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Feature This week, we present the third edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook – a review of central bank surveys of bank lending standards and loan demand. The data from lending surveys during the last quarter of 2021 were mixed, with business credit standards easing in the US, Japan, Canada, and New Zealand while remaining mostly unchanged in the euro area and UK (Chart 1). Supply chain disruptions have had a two-pronged effect on borrowing. While they have hurt business confidence and prospects, they have also created loan demand as firms look to replenish depleted inventory stocks. The overall picture is one of solid economic fundamentals that are nonetheless perturbed by inflation concerns and lingering uncertainty regarding Covid-19 infections. Chart 1Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 Credit Standards Eased In Most Developed Markets In Q4/2021 An Overview Of Global Credit Conditions Surveys Chart 2Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As they have access to detailed, non-public information on a large number of borrowers, loan officers are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of either current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice-versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, a net percentage of domestic respondents to the Fed’s Senior Loan Officer Survey, reported easing standards for commercial and industrial (C&I) loans to firms of all sizes over Q4/2021 (Chart 3). This marks the fourth consecutive quarter of easing standards. However, banks did report a slower pace of easing, which correlates with tighter financial conditions on the margin (top panel). While we are still in a period of easy financial conditions in absolute terms, this could soon start to change as hot inflation prints and booming economic data cause the Fed to turn increasingly hawkish. Despite this, banks expect to ease standards further over 2022, indicating confidence that underlying economic fundamentals and corporate health will be able to weather monetary tightening. US banks also reported stronger C&I loan demand from all firms in Q4, marking three consecutive quarters of improvement (middle panel). The picture was optimistic, with banks attributing increased loan demand to inventory financing, mergers & acquisitions, and fixed investment. Meanwhile, only 4.2% and 12.5% of banks saw a decrease in internal funds and increasing precautionary demand, respectively, as somewhat important. Inventories accounted for all but 2% of the 6.9% annualized GDP growth in Q4. With inventory stocks still depressed in absolute terms, we expect inventory restocking will continue to buoy demand over 2022. Chart 3US Credit Conditions US Credit Conditions US Credit Conditions ​​​​​ Chart 4US Loan Demand Outlook For 2022 Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? On the consumer side, banks reported easier standards across the board, with standards easing for credit card, auto, and other consumer loans (bottom panel). However, the pace of easing, which has historically been good at calling turning points in consumer confidence (on a rate-of-change basis), appears to have peaked. Consumer sentiment has already been battered by rampant inflation and falling real wage expectations; tighter credit standards down the road could prove to be a further headwind. As part of the one-off special questions in this edition of the survey, respondents were asked about the reasoning behind their outlook for loan demand over 2022 (Chart 4). Of those that expected higher demand, 70% cited higher spending and investment demand from borrowers as their income prospects improved. Meanwhile, only 33% thought that precautionary demand for liquidity would be a factor. Lenders thought that both, a worsening or an improvement in supply chain disruptions, could contribute to increased demand. 53% expected that continued disruption would create greater inventory financing needs. Meanwhile, 55% expected that easing supply chain troubles would boost demand as product availability concerns faded. Of those that expected weaker loan demand, interest rates were by-and-large the biggest factor, with an overwhelming 96% believing that rising rates would quell loan demand. This was followed by concerns that supply chain disruptions would keep prices high and product availability scarce (70%). On the whole, the responses capture a US economy that is at a tipping point, with market participants watching to see how it weathers an aggressive rate hiking cycle from the Fed. While underlying economic variables such as growth and employment remain strong, it still remains to be seen how much of a tightening in financial conditions the markets can bear. Euro Area In the euro area, banks on net reported a very slight tightening of standards to enterprises for the second consecutive quarter in Q4/2021 (Chart 5). Effectively, standards were unchanged as 96 of the 100 respondents to the survey reported no change from Q3. Slightly lower risk tolerance from banks contributed to tightening while lower risk perceptions related to the general economic outlook and the value of collateral had an easing effect. As in the US, standards in the euro area do show a correlation to overall financial conditions. Those have already tightened noticeably since the February 3rd meeting of the European Central Bank (ECB) Governing Council where President Lagarde set a more hawkish tone. While banks do expect a slight easing of standards over Q1/2022, that is unlikely given high inflation and geopolitical uncertainties which will negatively impact risk perceptions. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions ​​​​​​ Chart 6Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies Credit Demand In Major Euro Area Economies ​​​​​​ Loan demand growth from enterprises was remarkably strong in Q4, with 18% of firms reporting increased demand for loans (middle panel). The main driver was increased demand for inventories, followed closely by fixed investment and merger & acquisition needs. Loan demand leads realized growth in inventories, which has been already been picking up. In Q1, banks expect continued growth in loan demand, albeit at a slower pace. On the consumer side, however, loan demand only increased slightly, with the pace of growth slowing from the previous quarter (bottom panel). This was in line with consumer confidence taking a hit from rising inflation and the Omicron variant in the fourth quarter. The generally low level of interest rates had a small positive impact, while durable goods spending had a slight negative impact on consumer credit demand. Lenders expect moderate growth in consumer credit demand in Q1. Moving to the four major euro area economies, demand for loans to enterprises picked up in Germany, France, and Italy, while remaining unchanged in Spain (Chart 6). Fixed investment needs made a positive contribution across the board. This is corroborated by data on total lending, which is still growing on a year-on-year basis, even though the pace of growth is slowing in all the major euro area economies except Spain. UK In the UK, overall corporate credit standards eased slightly in Q4/2021, marking the fourth