold or industrial metals like copper, a practice that continues to this date. Huge deposit discoveries preceded the advent of silver currency The discovery of large silver deposits in Bolivia by the Spanish in the 16th century set the basis for the world's monetary system until late in the 19h century (Chart 1). These silver dollars were the international trading currency of choice for nearly 400 years and kept a stable value relative to gold. The Spanish milled dollar was even used as a standard to set up the US dollar by the Federal Government. However, carrying large amounts of silver or gold was not practical. So the world started to move steadily to paper money, particularly in the last 200 years. At first, most governments maintained an asset or precious metal-backed currency system where paper currency could be exchanged for hard metal at a fixed rate. However, the supply of this money was fixed, creating huge inflationary and deflationary waves in the economy as the business cycle fluctuated every few years (see US example in Chart 2). Chart 1: Silver dollars were the international tracing arrency of choke for nearly 400 years and kept a stable value relative to gold History of gold and silver price $1.800 $1.600 $1.400 $1.200 $1.000 $800 $600 $400 $200 $0 N COON cl'0030N 0'000N mr<DOZI 0)0— 0 <0 N. CO — NO •O' CD l•-• CO 0) 0 N CO CO CO CO CO CO CO CO CO Or 0 0 01 01 01 01 01 0 —Gold (LHS) Silver (RHS) $35 $30 $25 $20 $15 $10 $6 Chart 2: However, the supply of this money was fixed, creating huge inflationary and deflationary waves every few years 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% US inflation rate history annual M. change 2.7agS3Z2S6 -MSSZT;MSSCRialIRME T: Source Mco.Elloonterg Source. Minneapolis Fed Macro financial stability considerations propelled flat currencies Following the Great Depression in 1933. the US government moved away from the gold standard domestically and left the economy running solely on silver, in effect a quantitative easing of sorts. Still, international payments were settled in gold. The domestic silver standard was eventually constrained by Kennedy in 1963. as inflation caught up with dollar silver certificates issued by the Treasury. Then Nixon announced in 1971 that the US government would no longer redeem US dollar currency for gold in international markets. A major spike in precious metals prices followed (Chart 3). As of today. most countries have moved to locally minted fiat currencies that have no intrinsic BankofAmenca'," Merrill Lynch Global Liquid Markets Weekly 124 July 2017 3 EFTA00788477 international value other than the full faith of the issuing government In effect, central banks safeguard the value of the fiat currency mainly by complying with their inflation mandate. However, central banks have the ability to create fiat currency at will as long as the pre-established inflation target has not been met (Chart 4). Chart 3: The end of dollar/gold convertibility In 1971 led to a major spike in precious metals prices Pit o history of precious metals 2000 800 -USD 1600 - 1400 - 1200 - 1000 - 800 - 600 400 - 200 CO co .0 1 P.- , 0 03 0 0:1 0) 00 g0)03010101010101 40 - 35 - 30 - 25 - 20 - 15 - 10 -5 0 —Gold — Platinum — Palladium — Silver (RHS) Source INoombergioth Memll Lynch Global Research Chart 4: Central banks safeguard the value of a fiat currency by mainly complying with their inflation mandate, but can create currency at will _ 20000 Total assets of major mutat banks 18000 16000 14000 12000 10000 8000 6000 4000 2000 0 02 03 04 05 06 07 08 09 10 It 12 • FED = BOJ • PBoC Some FRED- St. Louis Fed Bbomberg bn USD Technological advancements have enabled cryptocurrencles Decentralized digital cryptocurrencies first came about at the depth of the Global Financial Crisis in 2009 when a group of developers created Bitcoin. The idea of a virtual means of exchange that is controlled by an algorithm and escapes government control certainly has appeal to many. Ever since, cryptocurrencies have expanded in a dramatic fashion by making transactions cheaper and faster. Indeed. cryptocurrencies have a few advantages over fiat currencies, such as the ability to transfer money instantaneously anywhere in the world at a low cost or to code in specific contractual obligations. Also, while paper money is arguably untraceable and digital money can be hard to trace at times, cryptocurrencies allow for full transaction traceability through a digital ledger. also known as a blockchain. True, users in some jurisdictions may remain anonymous, but that is unlikely to be the case for bitcoin trades happening in exchanges based in the US. Europe, or Japan. Now, what turns a digital token into a proper store of value? We would argue that a reserve currency has to meet three "must have" criteria: safety, liquidity, and retum. Also, there are "nice to have" criteria such as diversification benefits. Bitcoin and other cryptocurrencies score well on some, and not so well on others. Bitcoin