Chart of the Day: Market implied basis points of tightening forFOMC meeting dates

Note: navy bars indicate FOMC meeting date with press conference, orange bars indicate FOMC meeting date without press conference

Source: BofA Merrill Lynch Global Research, Tullet Prebon, Bloomberg

Key takeaways

• History and independence argue that the Fed will not be deterred from raising rates due to a presidential election

• Recent presidential elections have resulted in higher uncertainty but not a material tightening of financial conditions

• The Fed will likely treat meetings ahead of the election as "live" and we recommend that investors view them similarly

  By Mark Cabana and Michael S. Hanson

  Chart of the Day: Market implied basis points of tightening for FOMC meeting dates

  9 8 7 6 5 4 3 2 1 0

  Note: navy bars indicate FOMC meeting date with press conference, orange bars indicate FOMC meeting date without press conference Source: BofA Merrill Lynch Global Research, Tullet Prebon, Bloomberg

  Fed will not be deterred from raising rates due to election

  Over recent weeks, a number of clients have asked: “will the Fed be deterred from raising rates due to a presidential election?” Recent Federal Reserve commentary, history, and central bank independence all indicate the answer is “no.” Assuming the Fed felt sufficient progress had been made to warrant another rate increase, it would only likely delay if this November’s election coincided with heightened economic uncertainty that weighed on the outlook or resulted in a material tightening of financial conditions.

  Market pricing currently assigns the largest incremental odds to the next rate move in June or July, with more limited pricing for September and November FOMC meetings as shown in the Chart of the Day. The Fed will likely treat meetings ahead of the election as “live” and we recommend investors view them similarly. We believe the timing of the next rate increase is most likely in September, although a summer rate hike remains a possibility, particularly in light of recent Fed communications.

  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 8 to 9. Analyst Certification on page 7. 11635230

Rates and Currencies Research Global

Global Rates & Currencies Research

MLI (UK)

Mark Cabana, CFA

Rates Strategist MLPF&S
+1 646 855 9591 mark.cabana@baml.com

Michael S. Hanson

Global & US Economist MLPF&S
+1 646 855 6854 michael.s.hanson@baml.com

Adarsh Sinha

FX Strategist
Merrill Lynch (Hong Kong) +852 3508 7155 adarsh.sinha@baml.com

Yang Chen

Rates Strategist
Merrill Lynch (Hong Kong) +852 3508 8695 ychen8@baml.com

See Team Page for Full List of Contributors

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Recent history: election years no barrier to hiking

Historically, presidential election years have not precluded policy tightening by the Fed. Of the last five Fed hiking cycles, four either began during or continued into an election year. Two of these—1988 and 2004—started in an election year, some months before Election Day (in March and June, respectively). Two others—1983 and 1999—began the year before an election, with hikes continuing well into the following year (Chart 1). Both these hiking cycles stopped before Election Day (in August and May, respectively), perhaps fueling speculation about the Fed’s motives. But the Fed did not resume hiking once Election Day passed — in contrast to what one should expect if the Fed were temporarily holding back hikes around an election. Rather, each of these tightening cycles concluded as the Fed returned rates to a more neutral stance.

Chart 1: Fed has both raised and lowered rates ahead of elections (%)

20 15 10

5

0
Jan-80 Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Jan-12 Jan-16

Election Year Fed Funds Target Source: BofA Merrill Lynch Global Research, Bloomberg

Guarded independence

Chart 2: Number of additional 25 basis point rate hikes priced by date

2.5 2.0 1.5 1.0 0.5 0.0

1/1/2016

2/1/2016 3/1/2016

4/1/2016

5/1/2016

June July
Source: BofA Merrill Lynch Global Research, Tullet Prebon, Bloomberg

December

Is past performance a good predictor of future policy? Given how strongly independence is held at the Fed, we suspect it is. Numerous studies show that politically independent central banks deliver the best inflation and growth outcomes, and Fed officials know even the perception of political influence can undermine their best intentions. Rather than trying to avoid being news by keeping policy unchanged in an election year, the best strategy would be to move in a very deliberate, well-communicated and data- dependent way – one that not only has nothing to do with the political cycle, but would not even give that impression.

Indeed, if the Fed really wanted to minimize political pressure today, it is not at all obvious what policy they should pursue. If the data warrant hiking and the Fed decides to hold pat, conservatives would claim the Fed is favoring the incumbent party. If the Fed then hiked in December, this would make them look doubly biased. On the other hand, hiking before the election would incur the wrath of liberals. Any action or inaction is bound to upset (at least) one party – so why even try? Recent Fed communications have raised the odds associated with a rate hike later this year, and that certainly indicates the Fed has not been deterred from considering another rate hike ahead of an election (Chart 2).