straight quarter of easing (Chart 7). However, there was dispersion along firm size. Large private non-financials accounted for all the easing and standards for small and medium firms actually tightened slightly. Going forward, lenders expect a further easing in standards in Q1, about on par with the easing seen in Q4. Chart 7UK Credit Conditions UK Credit Conditions UK Credit Conditions ​​​​​ Chart 8UK Lenders Expect A Robust Growth To Ease Credit Availability Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? ​​​​​​ On the demand side, lenders reported slightly weaker corporate demand for lending in Q4. Again, the results were uneven across firm size – loan demand from large firms strengthened moderately, while demand from small and medium firms weakened. On average, lenders expect a slight pickup in corporate demand over Q1. Moving to the UK consumer, demand for unsecured lending continued to rise at a brisk pace, hovering around the highest levels since Q4/2014 (bottom panel). Going forward, lenders expect a continued increase in demand, but at a much slower pace. The strong developments in loan growth are seemingly at odds with the GfK consumer confidence index which has declined a total of 12 points since its July peak. Although the Bank of England does not survey respondents on the factors driving household unsecured lending demand, the divergence between confidence and loan demand suggests that precautionary demand for liquidity is playing a role. This lines up with the GfK survey, where expectations for the general economic situation over the next year are in freefall with consumers bracing for high inflation and further Bank Rate increases. Pivoting back to the drivers of corporate lending, the leading factor behind increased credit availability was an improvement in the overall economic outlook, followed by market share objectives (Chart 8). In contrast to the UK consumer, lenders are bullish on the economic outlook and believe it will continue to drive further easing over Q1/2022. On the demand side, investment in commercial real estate, which has seen steady improvement since Q3/2020, was the leading factor. This was followed by merger & acquisition and inventory financing needs. Capital investment needs, meanwhile, were a drag on demand. Moving forward, real estate investment and inventory restocking needs are expected to drive demand. Japan In Japan, credit standards to firms and households continued to ease in Q4/2021 (Chart 9). However, more than 90% of respondents in each case reported that standards were basically unchanged, and there were no reported instances of tightening among the sample of 50 lenders. Those that did report easier standards cited aggressive competition from other banks and strengthened efforts to grow the business. The vast majority of lenders expect standards to remain unchanged over Q1, but there is a slight easing expected on a net percentage basis. Chart 9Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions Business loan demand on the whole was unchanged in Q4 although small and medium firms did increase demand slightly (middle panel). In contrast to other regions, business loan demand tends to behave counter-cyclically in Japan, with businesses borrowing more on a precautionary basis when they are pessimistic and vice-versa. Those dynamics were at play in Q4, with lenders attributing increased demand to a fall in firms’ internally generated funds. Banks expect a slight net pickup in demand next quarter, in line with business confidence which has fallen from its September peak on the back of concerns about Covid-19 infections, supply chain disruptions, and rising input prices. On the consumer side, loan demand was basically unchanged, with a very small net percentage of banks reporting weaker demand (bottom panel). The key reason for decreased demand was a decrease in household consumption, which is in line with retail sales, where the pace of growth has been falling. Even though core inflation in Japan is low, consumers are still exposed to rising energy prices, which might cause them to tighten other parts of their budgets. Canada Chart 10Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions In Canada, business lending standards continued to ease at a slightly slower pace in Q4/2021 (Chart 10). This marks the fourth consecutive quarter of easing conditions, coming amid booming economic activity, high capacity utilization, and buoyant sentiment. Both, price and non-price lending conditions eased at roughly the same pace. On the consumer side, non-mortgage lending conditions continued to ease, but at a slower pace (middle panel). 1-year ahead consumer spending growth expectations, sourced from the Bank of Canada’s (BoC) Survey Of Consumer Expectations, and non-mortgage lending conditions typically display an inverse correlation, with expected spending growth increasing when standards are getting easier on the margin and vice-versa. The divergence in Q4 is explained in part by excess savings accumulated during the pandemic that have yet to be spent down, and in part by expected price increases over the coming year. In either case, it demonstrates that nominal spending has room to grow even in an environment where consumer credit availability is worsening. We also saw mortgage standards ease at a slightly slower pace in Q4, with both price and non-price lending conditions easing (bottom panel). While the BoC has made a hawkish pivot, underlying conditions are still easy – the conventional 5-year mortgage rate is still flat at 4.79%, the same level as Q3/2020. However, house price growth has peaked, and rate hikes this year will help prices moderate further. New Zealand Chart 11New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions In New Zealand, business credit standards eased in the six month period ended September 2021 (Chart 11). However, the real impact of the Reserve Bank of New Zealand’s (RBNZ) tightening is being felt in the housing market, where actual standards entered tightening territory. More importantly, a net 23.1% of respondents expect mortgage credit availability to erode by the end of March; if realized, this figure would be a series high. Banks reporting less credit availability cited regulatory changes and risk perceptions. On the mortgage loan demand side, banks continued to see increased demand even after the record spike in March 2021 (middle panel). Going forward, demand is expected to moderate and fall from current levels. These dynamics have already made their mark on house prices which have already peaked, indicating that the RBNZ’s push is working as intended. Business loan demand does not appear to have been much affected by higher rates, with demand picking up slightly and expected to increase going forward (bottom panel). However, confidence has been falling since September 2021, with businesses feeling the twin bite of supply chain disruptions and labor shortages.   Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/ Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2021/2021-q4 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Footnotes 1      The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Q1/2022 Credit Conditions Chartbook: Tightening Cometh? Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The first month of this year continues to see economic growth moderating around the world. However, it remains well above trend. There is a tentative growth rotation from the US to other G10 economies. The market expects five interest rate hikes from the Fed this year, but our bias is that they will underwhelm market expectations. A surge in eurozone inflation suggests that many central banks (including the ECB) will gently catch up to the Fed. We were stopped out of our long AUD/USD trade for a small profit and are reinstating this trade via a limit-buy at 0.70. The Dollar Is Flat In 2022, Despite A Hawkish Fed Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed Recommendation Inception Level Inception Date Return Long AUD/NZD  1.05 Aug 4/21 1.72% Long AUD/USD 0.7 Feb 3/22 -     Bottom Line: The US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US and tightening financial conditions that will sap US growth, and trigger a rotation from US stocks. Feature Chart 1The Dollar Has Been Flat In 2022 Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed The dollar was volatile in January. The DXY started the year on a weakening path, surged last week on the back of a hawkish Federal Reserve, and is now relapsing anew. Year to date, the dollar index is flat. Remarkably, emerging market currencies such as the CLP, BRL, and ZAR, which are very sensitive to the greenback and financial conditions in the US, have been outperforming (Chart 1). Incoming economic data continues to be robust, but there has been a slight rotation in favor of non-US growth. The economic surprise index in the US has fallen below zero, while it is surging in other G10 countries (Chart 2). Manufacturing PMIs continue to roll over around the world, but remain robust, even in places like the euro area, which is more afflicted by the energy crisis, and the potential for military conflict in its backyard (Chart 3). Chart 2A Growth Rotation Away From The US A Growth Rotation Away From The US A Growth Rotation Away From The US Chart 3APMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally Chart 3BPMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Our take is that a growth rotation from the US to other economies is underway, and that will ultimately support a lower greenback (Chart 4). That said, near term risks abound, including geopolitical tensions, the potential for more hawkish surprises from the Federal Reserve, and the potential for a policy mistake in China. Chart 4The IMF Expects A Growth Rotation From The US This Year Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed US Dollar: In A Tug Of War The dollar DXY index is flat year to date. Economic growth continues to moderate in the US, from very elevated levels. According to the IMF, the US should see robust growth of 4% this year, from 5.6% last year. This is quite strong by historical standards, and in fact argues for less accommodative monetary policy. The caveat is that financial conditions in the US are tightening quite quickly, which could accentuate the slowdown the IMF expects. There have been a few key data releases over the last month. The payrolls report was underwhelming, with only 199K jobs added in December, versus a consensus of 450K. Friday’s number will likely also be on the weaker side. That said, with the unemployment rate now at 3.9%, average hourly earnings growing at 4.7%, and headline CPI inflation at 7%, the case for curtailing monetary accommodation in the minds of the FOMC remains compelling. Last week, the FOMC opened the window for a faster pace of a rate hikes than the market was anticipating. Fed fund futures now suggest around five interest rate increases this year. In our view, the Fed could underwhelm market expectations for a few reasons. Sentiment has begun to deteriorate. The University of Michigan survey saw its sentiment index fall from 70.6 to 67.2. The expectations component fell from 68.3 to 64.1. These also came in below expectations. Both the Markit and ISM purchasing managers’ indices are rolling over. The services PMI in the US is sitting at 50.9, a nudge above the boom/bust level. The goods trade balance continues to hit a record deficit, at -$101bn in December, suggesting the dollar is too strong for the US external balance. In a nutshell, the economic surprise index in the US has turned firmly negative, at a time when market participants are pricing in a very hawkish pace of interest rate increases. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. As such, we believe the Fed will slightly underwhelm market expectations of five rate hikes. With speculative positioning in the dollar close to record highs, this will surely deal a blow to the greenback. Chart 5AUS Dollar US Dollar US Dollar Chart 5BUS Dollar US Dollar US Dollar The Euro: War And Inflation The euro is up 0.6% year to date. Economic data in the eurozone has been resilient, despite a surge in the number of new COVID-19 cases, rising energy costs and the potential for military conflict between Ukraine and Russia. On the data front, inflation continues to surge. HICP inflation came in at 5.1% on the headline print and 2.3% on the core measure in January. This followed quite strong prints in both Germany and Spain earlier this week, where the latter is seeing inflation at 6.1%. Meanwhile, the unemployment rate continues to drift lower, falling to 7% in December for the entire eurozone, and as low as 5.1% for Germany. House prices are also surging across the monetary union. This begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. Our favorite forward-looking measures for eurozone activity continue to point towards improvement. The Sentix investor confidence index rose from 13.5 to 14.9 in January, well above expectations. The ZEW expectations survey surged from 26.8 to 49.4 in January. The manufacturing PMI remained at a healthy 58.7 in January.  The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their analysis, inflation is stickier than anticipated, but will ultimately head lower. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. Ultimately, if inflation does prove transitory, then the hawkish pivot by other central banks will have to be reversed, in a classic catch-22 for the euro. Most of the above analysis suggests that investors should be buying the euro on weaknesses. However, the potential conflict in Ukraine raises the prospect that energy prices could stay elevated, which will hurt European growth. This will weaken the euro. Also, speculators are only neutral the currency according to CFTC data. As such, we are standing on the sidelines on EUR/USD and playing euro strength via a short cable position.  Chart 6AEuro Euro Euro Chart 6BEuro Euro Euro The Japanese Yen: The Most Undervalued G10 Currency The Japanese yen is flat year to date. The number of new COVID-19 infections continues to surge in Japan, which has led to various restrictions across the region and constrained economic activity. This has split the recovery on the island, where domestic activity remains constrained, but the external environment continues to boom. Inflation remains well below the Bank of Japan’s long-run target, coming in at 0.5% for the core measure, and -0.7% for the core core measure (excluding fresh food and energy) in January. The Jibun Bank composite PMI was at 48.8 in January, below the 50 boom/bust level, even though the manufacturing print is a healthy 55.4. The labor market continues to heal, with the unemployment rate at 2.7% in December, but the jobs-to-applicants ratio at 1.16 remains well below the pre-pandemic high of 1.64. This is 30% lower. As a result, wage growth in Japan has been rather anemic.   