does not score well on the safety parameter On the first parameter, safety, it is hard to argue that a crypto token meets the criteria of a reserve currency. On the one hand, the system creates enough incentives for miners to guarantee settlement of bitcoin transactions within hours, compared to 2 or 3 days for conventional securities such as equities or bonds. On the other. the lack of a centralized decision-making process or authority creates risks such as a currency split. If participating coders (also referred to as miners) cannot agree on a solution to a specific problem. a digital currency can break into two. This risk is arguably behind the sharp selloff observed across the cryptocurrency world in recent weeks. Also, risks such as hacking, identity theft or outright scams are a recurring problem. But you could also argue that fiat currency holdings are exposed to them. Most importantly. volatility is the key parameter to understand the concept of safety in a reserve currency, in our view. In that regard. bitcoin's score has improved in recent years as volatility has continued to drop (Chart 5). Still, bitcoin's volatility is very high compared to the euro, the yen or even gold. But it fell twice last year below the volatility of silver (Chart 6), the world's currency for 400 years. 13 14 15 16 17 n ECB 4 Global Liquid Markets Weekly 124 July 2017 Bankof Amenca 40" Merrill Lynch EFTA00788478 Chart 5: Volatility is a key parameter for safety Ina reserve armicy and blurt vols have been falling for a while Annualied STDEV of daily returns 100% 90% 80% 70% - 60% 50% 40% - 30% 20% - 10% - 0% Bitcoin Gold Silver EUR any • Last 5yr Last 4yr • Last 3yr • Last 2yr • Last tyr Source &tombs& Both MentliLynCh Elctd Research Chart 6: True, bitcoin's volatility is very high compared to the euro, the yen or even gold, but it is starting to approach silver 300% 250% 200% 150% 100% 50% 0% 3M-rolling annualized stdev of daily returns -Silver —Sltcoln —Gold Source Blomberg BoWAMm11 Lynch Gbbal Research A wide array of risks obscure the future of cryptocurrencles When examining the safety of any asset, volatility is not the only source of concern. In the case of bitcoin and other virtual tokens, worries are magnified given that it is not legal tender in many places in the world or regulated by any government bodies. In fact. decentralization is central to bitcoin. As such, risks like fraud, hacking, and outright theft have plagued the cryptocurrency world in recent years. In particular. the surge in initial coin offerings seems hard to justify and creates a risk of fragmentation in the market. Confidence could suffer if many of these offerings tum out to be outright scams to circumvent investor protection regulations. After all, it is hard to "know your client' if a bitcoin transaction happens through an exchange in an obscure jurisdiction. Other issues more specific to the functioning of cryptocurrencies, such as finding an agreement regarding the adoption of certain protocols, are also worth mentioning. For example. should bitcoin split into two digital tokens because miners cannot find common ground. a collapse in confidence and value could follow. Lastly, it is worth noting that cryptocurrency transactions are taxable in many jurisdictions, presenting additional challenges to users that are unfamiliar with the fiscal implications of using bitcoin. Yet, EM currency pegs and capital controls encourage bitcoin use True, bitcoin is still volatile compared to even Emerging Market currencies. But it is also worth noting that EM FX volatility tends to be artificially suppressed by controls. When looking at 16 countries with severe capital controls based on IMF indicators (Algeria, Angola, China, Malaysia, Tunisia, Cote d'Ivoire. India. Morocco, Pakistan, Philippines, Sri Lanka, Swaziland. Tanzania, Togo, Ukraine, and Uzbekistan), we find that bitcoin is more volatile than these currencies (Chart 7). However, it is not uncommon for these EM currencies to suffer from high inflation rates (Chart 8). When pegged or semi-pegged FX regimes face high inflation or sharp FX reserve drawdowns, steep exchange rate adjustments eventually follow. So the more official and black market exchange rates diverge, the more attractive bitcoin may appear to some as a means of payment and store of value. And the more liquidity and scale bitcoin builds to, the lower the volatility over time, in our view. BankofAmenca ea* Merrill Lynch Global Liquid Markets Weekly I 24 July 2017 5 EFTA00788479 Chart 7: We find that bItcoin is more volatile than the currendes with severe capital controls Annualized STDEV of weekly returns 60% 50% 40% 30% 20% 10% ......,1,11.._•_11•1.ri<% .8. -4, .4., 4., .4,e .40 tissp .., et my> cp oe .Oe ae cr e 4? _-0 .21,1, .0 ..43 „0 ,„ se ,be „N." .t e> ,,--0- #ets ,z,c o, /.04.6v oriesbtesecsla-204., CR x -, .3v Sarre Bloomberg. Bofn Merrill Lynch00M Ftesea«h Chart 8: However, it is not uncommon for these EM currendes to suffer from high inflation