Fed could be delayed if uncertainty weighs on growth or financial conditions

The most direct way in which a US presidential election could impact Fed policy is if uncertainty associated with the cycle weighed on overall economic activity or materially tightened financial conditions. Economic policy uncertainty has typically increased heading into US presidential elections, as measured by the Baker, Bloom, and Davis composite index (Chart 3). However, this index may overstate the magnitude of actual economic uncertainty given the index measures the frequency of words in newspaper

2 Liquid Insight | 25 May 2016

articles that might be expected to increase as a presidential election approaches.1 The index has remained relatively low thus far this year, but could rise as we approach the November election. The index has increased an average of 23 points from end-May through the end-November in prior presidential election years. A large spike in uncertainty around the election could weigh on growth in the second half of the year, delaying further potential policy tightening. However, we think the probability of a significant shock to growth is low.

Chart 3: Economic policy uncertainty tends to rise around elections (pts)

200 180 160 140 120 100

Chart 4: VIX and economic uncertainty tend to move together (pts)

60 300 50 250 40 200 30 150 20 100 10 50

80
60
40 0 0

Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Jan-15 Election Period Economic Policy Uncertainty Index

Note: shaded “election period” region is from the end of May through the end of November Source: BofA Merrill Lynch Global Research, Baker, Bloom, Davis, Bloomberg

Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Jan-15

VIX (LHS) Economic Policy Uncertanity (RHS) Source: BofA Merrill Lynch Global Research, Bloomberg

The Fed could also be delayed from raising rates if presidential election uncertainty resulted in a sharp tightening of financial conditions. While the VIX index and the Baker, Bloom, and David economic policy uncertainty index have been correlated over recent years, there is limited other evidence to suggest a consistent pattern of asset price movements leading into presidential elections (Chart 4). Using data from the post- Volcker period, we took a snapshot of asset prices that roughly correspond with the number of days the June, July, and September FOMC meetings are away from this year’s November 8 election (ie, 150, 100, and 50 days, respectively). We find that conditions across equity, rates, and currency markets have generally been mixed leading into US presidential elections without strong evidence of a significant tightening in financial conditions (Exhibit 1).

When a presidential election falls within 150 or 100 days, equities and the VIX have tended to increase modestly into the election, while interest rates have declined and the US dollar has slightly appreciated. In the 50 days before a presidential election there are clearer signs of uncertainty as equities decline slightly while the VIX rises further, and both longer-dated interest rates and the DXY index are generally below their post- election levels. Price action following presidential elections appears consistent with a modest reduction in uncertainty as equity markets rise, the VIX falls, and rates and the DXY index tend to increase. If 2008 and 2012 are removed from the sample due to distortions from the financial and European peripheral crises, there is not a material difference in results leading into a presidential election; however, after the election there appears to be a larger reduction of uncertainty amidst a more pronounced increase in equities, rates, and the DXY index.

Given this set of asset price developments, we do not see evidence of any systematic tightening of financial conditions ahead of presidential elections that might be expected to preclude the Fed from raising rates if they felt economic conditions warranted. The Fed will, of course, remain attuned to economic and financial market developments in

1 The index reflects the frequency of articles in 10 leading US newspapers that contain the following triple: “economic” or “economy”; “uncertain” or “uncertainty”; and one or more of “congress”, “deficit”, “Federal Reserve”, “legislation”, “regulation” or “White House”.

Liquid Insight | 25 May 2016 3

coming months and adjust their policy stance should the outlook deteriorate or economic uncertainty materially increase. However, we do not expect this and, in our view, another hike before this year’s election is more likely than not.

Exhibit 1: Recent presidential election cycles not consistently associated with sharp tightening of financial conditions

S&P 500 (∆ in %)
Calendar Days Ahead of Election Calendar Days After of Election

-150 -100 -50 50 100 150
2012 7.7% 3.1% -2.2% -0.6% 6.5% 8.7% 2012 -3.7 0.9 3.0 1.9 -4.9 -3.7 2008 -26.1% -20.0% -15.7% -13.7% -17.0% -16.2% 2008 24.2 24.8 16.0 -3.5 -6.5 -8.0 2004 0.7% 4.1% 0.4% 7.0% 5.9% 3.7% 2004 -0.6 -0.3 3.0 -4.7 -4.7 -2.1 2000 -1.7% 0.8% -0.9% -7.2% -7.4% -21.2% 2000 2.8 4.1 4.7 3.2 -4.6 6.8 1996 6.1% 12.3% 4.4% 5.2% 13.7% 6.1% 1996 1.6 0.2 2.2 1.0 1.6 1.6 1992 1.6% 2.0% -1.3% 4.6% 6.6% 5.1% 1992 2.7 4.0 4.3 -5.8 -4.6 -2.8 1988 0.01 0.01 0.02 0.01 0.07 0.08 1988 -- -- -- -- -- --