The external environment continues to perform well. Machine tool orders rose 40.6% year on year in December, following strong machinery orders of 11.6% year on year in November. Exports also rose 17.5% year on year in December. That said, the surge in energy prices and a weak yen continues to be a tax on Japanese consumers. We have been constructive on the yen, on the back of a wave of pent-up demand that will be unleashed as Omicron peaks. The Bank of Japan seems to share this sentiment. While monetary policy was kept on hold at the January 17-18 meeting, the BoJ significantly upgraded its GDP growth forecasts. 2022 forecasts were upgraded from 2.9% to 3.8%. This dovetailed with the latest IMF release of the World Economic Outlook, where Japan was the only country to see improving growth from 2021 in the G10. In short, bad news out of Japan is well discounted, while any specter of good news is underappreciated. The bull case for the yen remains intact over a longer horizon in our view. From a valuation standpoint, it is the cheapest G10 currency. It is also one of the most shorted. And as we have witnessed recently, it will perform well in a market reset, given year-to-date appreciation. Should the equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan continue, the yen will also benefit via the portfolio channel. Chart 7AJapanese Yen Japanese Yen Japanese Yen Chart 7BJapanese Yen Japanese Yen Japanese Yen The British Pound: A Hawkish BoE The pound is up 0.5% year to date. The Bank of England raised interest rates to 0.5% today. According to its projections, inflation will rise to 7.25% in April before peaking. The BoE also announced it will start shrinking its balance sheet, via selling £20bn of corporate bonds and allowing a run-off from maturing government bonds. The Bank of England is the one central bank caught between a rock and a hard place. Inflation in the UK is soaring, prompting the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. Headline CPI for December was at 5.4% and core CPI at 4.2%. The retail price index rose 7.5% year on year in April. At the same time, the UK is facing an energy crisis that is hitting consumer spending, ahead of a well-telegraphed tax hike in April. The labor market continues to heal. The ILO unemployment rate fell to 4.1% in November. This was better than expectations and below most estimates of NAIRU. As such, the UK runs the risk of a wage-price spiral, that will corner the BoE in the face of tighter fiscal policy. Average weekly earnings rose 4.2% year on year in November, pinning real wages in negative territory. Nationwide house prices also continue to inflect higher, accelerating much faster than incomes. This will lead to demand for much higher wages in the UK, in the coming months. The Sonia curve is currently pricing four or more interest rate hikes this year. This is despite Omicron cases in the UK surging to new highs and tighter fiscal policy. Should the BoE tighten aggressively ahead of a pending economic slowdown, this will hurt the pound. PMIs remain relatively well behaved – the manufacturing PMI was 57.3 in January, above expectations, while the services PMI was a healthy 53.3, but this could turn quickly should financial conditions tighten significantly. The political situation in the UK remains volatile, especially with Prime Minister Boris Johnson facing a scandal domestically, while lingering Brexit tensions continue to hurt the trade balance. As such, portfolio flows are likely to keep the pound volatile in the near term. An equity market correction, especially on the back of heightened tensions in Ukraine, will also pressure cable. That said, more political stability domestically and internationally will allow the pound to continue its mean reversion rally. Given the above dynamics, we are long EUR/GBP in the short term but are buyers of sterling over the longer term.  Chart 8ABritish Pound British Pound British Pound Chart 8BBritish Pound British Pound British Pound Australian Dollar: RBA Watching Inflation And Wages The Australian dollar is down 1.7% year to date. The Reserve Bank of Australia kept rates on hold at its February 1 meeting, even though it ended quantitative easing. The two critical measures that the RBA is focusing on are the outlook for inflation, especially backed by an increase in wages. In our view, a more hawkish outcome is likely to materialize over the course of 2022. On the inflation front, key measures are above the midpoint of the central bank’s target. In Q4, headline inflation was 3.5%, the trimmed mean measure was 2.6%, and the median print was 2.7% year on year. In fact, the increase in Q4 prices took the RBA by surprise and was attributed to rising fuel prices. The RBA expects inflationary pressures to remain persistent in 2022, but to ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 1-3% target range. The employment picture in Australia is robust, barring lackluster wage growth. The unemployment rate fell to 4.2% in December from 4.6%, which, according to most measures, is below NAIRU. The RBA expects this rate to dip towards 3.75% next year. Admittedly, wage growth is still low by historical standards, but it is also true that the behavior of the Phillip’s curve at these low levels of unemployment is uncertain. Ergo, we could see an unexpected surge in wage growth. House prices are rising at a record 32% year-on-year in Sydney. This is a clear indication that monetary policy remains too easy, relative to underlying conditions. In the very near term, COVID-19 continues to ravage Australia, which will keep the next set of economic releases rather underwhelming. Combined with the zero-COVID policy in China (Australia’s biggest export partner), the outlook could remain somber in the very near term. This will keep the RBA dovish. On the flip side, a dovish RBA has softened the currency and allowed the trade balance to recover smartly. Meanwhile, it has also led to a record short positioning on the AUD. Our expectation going forward remains the same – as China eases policy, Australian exports will remain strong. A simultaneous peak in the spread of Omicron will also allow a domestic recovery, nudging the RBA to roll back its dovish rhetoric, relative to other central banks. Ergo, investors will get both a terms-of-trade and interest rate support for the AUD. We are reintroducing our limit but on AUD/USD at 70 cents, after being stopped out for a modest profit. Chart 9AAustralian Dollar Australian Dollar Australian Dollar Chart 9BAustralian Dollar Australian Dollar Australian Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar is down 2.3% year to date, the worst performing G10 currency. The Reserve Bank of New Zealand has been among the most hawkish in the G10. This has come on the back of strengthening economic data. In Q4, inflation in New Zealand shot up to a 32-year high of 5.9%. The labor market continues to heal, with the