rates Average inflation rates over the past 5 years 55 50 45 40 35 30 25 20 15 10 5 0 Average inf ation rate for the world over the past 5 years = 2.93% 0.9 0> cp e eg „e ,et? „," eet• <te Some FRED- St. Louis Fed Bbomberg BMA Memll Lynch GlobS Researth Liquidity, however, keeps increasing at a very fast rate Moving on to our second parameter, liquidity, it is hard to ignore that trading volumes for major digital currencies like bitcoin and ethereum have skyrocketed in recent years. For example, daily trading volumes for bitcoin were $400mn in 2012 and have now moved up to about $2bn a day at present (Chart 9). Meanwhile. ethereum had daily trading volumes of $1.5mn when it first launched in 2015 and it is now experiencing daily trading of about $1bn. Most importantly. for a digital token to become a currency. it must build to a certain scale, a bit like the silver mine in Bolivia found by the Spanish. In some ways, this is exactly what has been happening in recent quarters, with the total market value of digital tokens growing exponentially from $1.5bn to around $87bn at present (Chart 10). Put differently, cryptocurrencies have built scale rapidly and are now accepted as a means of payment by some corporations and individuals. Chart 9: Daily trading volumes for bitcoin were $0.04bn In Jan. 2014 and have now moved up to about $1bn a day at present Daity trading volume for GLD and BItcoln 6 5 4 3 2 0 bn USD Jan-14 Aug-14 Mar-15 Oct-15 May-16 Dec-16 Jul-17 —GLD US Equity —Bitcoln Source conmarketcap ccol Chart 10: The total market value of bitcoin exploding growing exponentially from $1.5bn to around $43bn at present 100 90 80 70 60 50 40 30 20 10 0 Ap -13 Apr-14 Apr-15 ■ Bitcoin • Ethereum Source corcroketcap corn bn USD Apr, t 6 • Ripple Returns of cryptocurrencies depend mostly on price appreciation... On our third parameter, there are several ways to look at the return produced by a reserve currency. Because a government issues both debt and currency simultaneously. perhaps the most important measure of value for a reserve currency is the real interest rate (Chart 11). Then there is the term premium, as fixed income markets typically make it more expensive to borrow for longer periods of time. In fact despite quantitative easing, most major currencies like the EUR, the USD, or the GBP maintain a positive Market cap of cryptocurrencies Apr- 17 . Litecoin 6 Global Liquid Markets Weekly 124 July 2017 Bankof America 40' Merrill Lynch EFTA00788480 spread between their 2 year and their 10 year interest rate (Chart 12). Yet, there are some widely accepted reserve assets like gold or even the WY that do not pay a yield. Chart 11: The most Important measure of value for a reserve arrency is the real Interest rate 7 Real 10 year yield based on headline CPI 6 5 4 3 1 0 -1 -2 -3 -4 97 99 01 03 05 07 09 11 13 15 17 —US —Japan —Euro Area Source Bloomberg Chart 12: The term premium means that currencies maintain a positive spread between their 2 year and their 10 year interest 2Y10Y goverment bond yield spread 02 04 06 08 10 12 14 16 94 96 98 00 — Euro Smoce Bloomberg ...although some exchanges offer a return for borrowing tokens Bitcoin and other digital currencies do not have an interest rate set by a central bank And it is hard to calculate a real interest rate, as there is no specific national inflation metric to match it against However, just like in gold, there is still an interest rate set by the market After all. bitcoin exchanges need digital currency for short lending purposes. Some of the most popular services offer 1% for 14 days and scales to 5% for 1 year. Even then, retums paid by exchanges are arguably more of a credit spread than a real interest rate. Moreover, with volatility in excess of 50% or higher, a 5% return on a cryptocurrency over the course of 1 year as compensation for lending a bitcoin to an online exchange does not seem like a particularly attractive proposition. A key step for bitcoin would be to become pledgeable collateral Still. bitcoin and ethereum have delivered impressive returns so far (Chart 13) as fiat currency flowed into these digital tokens. Is it realistic to assume cryptocurrencies will continue to appreciate over time? The dollar price of gold has appreciated over centuries in line with inflation (Chart 14), but some periods have experienced much faster gold price appreciation than others. Moreover, periods of high real interest rates have been particularly damaging for gold returns in the past. In our view. cryptocurrency returns will mostly depend on the faith placed by individuals, corporations, and financial institutions on this emerging technology. As discussed earlier, there are large inherent risks to digital tokens such as fraud, hacking, outright theft, new protocol adoption. limited acceptance, and that it is not legal tender in many places in the world. Moreover, a crucial hurdle remains. Most regulated financial institutions allow their clients to borrow against financial or physical