Median 1.4% 2.0% -0.9% 0.7% 6.5% 5.1% Median 2.1 2.4 3.7 -1.2 -4.7 -2.5

Note: VIX data unavailable in 1988
Source: BofA Merrill Lynch Global Research, Bloomberg

September Fed rate move should not be discounted due to election

Given prior history, we do not believe investors should fade the potential for the Fed to tighten policy later this year based solely on the existence of the US presidential election. Although the presumptive candidates Trump and Clinton differ in their views on the economy, taxes, and spending (discussed here), many of their plans are difficult to implement in practice. Their policies would likely face opposition under a split government, which is seen as the most likely scenario according to Iowa Electronic Markets. Expectations for a split government could limit the degree of uncertainty associated with the election outcome and reduce fears of a more extreme policy stance by either presidential candidate.

We continue to believe incoming data will justify a Fed rate hike in September, if not sooner, and caution investors from fading this potential solely based upon election considerations. Market pricing currently assigns the largest incremental odds to a rate move in June or July, with more limited pricing for September or November FOMC meetings as shown in the Chart of the Day. While market pricing in September or November may be limited due to the expectation that the Fed will raise rates in the summer and then wait several meetings (until December or later) before raising rates again, we caution investors from applying a significant discount to these meetings solely based on election considerations.

VIX(∆ in pts)
Calendar Days Ahead of Election Calendar Days After of Election -150 -100 -50 50 100 150

10 Year Note (∆ in bps)
Calendar Days Ahead of Election Calendar Days After of Election

-150 -100 -50 50 100 150
2012 11.5 20.4 -9.1 0.0 24.7 -3.8 2012 -2.3% -2.5% 2.0% -1.2% -0.2% 2.3% 2008 -18.5 -37.2 33.8 -154.3 -94.2 -83.9 2008 17.1% 16.4% 7.4% -4.2% 2.1% -0.7% 2004 -72.5 -38.4 -8.9 14.7 4.2 40.1 2004 -3.5% -4.2% -3.5% -4.1% -1.1% -1.2% 2000 -26.0 -16.8 -0.5 -76.2 -70.0 -97.6 2000 8.1% 5.3% -0.4% -4.7% -2.1% -0.7% 1996 -63.2 -58.2 -45.7 7.2 4.0 63.8 1996 -1.2% 1.0% -0.2% 1.7% 8.5% 8.9% 1992 -45.2 11.7 54.5 -18.8 -48.7 -69.7 1992 2.3% 6.5% 6.8% 2.8% 6.5% 3.2% 1988 -6.3 -23.6 -10.0 31.7 33.2 40.2 1988 3.3% -3.9% -4.1% -0.4% 1.3% 4.1%

Median -26.0 -23.6 -8.9 0.0 4.0 -3.8 Median 2.3% 1.0% -0.2% -1.2% 1.3% 2.3%

DXY Index (∆ in %)
Calendar Days Ahead of Election Calendar Days After of Election

-150 -100 -50 50 100 150

4 Liquid Insight | 25 May 2016

Notable Rates and FX Research

* Global Rates & Currencies 2016 Year Ahead, 23 November 2015
* USD/CHF to climb higher, FX Quant Trader, 23 May 2016
* Will the real Fed please stand up, Global Rates and FX Weekly, 20 May 2016 * The cost of jawboning, US Rates Weekly, 20 May 2016
* USD comeback, Liquid Cross Border Flows, 16 May 2016

Key trade ideas
Top Rates and FX trades for 2016
For rationale and details, refer to Global Rates & Currencies 2016 Year Ahead: The “Great Divorce”, 23 November, 2015

Rates:

Buy US 30y TIPS, entry: 1.2%, target: 70bp, stop loss: 1.55%
Closed at 101bp (3 Mar 2016): Short USD 5y5y vs EUR 5y5y, entry: 115 bp, target: 160 bp, stop-loss: 90 bp (3 Sep 2015)
Long $100mn 6m5y ATMF UK vs $100.75mn US rates straddles, net take-in: $126K, target: +450K, stop: -$225K
Sell 3y Fannie Mae debt vs Treasuries, entry: 6bp, stop: 2bp, target: 20bp
Closed at 11bp - Long 12m Treasury bills vs OIS, entry: 1bp, target: -10bp, stop: 7bp

FX:

Buy USD/CNH 6m forward outright, entry: 6.5260, stop: 6.40
Closed at 0% - Buy EUR/USD 3m 1.10 call with a 16 Dec 1.1050 window KO, cost: 0.55% EUR (spot: 1.0690)
Buy 1y EUR/USD<1.00, USD/JPY<120 dual digital, cost: 7.0% USD (spot: 1.0690, 122.80) Closed at 902 (10 Mar 2016): Buy AUD/KRW, entry: 832, target: 920, stop: 859 (revised from 790)
Closed at 38.25 (18 Apr 2016): Sell TRY/JPY, entry: 43.40, target: 36.15, stop: 45.25 Closed at 8.27: Sell USD/NOK spot 8.685, target: 8.27, stop-loss: 8.60 (revised from 9.00)

New trade
Rates:
Receive NZ 2y swap, pay AU 2y swap, entry: 48bp, target: 20bp, stop-loss: 62bp (24 May 2016)
* The RBNZ has a stronger dovish stance than the RBA even if there is some doubt over a June rate cut in NZ. A spread position removes direct exposure to global rates. There is more scope for AU rates to reprice in the near-term.

Existing open trades
Rates:
Sell the SPGB Apr21 and buy the BTPS May21, entry: -0.6bp, target: 11bp, stop: -7bp (27 Apr 2016)
* The Spanish new elections and the country's budgetary concerns may cause some SPGB underperformance

Liquid Insight | 25 May 2016 5

OATei 2018/2027 flattener; entry: 78.5bp, target: 40bp; stop-loss: 100bp (11 Mar 2016) * We see ECB developments favoring real yield curve flatteners in four ways. A fifth support is near- and longer-term carry.

Buy €100mn 3m7y ATM/ATM+25bp payer spread (enter: €510K, max payout: 3.4:1)

* Driven by ECB disappointment this week, the 3m7y has an attractive payout ratio vs other expiries/other long tails.

Buy 3-year 3.5% ZC RPI inflation caps, entry: 26.0c; current 37.5c (21 Oct 2015) *Sterling vulnerability due to the UK's large current account deficit makes being long inflation volatility attractive. Pairing this trade with a long-standing recommendation to be short 30-year UK breakevens is an attractive way to finance it.

Buy 1y2y receiver ladders: Buy $200mn of 1y2y ATMF receivers, sell $200mn of 1y2y ATMF-20bp receivers, and sell $200mn of 1y2y ATMF-40bp receivers. Entry: -$90K. Target: $700K, stop-loss: -$350K(1 Oct 2015)
* The trade monetizes the richness of vols to rates and should be profitable in a wide range of Fed scenarios.

Short USD 5y5y vs EUR 5y5y, entry: 115 bp, target: 160 bp, stop-loss: 90 bp(3 Sep 2015) * Poor performance of bond markets in the equity rout point to the presence of a price insensitive seller in fixed income. Selling pressure from foreign central banks should put less upward pressure on euro area bond yields relative to the US, given the ECB’s asymmetric response function.

Own 2y2y BE vs 3s-5s nominal curve flatteners, target: 25bp, stop loss: 15bp (10 Aug 2015) * Eventually we see one of two scenarios: 1) Forward BEs are wrong and the Fed's expectations of inflation gradually returning to target are realized. 2) Or forward breakevens are right, in which case we are staring at 1.5% PCE even two years out. In this scenario, the 3s-5s curve will probably be much flatter given that hike expectations and terminal rates will get revised lower.

FX:

Buy 6w GBPUSD 1.44/1.40 put spread for 86 USD pips (1.46 spot reference) (4 May 2016)
* EU referendum polls still remain too close to call. We see the seasonal rally in April as an attractive opportunity to sell GBP

Buy 3m EURCHF 1.08/1.03 put spread for 0.76% Eur (7.75/8.05 ag 10.45 vols off 1.0930 spot)(1 Apr 2016)
* EUR is underpricing Brexit and that shorting Euro was a cheaper way to express such a view via options. CHF tends to perform strongly when risks become more localized.

Buy EUR/USD 6m 1.00/1.20 strangle for 155 usd pips (off 1.1020 spot, DF two-way vols 12.1/12.3) (29 Feb 2016)
*Owning low delta EURUSD strangles may be an effective and cheap double hedge in the scenario that either the US enters a recession or the European debt crisis resurfaces.

6 Liquid Insight | 25 May 2016

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 the risks involved with investing in listed options: http://www.theocc.com/about/publications/character-risks.jsp.

Analyst Certification

We, Athanasios Vamvakidis, Adarsh Sinha and Yang Chen, hereby certify that the views expressed in this research report about securities and issuers accurately reflect our respective models applied in the analysis. We also certify that no part of our respective compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.