unemployment rate at a post-GFC low of 3.2% in Q4, well below NAIRU. Meanwhile, house prices continue to inflect higher, with dwelling costs in Wellington up over 30%. The trade balance continues to print a deficit but has been improving in recent quarters on the back of rising terms of trade. Meanwhile, given New Zealand currently has the highest G10 10-year government bond yield in the developed world, and bond inflows have been able to finance this deficit. In a nutshell, we expect the RBNZ to stay hawkish, but also acknowledge that is being well priced by bond markets. Overall, the kiwi will appreciate versus the US dollar, but will lag AUD, which is much more shorted and has a better terms-of-trade picture. As such, we are long AUD/NZD. Chart 10ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 10BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar: A Terms-Of-Trade Boom The CAD is down 0.3% year-to date. The Bank of Canada kept rates on hold at its January 26 meeting. This was a surprising outcome for us, as we expected the BoC to raise interest rates, but was in line with market expectations. Taking a step back, all the conditions for the BoC to raise interest rates are in place. The widely viewed Business Outlook Survey showed improvement in Q4, especially vis-à-vis wage and income growth. This is on the back of very strong inflation numbers out of Canada. The headline, trim and median inflation prints were either at or above the upper bound of the central bank’s target at 4.8%, 3.7% and 3%. On the labor front, employment levels in Canada are back above pre-pandemic levels, with the unemployment rate at 5.3%, close to estimates of NAIRU, while the participation rate has also recovered towards pre-pandemic levels. House price inflation is also prominent across many cities in Canada, which argues that monetary policy is too loose for underlying demand conditions. Longer term, the key driver of the CAD remains the outlook for monetary policy, and the path of energy prices. We remain optimistic on both fronts. On monetary policy, we expect the BoC will continue to monitor underlying conditions but will ultimately have to tighten policy as Omicron peaks. Among the G10 countries, Canada is one of the only countries where infection rates have peaked and are falling dramatically. Oil prices also remain well bid, as the Ukraine/Russia conflict continues to unfold. Should we reach a diplomatic solution in Ukraine, while Omicron also falls to the wayside, travel resumption will bring back a meaningful source of oil demand. From a positioning standpoint, speculators are only neutral the CAD. That said, we are buyers of CAD over a 12–18-month horizon given our analysis of the confluence of macro factors.  Chart 11ACanadian Dollar Canadian Dollar Canadian Dollar Chart 11BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc: Sticking To NIRP The Swiss franc is down 0.8% year to date. The Swiss economy continues to hold up amidst surging COVID-19 infections. Economic wise, inflation is inflecting higher, the unemployment rate has dropped to 2.4%, and wages are rising briskly. This is lessening the need for the central bank to maintain ultra-accommodative settings. House price inflation also suggests that monetary conditions remain too easy relative to underlying demand. The Swiss National Bank remains committed to its inflation mandate, and inflation in Switzerland is among the lowest in the G10. As such, it will likely lag the rest of other developed market central banks in raising rates, with currently the lowest benchmark interest rate in the world. On the flip side, Switzerland runs a trade surplus that has been in structural appreciation, underpinning the franc as a core holding in any FX portfolio. In the near term, rising interest rates are negative for the franc. We are long EUR/CHF on this basis, as we believe the ECB will begin to react to rising inflation pressures. That said, we were long CHF/NZD on the prospect of rising volatility in the FX market and took 4.6% profits on January 14. In the near term, this trade could continue to perform well.  Chart 12ASwiss Franc Swiss Franc Swiss Franc Chart 12BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone: Higher Rates Ahead The NOK is up 1.1% year-to-date. The Norges Bank kept the policy rate unchanged at 0.5% at its January meeting and reiterated that rate increases in March are likely. In their view, rising prices, low unemployment, and an easing of Covid-19 restrictions will give way to policy normalization, barring a persistence in Omicron infections. With as many as four rate hikes expected in 2022, the central bank is among the most aggressive in the G10. Headline CPI rose to 5.3% in December, spurred by record high electricity prices, while the core inflation came in at 1.8%. The unemployment rate dropped to 3.4% in Q4, the lowest since 2019. The manufacturing PMI rolled over slightly in January but at 56.5 remains well above the long-term average. Daily Covid-19 cases continue to hit record highs, but hospitalizations remain low, and the government has already scaled back most restrictions after a partial lockdown in December. This will contribute to an economic upswing and aid a recovery in retail sales that were down 3.1% month on month in December.  Norway’s trade balance shot up to record highs in December, driven by surging oil and natural gas export prices. A surging trade surplus supports the krone. Meanwhile, in a rising rate environment, portfolio flows into the cyclical-heavy Norwegian stock market could provide further support for the NOK. In a nutshell, the krone is undervalued according to our PPP models and appears attractive on a tactical and cyclical basis.  Chart 13ANorwegian Krone Norwegian Krone Norwegian Krone Chart 13BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona: Lower Now, Strong Later The SEK is down 0.5% year-to-date. The Swedish economy continued to strengthen in Q4 with GDP growth rising 1.4% quarter-on-quarter, exceeding expectations. In December, the unemployment rate fell to 7.3%, the lowest since the onset of the pandemic, and household lending edged higher to 6.8% year on year. In other data, the manufacturing PMI increased to 62.4 in January. Headline inflation adjusted for interest rates rose to 4.1%, highest since 1993, well above the Riksbank’s 2% target. This has raised doubts on whether the central bank will be able to hold off raising rates until 2024 as it had previously announced. However, excluding energy prices the CPI declined slightly to 1.7%. In short, the Riksbank faces the same conundrum as the ECB, on the persistence of higher inflation, driven by high energy costs. The Omicron variant continues to spread at record pace in Sweden, but recent numbers suggest some moderation. This was probably due to stricter measures in Sweden, in contrast to its Scandinavian neighbors. The cost of this stringency has been softer business and consumer confidence, which are down to multi-month lows. Retail sales also fell by 4.4% in December from the previous month. Taking a step back, Sweden is a small open economy very sensitive to global growth conditions. As such, a rebound in global and Chinese economic activity will hold the key to a rebound in SEK. In our models, the SEK is also undervalued. Chart 14ASwedish Krona Swedish Krona Swedish Krona Chart 14BSwedish Krona Swedish Krona Swedish Krona   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Highlights Federal Reserve: Market turbulence will not dissuade the Fed from starting to hike rates in March, with longer-term consumer inflation expectations climbing steadily higher. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Canada: Canadian growth is set to recover as the intense Omicron wave has peaked, further intensifying inflationary pressures. The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with inflation expectations above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates. Feature Chart of the WeekA Less Friendly Policy Backdrop For Risk Assets A Less Friendly Policy Backdrop For Risk Assets A Less Friendly Policy Backdrop For Risk Assets Risk assets have taken a beating over the past week, with major equity indices in the US and Europe suffering the sharpest selloffs seen since the early days of the pandemic. There are many sources of investor angst fueling the risk aversion wave - a potential Russian invasion of Ukraine, some mixed results on Q4/2021 corporate earnings reports, the lingering Omicron wave and most importantly, fears of tighter global monetary policy. The latter is most evident in the US, with a few prominent Wall Street investment banks now calling for the Fed to deliver much more than the 3-4 rate hikes currently discounted for 2022. The Fed is now in a difficult spot. Realized US inflation remains very high, supply chain disruptions are not going away, and wage growth is accelerating amid tight US labor market conditions. Survey-based consumer inflation expectations show little sign of peaking, with longer-term expectations now climbing steadily higher. As a result, the Fed has been forced to rapidly shift its policy guidance in a more hawkish direction. These trends are not unique to the US, however, as similar inflation dynamics are playing out in places like the UK and Canada where central banks are also expected to deliver a lot of monetary tightening this year (Chart of the Week). For inflation targeting central banks, a surge in inflation that becomes increasingly embedded in longer-term inflation expectations is a direct challenge to their credibility. The policy prescription must involve monetary tightening to raise real interest rates in a bid to stabilize inflation expectations. At the same time, given the starting point of near-0% nominal policy rates and high inflation, deeply negative real interest rates have a lot of room to rise before becoming a serious restraint on economic growth. This limits how far bond yields can decline in response to a generalized risk-off move like the one seen over the past week. For financial markets hooked on easy monetary policies, an inflation-induced monetary tightening cycle will lead to even higher bond yields – especially real yields - and more frequent bouts of market volatility this year. The events of the past week will likely not be a one-off. The Fed Cares About Inflation, Not Your Equity Portfolio US equity markets have had a rough start to 2022. The S&P 500 is down -9% so far in January, with the tech-heavy NASDAQ index down a whopping -13% (Chart 2). The VIX index now sits at 31, nearly double the level seen at the end of 2021. The selloff in risk assets has occurred alongside an increase in real US bond yields. TIPS yields for the 2yr, 5yr and 10yr maturities are up +20bps, +36bps and +43bps, respectively since the start of the year - a reflection of increasing Fed rate hike expectations. Yet other financial markets have seen more limited swings so far in 2022. Non-US equities are sharply outperforming the US; the EuroStoxx index of European equities is down -6%, while the MSCI emerging market (EM) equity index is down just -2%. US investment grade and high-yield spreads, using the Bloomberg benchmark indices, are up a relatively modest +9bps and +36bps, respectively, while the DXY US dollar index is up only +0.4%. The risk asset selloff seen year-to-date has been sharp, but has likely not been enough for the Fed to postpone the expected March liftoff of the fed funds rate. US financial conditions have tightened, but not nearly by enough to make the Fed to more concerned about the US economic growth outlook (Chart 3). Also, financial markets appear to be functioning normally, suggesting what is happening is a repricing of risk assets rather than a selloff driven by poor market liquidity conditions. Chart 2A 'Real' Equity Market Correction A 'Real' Equity Market Correction A 'Real' Equity Market Correction ​​​​​​ Chart 3High Inflation, Not High Asset Values, is The Fed's Biggest Concern High Inflation, Not High Asset Values, is The Fed's Biggest Concern High Inflation, Not High Asset Values, is The Fed's Biggest Concern ​​​​​​ The bigger risk to US growth may actually come from high inflation, rather than falling asset values. Real US household income growth, derived from responses in the New York Fed’s Survey of Consumer Expectations to individual questions on incomes and inflation, is expected to contract -3% over the next year (bottom panel). Given that decline in perceived spending power, with inflation far exceeding wage growth, it is no surprise that the University of Michigan consumer confidence index is near an 8-year low. US business confidence has also been hit by high inflation. The NFIB survey of small business sentiment and the Conference Board survey of corporate CEO confidence declined in the latter half of 2021, largely in response to inflationary supply chain disruptions and labor shortages. Nearly one-quarter of NFIB survey respondents cite “inflation” as the single most important problem in operating their businesses. Economic sentiment has clearly taken a hit because of elevated US inflation, even with the US unemployment rate at 3.9% and overall real GDP growth remaining solidly above trend. This suggests that slowing inflation could actually provide a more sustainable boost to the US growth through improved confidence – if the Fed can first successfully engineer a “soft landing” for the economy once it begins hiking rates. The problem the Fed now faces is that the high inflation of the past year is starting to leak into longer-term survey-based measures of inflation expectations. 