assets. but we are not aware of any major institution that takes cryptocurrency as collateral at the moment. Thus, in our view, a key step for bitcoin would be for it to become pledgeable collateral. US - UK BankofAmencae Merrill Lynch Global Liquid Markets Weekly 124 July 2017 7 EFTA00788481 Chart 13: So far, bitcoin has delivered exceptional returns as flat currency flowed into these digital tokens Yearly once returns (Bitcoin) 600% 500% - 400% - 300% - 200% - 100% - 0% -100% 1 2017 2016 2015 2014 2013 2012 2011 (YTD) Source Bloomberg Note Data avarbbie fromjuly 1010 u> current There were almost non puce fluctuations before 1011 Chart 14: The dollar price of gold has appreciated over centuries in line with inflation, but returns have fluctuated over the cycle 140% 120% 100% 80% 60% 40% 20% 0% -20% -40% -60% •-• <0 •-• <0 •-• <0 •-• CD •-• <0 •-• <0 •-• <0 •-• <0 •-• <D 0 0 el. O N <0 <0 03 03 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 CY CY CY CY Saute Bloomberg 11Annual gold returns ILI 1) ir 1 1 Bitcoin correlations to EM and 610 flat currencies are near zero-. Lastly, a financial instrument tends to be more attractive if it offers diversification benefits. In that regard. bitcoin and other cryptocurrencies score well. For starters, we find near zero correlation in weekly returns between bitcoin and fiat currencies (Table 1). Remarkably, while some currency like DXY arid CHF exhibit a correlation of 0.67, bitcoin returns are uncorrelated to any other major EM or G10 currency in our analysis. Table 1: EM and GIO currencies - weekly returns correlation BItcoln DXY EUR JPY GBP MXN CNY KRW CAD CHF Bitcoln -0.04 0.04 4.01 0.05 -0.06 4.04 0.02 0.01 4.01 DXY -0.96 0.45 -0.69 0.33 0.25 025 0.53 0.67 EUR .0.30 0.59 -028 -0.20 -0.25 0.42 -0.62 JPY 4.19 0.02 0.17 0.11 0.14 0.32 GBP -026 822 -0.34 0.44 -0.43 MXN 0.19 0.43 0.55 0.19 CNY 025 0.26 0.14 KRW 0.49 026 CAD 026 CHF Source Bloomberg Bofil blemll Lynch Gobi Research Note Dauasailiok fromiltiy 2010 tocurrenc There ~wimps, nopnce flucruauons bete« lot I ...and bitcoin is also uncorrelated to volatile, inflation prone EM FX Arguably. bitcoin is not particularly attractive as a means of exchange in a very large and stable economy like the US that boasts the world's pre-eminent trading currency. But what about emerging markets? After all, bitcoin does not face the same capital controls and banking rules as do some currencies in highly constrained economies. It could potentially deliver low cost fast cross border transactions. We look again at the correlations between EM FX and bitcoin and we find that bitcoin lacks correlation to a whole range of EM currencies (Table 2). 8 Global Liquid Markets Weekly I 24 July 2017 Bankof America e Merrill Lynch EFTA00788482 Table 2: Inflation prone EM FX - weekly returns correlation Bitcoln DZD AOA CNY MYR TND XOF INR MAD PKR PHP LKR SZL TZS UAH UZS Bitcoin 4.07 4.03 403 4.06 0.02 4.02 4.01 4.02 0.03 401 4.06 0.02 4.01 406 .0.07 DZD 0.03 0.32 0.31 0.40 0.49 0.17 0.54 0.06 0.13 0.05 0.27 0.01 0.05 -0.15 AOA 0.25 0.12 0.00 0.01 0.02 1.01 1.03 -0.01 0.00 0.13 0.16 0.01 -0.07 CNY 0.30 0.16 0.16 0.15 0.17 1.01 0.20 0.09 0.26 0.03 0.07 0.01 MYR 0.15 0.23 0.43 0.26 0.02 0.56 0.14 0.45 0.03 1.10 -0.07 TNO 0.77 0.17 0.79 0.06 0.10 0.05 0.31 0.03 1.03 -0.08 XOF 0.22 0.95 0.10 0.16 0.04 0.34 0.03 1.03 -0.09 INR 0.24 0.07 0.45 0.20 0.39 0.00 1.01 -0.14 MAD 0.08 0.17 0.05 0.37 0.04 -0.04 -0.07 PKR 0.07 0.09 0.01 1.05 .0.09 -0.06 PHP 0.15 0.31 0.03 0.01 0.03 LKR 0.05 0.01 0.04 0.03 SZL 0.01 -0.04 -0.05 TZS 0.19 -0.06 UAH -0.01 UZS s.urct, tiii.:niters, Befit Memll Lynch Glohal Research Note Data aattabk fromMy2010 CO current_ There were almost no puce flt.ctuations before 2011 Bitcoin correlations to gold, oil, or copper are also about zero The same applies to commodities. While gold and silver maintained a correlation on weekly returns of around 80% since 2011, we do not observe any meaningful correlation between bitcoin and precious, industrial or energy commodities (Table 3). Table 3: Commodities - weekly returns correlation Blicoin Gold Silver Platinum Palladium BCOM Brent Copper Bitcoin 0.05 0.04 _ 0.07 0.06 0.06 0.05 0.02 Gold 0.80 0.70 0.35 0.40 0.14 0.26 Silver 0.68 0.46 0.56 0.27 0.44 Platinum 0.60 0.50 0.28 0.43 Palladium 0.44 0.27 0.48 BCOli1 0.74 0.57 Brent 0.34 Copper Sout<e 0gvntr8 Befit Memil LynchGlobal Research Note. Data asailtok fromMy2010 CO current_ There were almost noprice flLctuations before 2011 When looking at equities, we also observe minimal correlations Equity markets, partly because of their interconnectedness. tend to move together with average correlations nearing or exceeding 50%. Once more. bitcoin exhibits near zero correlation with all major equity markets around the world (Table 4). Table 4: Equities • weekly returns correlation Bitcoln .500 MSCI World HSCEI HSI NIFTY EURO STOXX 50 Nikkei Bitcoin IL 0.04 0.05 0.02 IMIliale rliarliC • 500 0.96 0.50 0.54 0.51 0.78 0.53 MSCI World 0.58 0.65 0.57 0.85 0.61 HSCEI 0.93 0.60 