5-10 year ahead consumer inflation expectations from the University of Michigan survey are now at a 10-year high of 3.1%, while the 10-year-ahead inflation forecast from the Philadelphia Fed’s Survey of Professional Forecasters is at a 23-year high of 2.6% (Chart 4). Market-based inflation expectations like TIPS breakevens have stopped rising, as a more hawkish Fed has boosted real TIPS yields, but remain elevated at levels consistent with the Fed achieving, but not exceeding, it's 2% medium-term inflation target (bottom panel). The combination of a tight US labor market and consumers expecting more inflation raises the risk that the US could enter a wage-price spiral, where workers demand wage increases in response to higher inflation and companies are therefore forced to raise prices to maintain profitability. The conditions for a wage-price spiral seem to now be in place in the US (Chart 5): unemployment is low, wages are accelerating and a growing number of US workers are quitting jobs to find better work. Perhaps most importantly, US consumers are more uncertain about where inflation will be in the future. Chart 4US Inflation Expectations Becoming More Entrenched US Inflation Expectations Becoming More Entrenched US Inflation Expectations Becoming More Entrenched ​​​​​ Chart 5The Start Of A US Wage/Price Spiral? The Start Of A US Wage/Price Spiral? The Start Of A US Wage/Price Spiral? ​​​​​​ The New York Fed Survey of Consumer Expectations asks respondents to place probabilities on certain ranges for future US inflation rates one and three years ahead. The probability-weighted average of those inflation rates is dubbed “inflation uncertainty”, and those have doubled over the past year from 2% to 4% (bottom panel). This means that the survey respondents now see higher inflation outcomes as more probable, which will likely result in increased wage demands to “keep up” with the cost of living. With the US labor market looking tight as a drum, amid extensive shortages of quality workers as reported in business confidence surveys, the odds of wage increases because of higher inflation instead of higher productivity – a.k.a. a wage-price spiral – have shot up significantly. Already, the 5-year-annualized growth rate of US unit labor costs has doubled since the start of the pandemic (Chart 6), evidence that wage increases are not being matched by faster productivity. Given the strong historical correlation between unit labor cost growth and core inflation in the US, the rise in the latter will be more persistent if US workers ask for bigger cost-of-living driven wage increases. Chart 6Rising US Labor Costs Provide A Lasting Boost To US Inflation Rising US Labor Costs Provide A Lasting Boost To US Inflation Rising US Labor Costs Provide A Lasting Boost To US Inflation ​​​​​​ Chart 7 ​​​​​ Former Fed Chair Alan Greenspan famously described “price stability” – the Fed’s stated medium-term goal - as a situation where “… households and businesses need not factor expectations of changes in the average level of prices into their decisions.” This is clearly not the situation in the US today, which is why the Fed has no choice but to move ahead with interest rate increases to begin the road back to price stability. Financial market selloffs may actually assist the Fed in achieving that goal through tighter financial conditions, thereby limiting how much interest rates must increase to cool off above-trend US economic growth. Interest rates must still go up first, though – especially in real terms. Already, investors have adjusted to that reality by lifting their medium-term “real rate expectations”. We proxy the latter by taking the difference between the forward path for nominal US interest rates discounted in the US overnight index swap (OIS) curve and the forward path of US inflation discounted in the US CPI swap curve. Over just the past month, that market-implied forward path for the real fed funds rate has shifted from discounting an average level of around -1% over the next decade to something closer to -0.25% (Chart 7). We anticipate that those real rate expectations will move even higher as the Fed begins to hike rates in March and continues its tightening cycle over the next 1-2 years. This will underpin the move higher in US bond yields that we expect this year, for both government and corporate debt, with the benchmark 10-year Treasury yield reaching a high of 2.25% by year-end. Bottom Line: Market turbulence will not dissuade the Fed from starting to hike rates in March. Longer-term consumer inflation expectations are climbing steadily higher, which is starting to feed into higher wage demands in a very tight labor market. Given the choice of fighting high inflation or supporting asset prices, the Fed will choose the former as tightening financial conditions are not yet an impediment to above-trend US economic growth. Stay below-benchmark on US interest rate exposure, both in terms of duration and country allocation, in global bond portfolios. Canada Update: The BoC Has A Lot Of Work To Do The Bank of Canada (BoC) meets this week and we anticipate that the first rate hike of this tightening cycle will be announced. This will just be the beginning of what will likely be an extended cycle. Canadian monetary conditions are far too accommodative given above-trend growth and accelerating inflation. The BoC places a lot of analytical weight on its Business Outlook Survey when assessing the state of the Canadian economy. The Q4/2021 survey signaled very strong business confidence and robust demand (both domestic and foreign), with a growing majority of firms surveyed planning to increase investment and hiring over the next year (Chart 8). Survey respondents also reported significant capacity constraints, especially in industries that have experienced strong demand during the pandemic, like retail, manufacturing and housing. This is related to global supply chain disruptions, but also to intensifying labor shortages. Chart 8A Bright Outlook For The Canadian Economy A Bright Outlook For The Canadian Economy A Bright Outlook For The Canadian Economy The survey was conducted before the Omicron variant began to spread through Canada, which lead to the reimposition of severe economic restrictions. The number of Canadian COVID cases has peaked, however, and some restrictions have already begun to be lifted in Ontario, Canada’s largest province by population. The economic impact of Omicron will therefore be concentrated in the first couple of months of 2022 and should not derail the hiring and investment plans indicated in the Business Outlook Survey. A reacceleration of Canadian economic growth post-Omicron would magnify high Canadian inflation at a time of intense capacity constraints and tight labor markets. The Canadian unemployment rate fell to 5.9% in December, just 0.2 percentage points above the pre-COVID low seen in February 2020. Headline CPI inflation reached a 31-year high of 4.8% in December 2021, with trimmed CPI inflation (which omits the most volatile components) reaching an 30-year high of 3.7% (Chart 9). The rise in inflation has been broad-based, with large increases seen for both goods inflation (6.8%) and services inflation (3.7%). Like the US, high inflation is becoming more embedded in survey-based inflation expectations. Canadian businesses expect inflation to be 3.2% over the next two years, according to the Business Outlook Survey.1 Canadian consumers expect inflation to be 4.9% over the next year and 3.5% over the next five years, according to the BoC’s Canadian Survey Of Consumer Expectations (Chart 10). The latter had been very stable around 3% since the survey began back in 2014, thus the 0.5 percentage point jump seen in the latest quarterly survey is a highly significant move that suggests the 2021 inflation surge is become more embedded in Canadian consumer psychology. Chart 9The BoC Has An Inflation Problem On Its Hands The BoC Has An Inflation Problem On Its Hands The BoC Has An Inflation Problem On Its Hands ​​​​​​ Chart 10Canadian Consumer Inflation Expectations Are Rising Canadian Consumer Inflation Expectations Are Rising Canadian Consumer Inflation Expectations Are Rising ​​​​​​ The Canadian inflation