0.49 0.50 HSI 0.64 0.55 0.56 NIFTY 0.53 0.49 EURO STOXX 50 0.58 Nikkei Source Bbomberg Bak Memil LynchGobi Research Note. Data asailtok fromMy2010 CO current_ There were almost no pnce flLcuations before 2011 Sitcom's Is also uncorrelated to Treasury securities or the VIX Lastly, we test the correlation of bitcoin to other liquid markets such as Treasuries and the VIX and our own BofA Merrill Lynch GFSIIU. Once more, the correlation between bitcoin and both near-term and long-term Treasury bonds and breakevens is near zero BankorAmenca .:3" Merrill Lynch Global Liquid Markets Weekly I 24 July 2017 9 EFTA00788483 (Table 5). Interestingly, the correlation of bitcoin to the VIX and to other risk indicators such as the BofAML GFSI is also very low, near zero, but negative (Table 6). Table 5: Correlation between weekly returns of Bitcoln and weekly changes In rates Bitcoln 2YR UST 10YR UST 2YR BE 10YR BE Bitcoln 2YR UST 0.74 •0.08 4.04 10YR UST 0.17 4.01 2YR BE 0.62 10YR BE Source Bbomberg BOK Memll Lynch Global Researdi Note Dacaavaibble from July 2010 co current There were almost no puce flicuations before 2011 Table 6: Correlation between weekly returns of Bitcoln and weekly changes in BofAML VIX and MI Bitcoln VIX BofAML GFSI - Risk BofAML GFSI - Flow B01MAL GFSI — Skew Bitcoln VIX 0.55 0.44 0.66 Bol4ML GFSI - Risk 0.46 0.59 BoIAUL GFSI - Flow 0.45 BofAML GFSI - Skew Clobal Research notr [ca Jo JIL jLI, It, to currenc Therewerealmost no price flscuanons before 2011 However, bitcoin returns are correlated to other cryptocurrencles To complete ou correlation analysis, we have also looked at the correlation patterns of the 10 major cryptocurrencies by market value. Our work suggests that bitcoin and other digital currencies are correlated for the most part (Table 7), although nowhere nearly as correlated as equity markets are to each other. Moreover, bitcoin and ethereum, the two biggest coins, seem uncorrelated to each other. Table 7: Ctyptocurrencies - weekly returns correlation Sitcoin Ethereum Ripple Litecoin Ethereum Classic Dash NEM Monero Bitshares Shells Bitcoln 0.01 0.21 0.56 0.t4 0.19 0.27 0.23 0.31 0.34 Ethereum 0.04 0.06 0.44 0.34 029 0.18 0.35 029 Ripple 0.60 OAS 4.12 022 0.02 0.35 0.19 Lltecoin 0.07 0.09 022 0.15 0.40 021 Ethereum Classic 0.19 024 .0.07 0.17 0.18 Dash 027 0.20 022 0.13 NEM 0.19 0.33 025 Monero 0.19 0.02 Bitshares 024 Stratis Source Bbomtere, Both memll Lynth Globi Research Note. Daca asailtok from My 2010 CO current There were almost no puce fltcuations before 2011 Rising production costs have supported bitcoin prices for now One final consideration in bitcoin and other digital currencies is their cost of production. Unlike gold. which is mined at a high cost (Chart 15). the marginal cost of creating a new digital token is near zero. This is the reason why the number of cryptocurrencies has risen to more than 900 in recent years. However, the marginal cost of "mining" established cryptocurrencies like bitcoin has increased exponentially (Chart 16) while the rewards for mining are designed to experience a logarithmic decline. The operational and electricity costs required to maintain ledgers have increased as tasks have become more complex. This could change with the advent of quantum computers or through agreements among developers to adopt simpler protocols. Thus, while rising marginal costs of production for bitcoin have been arguably a source of support for prices, falling mining costs for incremental units could also force prices to fall. 10 Global Liquid Markets Weekly 124 July 2017 Bankof Amenca 40" Merrill Lynch EFTA00788484 Chart 15: Gold is mined at a high cost. with most companies facing breakevens around 5600/oz on average and 51200+/oz on the margin Gold production cost curve (CI, C2, and C3 costs) 2500 800 US$/oz 2000 600 500 700 - 1500 400 - 1000 300 200 500 100 - 0 0 0 20 40 60 Source Bloomberg8°1A Memll Lynch Global Research of total production 80 100 Chart 16: The marginal cost of "mining- established ayptocutzendes like bitcoin has increased exponentially Bitcoin mining diifieully and block chain blocks size Giga Difficulty block size 1200 i 1000 800 600 12 13 14 — Difficulty Saute data bitcornicyorg Note. The difficulry is a unit of measurement &signed to indicate how ddficult it is to find a hash bebw the given target 400 200 0 Bitcoin faces many hurdles and risks, but liquidity keeps growing So is bitcoin a new liquid market? Certainly. cryptocurrencies score well in terms of liquidity when compared to other assets. But liquidity in equity, fixed income, or currency markets remains a large multiple of bitcoin (Chart 17). Also, while cryptocurrencies are still very volatile and thus not particularly safe, that could change as both their value rises and liquidity increases. Importantly. cryptocurrencies score well when it comes to diversification, as their correlation to equities, bonds, commodities, FX or selected measures of risk is near zero. A big uncertainty facing bitcoin and other digital tokens we see is their expected real rate of return. So far, early adopters have enjoyed a sharp appreciation in prices. While bitcoin seems to have followed a pattern similar to gold over a much more compressed time period (Chart 17), there is no certainty that that will continue and, most certainly, no way to predict it. Also, there are large inherent risks to digital tokens such as fraud, hacking, outright theft, new protocol adoption, limited acceptance, and it is not legal tender in many places in the world. Chart 17: Liquidity in equity, fixed income, or currency markets Is still a huge multiple of bitcoin Daily trailing volume (yearly average) as 30 bn USD 2 25 I 20 1.5 15 1 0.5 10 5 0 0 2014 2015 2016 2017 YTD TLT + HYG GLD Bitcoin —SPY (RHS) Source B/oomberg 15 16 Block size (RHS) Chart 18: It is still early days. but bitcoin seems to have followed a pattern similar to gold over a much more compressed time period Overlap of bitcoin and gold prices 3000 2500 2000 1500 1000 500 0 NN01 01 01 01 et et et et LO LO LO LO CO CO CO CO 0. 0- 88888888RRRR8R8RRRRR CM 0) WOO CO 0) CP, W) Qin IV CV ill 01 01 01 01 01 6-, ass ssss s § RR — Bitcoin —Gold Some Bloomberg Note. Years in parentheses correspond to Bacon Bankof Amenca ea* Merrill Lynch Global Liquid Markets Weekly 124 July 2017 11 EFTA00788485 G10 FX Athanasios Vamvakidis Rohit Garg MLI (UK) Merrill Lynch (Singapore) For a detailed view on global FX markets see: Global FX Weekly Draghi and the EUR EURUSD has been the best performing G10 FX cross so far this year. Although the market is long EUR, positioning is not stretched. EURUSD has appreciated despite the market already knowing that the ECB will have to announce QE tapering and the Fed already hiking more than markets have been expecting this year. The EURUSD move has been consistent with the data and could continue if relative EZ data keeps improving. At first glance, the ECB meeting this week should have not affected the Euro much. First, the EUR weakened as the ECB statement kept the option to do more QE if necessary. Then, the EUR strengthened when Draghi avoided talking the EUR down when he was asked about its recent strength. However, the EUR continued strengthening during and after the press conference, as the market was digesting all information. We believe that on balance the ECB meeting suggests more positive risks for the EUR. The pre-ECB EURUSD level was a key threshold for the market as this was the level at which the ECB used to intervene verbally in the past to express concerns about the strong currency and its negative implications for inflation. By avoiding such statements. Draghi has effectively removed the acceptable EUR ceiling for the ECB. Further EUR appreciation could become easier, as the ECB seems to have given up trying to "control" the currency. In practice, we do not see what policies the ECB could use to weaken the EUR, as they have removed the option to reduce depo rates further and they have to taper QE soon because of the issue limit and the capital key. These policy constraints may explain why Draghi gave up on the currency this week. But something has been lost in the process and the Euro could now appreciate freely if Eurozone data keeps improving. BoJ only dovish major central bank The BoJ left its policy unchanged this week and Governor Kuroda justified the current policy framework amid sluggish price developments. With little expected from the BoJ prior to the meeting, it was a non-event for the FX markets. We expect the BoJ to keep the current policy framework well into 2018. and just wait for policy normalization by the Fed and other central banks. After a round of sluggish data, failure to pass the healthcare bill, and not-so-hawkish Yellen comments, it may take some time before the USD reclaims its upward trend. At the same time, low volatility, high equity price, and policy divergence keep JPY from appreciating, though politics pose some risk We think USD/JPY will eventually rise beyond 115 into the autumn, and we would buy the pair's dip, but also remain concerned about downside short-term risks from a risk-off correction in global markets. Time to sell GBP We see bearish GBP risks mounting. The second round of Brexit negotiations this week show no progress. Press reports suggest that the ELI is not including the UK rebates in its calculation of UK budget contributions post-Brexit, which we believe would be a non- started for the UK In the meantime, the polyphony in the UK government on the Brexit strategy and goals, and high uncertainty about the government's sustainability in its current form continue. 12 Global Liquid Markets Weekly 124 July 2017 Bankof Amenca 40" Merrill Lynch EFTA00788486 Time to buy vol We reiterate our view that market volatility will increase this fall. In this report, we argue that brinksmanship over US tax reform and North Korea could be possible triggers. We add to our long vol trades by recommending buying a 6m EUR/SEK ATM straddle (see below for details). The difficulty in justifying EM longs There is no doubt that the last few weeks have been difficult for investors in deciding which way to lean in EM. On one hand, volatility continues to be depressed, equity markets keep making new highs (or at least are not showing any signs of slowing down) and emerging markets keep receiving inflows. In Best in 5 years we highlight that EM Asia has received the highest YTD inflows in the last 5 years on an aggregate level. On the other hand, positioning, stretched valuations, record low levels of volatility, increased geo-political concerns, uncertainty around US —China trade talks, uncertainty around Fed/ECB actions and, last but not the least, adverse August seasonality is making investors think twice or thrice before putting cash to work. This is despite cash levels being quite high within the investor community. How to hedge ? Our two latest risk off trade recommendations are long 4M USD puts. WY calls with strikes 107/102 (current 37bps) or entering long IPY. short KRW (current 10.017, target 10.4). The obvious risk to these trades is that N Korea backs down from further aggression and engages in talks. A more likely risk is that immediate confrontation is postponed and that EM asset inflows continue to accelerate. We are also long EUR/PLN through options as a hedge. Apart from hedges, we also recommend RV trades or idiosyncratic trades to navigate the current uncertain times. Specifically, we like long INR vs USD via options (current 30bps), long TRY vs ZAR and short CLP vs ARS. Otherwise, China data still kicking and we have a long bias In EM Asia Beyond the above risk factors, China data continues to show strength. 2Q GDP numbers surprised to the upside and the overall economic surprises for China/Asia have so far held up well (Chart 2). This is probably one big reason why, weaker US data has not been able to shake investor sentiment just yet. Consequently, we continue to be long EM Asia through long 6y bonds in India (current 6.66%) and Indonesia (FR73, current 7.40%). We are also constructive on China bonds and believe they are cheap by at least 20 bps. In EEMEA FX, we are short EUR/RON. We are also long EGP as a carry trade. In LatAm FX, we have a bearish bias on COP and MXN on valuations. Chart 19: Aggregate cumulative Inflows into EM Asia debt and equity markets 140 120 100 80 60 40 20 0 -20 2013 —2014 —2015 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Noses Each line shows fix Indonesia. Thailand Korea the aggregate cumulate& Ott ad equity 00.4 only equty 00.6 for Taiwan ard Phiippines and only debt fkrns for Malaysia Swrce BofA LrxhGlohal Researdt Bloomberg Chart 20: Economic Surprises for China have held up well so far 100 50 0 -so -100 -150 ••• -US Economic Surprise Index —China Economic Surprise Index llh 1/444 \o,fti sl• 0 sr It) It) It) It) CI, CCI <0. CO I,- A o- *t t Soiree 8ofA Mend Lynch Global Research Bloomberg Bankof Amenca Merrill Lynch Global Liquid Markets Weekly I 24 July 2017 13 EFTA00788487 Rates Sphla Salim MLI (UK) Erjon Satko MLI (UK) Rualrl Hourthane MLI (UK) Gilles Moec MLI (UK) • The ECB opted for a dovish tone, unanimously maintaining the easing bias in QE and pushing back the timing of a taper decision, with full details unlikely before October. • Draghi's message argues for a slower pace of tightening than what the market is pricing in terms of rate hikes and what investors are expecting in terms of tapering. • If the light was amber for summer carry trades, the ECB has now set it to Green. We are long ERH9. Given the tightening in peripherals, we reiterate our positive carry hedges. The ECB's focus on QE flexibility reinforces our long EU Supras view. ECB economics: Rendez-vous in the fall, whenever that Is The ECB took stock of market movements since the "Sintra speech" and opted for a dovish tone today. We were expecting a more balanced press conference, with in particular the removal of the easing bias on QE. Still, even the dovish tone did not suffice to convince the FX market This could reflects the fact that the market considers the ECB as inevitably on its way to reduce policy accommodation and does not see the possibility of an upgrade in QE as credible, in spite of Draghi's insistence on the flexibility embedded in the programme. Reasons aside, the stronger Euro will be a major issue for the ECB. In fact, its appreciation relative to the June forecasts could force the central bank to revise its inflation projections down by at least 25/30 bps. This, in our view, combined with the very cautious message from Draghi. strengthens our call for a very slow pace of tapering from Jan18 onward, in contrast with investors' expectations (discussed last week and in the FX and Rates Sentiment survey). We continue to think the ECB will opt for a two-step strategy, starting with a fixed quantum of 640bn/month for the first 6 months of 2018, followed by a gradual decline to zero by year end. However, we now change the call on policy rates. So far, we had a one-off deposit rate hike in Dec18. We push it to the spring of 2019 (+20 bps). We thought that shortening the delay between the end of QE and the first hike could be a compromise between hawks and doves in exchange for the ECB being in the market late into next year. We now believe that pressure from financial conditions, and the growing awareness at the ECB of the difficulty to bring inflation back to target, will force them to stick to a "fundamentalist" version of forward guidance. Finally, the ECB today made it clear that they would not pre-commit to a given date for the announcements on the future of QE. simply mentioning "the fall", which, according to Draghi, explicitly includes September. Further, Draghi affirmed that technical committees had not yet been tasked to review the possible options. While we know that the ECB likes to make announcements at the same time as new forecasts become available, we think the central bank will want more visibility and would prefer getting a sense of where market conditions are going throughout September. We think a key input there will be the Fed's decision. A more hesitant Fed, triggering more upward pressure on the euro, would help convince hawks that the slowest possible pace of tapering — scarcity permitting — is the right way to go. In rates, clearest takeaways are for front-end & spreads While the QE easing bias was maintained (unanimously) and the date to discuss tapering was implicitly pushed back, Bunds failed to meaningfully sustain their gains post the policy announcement. Interestingly, Draghi's insistence on the fact that his message in 14 Global Liquid Markets Weekly 124 July 2017 Bankof Amenca 40" Merrill Lynch EFTA00788488 Sintra was no different from that at the June meeting, and that the ECB's focus is still on the weak inflation outlook, had little impact on yields. We believe this confirms our interpretation that the selloff since then was most likely the result of a wake —up call. with term premia readjusting to the new reality of (1) already reduced QE purchases in Germany, and (2) diminished flight to quality bid, past Italian election fears. In that context, we believe that the clearest signals to take away from today's ECB meeting in rates are for peripheral spreads, front-end rates and EU Supras. If the light was Amber for summer carry trades, ECB Just turned It Green The easing bias kept for QE and the delay in the tapering decision, with full details unlikely to be announced before October. buys more time for peripheral carry trades. This, coupled with QE purchases in a low liquidity month. may set the stage for a similar spread tightening as in Aug16, with 150bp seen as next key level for 10y BTP-Bunds. Further, Draghi's reference to spreads having tightened as a reason not to be concerned about recent market price action, and his insistence on the flexibility embedded in QE (currently engineered through deviations from capital keys via Supras purchases) are both opening the possibility for ECB tapering discussions to be less negative than feared for peripheral spreads in the short term. That said, with the 1" principal component of peripheral spreads already back to its tightest levels since QI 2016, and with risks set to pick-up in autumn, we reiterate our recommendation to consider positive carry hedges. such as long 10y swap spreads, short the belly of the 5y10y30y BTP fly and 30y50y BTP flattener. Note that all three positions should be supported by heavy July index extensions in Germany and Italy at the end of next week. The trades are currently priced at 45bp. -30bp and 25bp respectively. The main risk to all is the market turning fundamentally bullish on the periphery. Dovish language supports our long (positive carry) position in Marl 9 Euribor The ECB meeting reinforces our high conviction recommendation to be long Marl 9 Euribor entered on 18-Jul at 100.035 — see Front end — EU (current: 100.065, target: 100.135). Ultimately, with Draghi insisting on "patience and "persistence", and our econ team pushing the first rate hike to Spring 2019, we believe the -30bp of hikes priced by 1Q19 appear excessive. Any delay in the QE decision should allow front-end vol to remain low and Euribors to grind higher over coming months. In this low vol context, the 6.5bp of roll on the trade also appears even more attractive. Interestingly, the Euro rally seen yesterday may actually support the trade even further. With the ECB running out of tools to combat Euro strength, and technical constraints potentially forcing a premature end to QE. forward guidance on rates may have to be explicitly reinforced to avoid an aggressive tightening of financial conditions. The risk to the trade is that the ECB, by choice or otherwise, ends QE in HI and hikes aggressively through 2H18 in order to engineer a rapid exit from negative rates. However, such a scenario appears overly hawkish to us given the 2018 inflation outlook 'When we needed flexibility,