backdrop has similarities to the US situation described earlier in this report. Like the US, one-year-ahead Canadian consumer inflation expectations are far above wage expectations (only +2%), which suggests that Canadian consumers expect real wages to contract -2.9%. Also like the US, falling real wage expectations are acting as a drag on Canadian consumer confidence (bottom panel). And also like the US, we expect Canadian workers to increase their wage demands to restore real purchasing power, potentially starting a wage-price spiral. Given widespread Canadian labor market shortages, this process has likely already started. According to the BoC Business Outlook Survey, 43% of firms had to boost wages in Q4/2021 because of “cost of living adjustments”, compared to 29% in Q3/2021 (Chart 11). An even larger share of respondents in the Q4 survey (54%) reported having to raise wages to attract and retain workers, up significantly from Q3 and an indication of how Canadian firms are seeing their wage bill go up trying to find quality labor in a tight job market. Chart 11 Given the messages on growth and inflation from its surveys, the BoC has all the evidence it needs to begin the rate hiking process as soon as possible. The bigger question is how high will rates have to go to cool off Canadian economic growth and bring inflation back into the BoC’s 1-3% target range. The BoC’s own internal models estimate that the neutral level of the policy interest rate is between 1.75% and 2.75%. Those estimates were last produced back in April 2021, however, and the range may need to be revised higher to reflect the changes seen in the Canadian economy since then – most notably the greater supply constraints and higher inflation. At a minimum, the BoC will likely have to raise the policy rate to the higher end of its last estimated range for the neutral rate. Current market pricing in the Canadian OIS curve discounts the BoC hiking the policy rate from 0.25% today to 1.6% by the end of 2022 (Chart 12). With eight scheduled BoC policy meetings this year, including this week, the 2022 pricing is realistically achievable. However, only another 50bps of hikes are priced for 2023 and no additional hikes after that. Chart 12Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Markets Are Underestimating The Likely Cyclical Peak In Canadian Rates Chart 13Stay Underweight Canadian Government Bonds Stay Underweight Canadian Government Bonds Stay Underweight Canadian Government Bonds A peak policy rate around 2% would only be in the lower half of the BoC’s range of neutral rate estimates. It would also represent a very low peak real rate of 0% assuming inflation returns to the midpoint of the BoC target range. It is possible that markets are underestimating how high the BoC will have to lift rates, both in nominal and real terms, because of a fear that rate increases will hurt highly indebted Canadian homeowners and trigger a sharp pullback in house prices. This is a legitimate concern given the stretched housing valuations across most major Canadian cities. However, the BoC is facing the same credibility issue that the Fed and other inflation-targeting central banks are facing in the pandemic era. Canadian inflation is too high and becoming more embedded in inflation expectations. Also like the Fed, the BoC will have to fight the inflation battle now and deal with the collateral damage on financial conditions (and the housing market) later. Importantly, with the Fed also likely to deliver several rate hike in 2022. Thus, the BoC has less need to fear a surge in the Canadian dollar, driven by widening interest rate differentials, that could aggressively tighten financial conditions beyond the impact on asset markets and house prices from higher interest rates (Chart 13). Summing it all up, we maintain our negative strategic outlook on Canadian government bonds as markets are underestimating the tightening that will be required from the BoC over the next 1-2 years. Bottom Line: The Bank of Canada has all the information from its consumer and business surveys to justify hiking rates immediately, particularly with medium-term consumer inflation expectations now above the central bank’s 1-3% target range. Stay underweight Canadian government bonds in global fixed income portfolios, as markets have not yet discounted the likely cyclical peak in policy interest rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Business inflation expectations calculated as the share of respondents reporting expected inflation within a certain range multiplied by the midpoint of the range. We assume a value of 0.5 for “less than 1” and a value of 3.5 for “greater than 3”. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Overlay Trades

Highlights 2022 Key Views & Allocations: Translating our 2022 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions to begin the year. Target a moderate level of overall portfolio risk, maintain below-benchmark overall duration exposure, make developed market government bond country allocations based on relative expected central bank hawkishness (underweight the US, UK and Canada; overweight Germany, France, Italy, Australia, Japan), and be selective on allocations to global spread product (overweight high-yield with a bias toward Europe over the US, neutral global investment grade, underweight emerging market hard currency debt). Specific Allocation Changes: Much of the current positioning in our model bond portfolio already reflects our 2022 investment themes. The only significant changes we make to begin the year are reducing emerging market USD-denominated corporate bond exposure to underweight, and shifting some high-yield corporate bond exposure from the US to Europe. Feature In our last report of 2021, we published our 2022 Key Views, outlining the themes and investment implications of the 2022 BCA Outlook for global fixed income markets. In this report, our first of the new year, we translate those views into more specific recommendations and allocations within the BCA Research Global Fixed Income Strategy model bond portfolio. The main takeaways are that another year of expected above-trend global growth, even after the risks to start the year from the Omicron variant, will further absorb spare capacity across the developed economies. Realized inflation will slow from the elevated readings of 2021, but will remain high enough to force central banks – led by the US Federal Reserve – to incrementally remove highly accommodative monetary policies put in place during the pandemic. The backdrop for global bond markets will turn far less friendly as a result, with higher bond yields (led by US Treasuries), flatter yield curves and much weaker returns on spread products that have benefited from easy monetary policies like investment grade corporate debt and emerging market (EM) hard currency debt. Against this challenging backdrop for overall fixed income returns, bond investors will need to focus more on relative exposures between countries, sectors and credit ratings to generate outperformance versus benchmarks. Our recommended portfolio allocations to begin 2022 reflect that shift (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely A Review Of The Model Bond Portfolio Performance In 2021 Chart 12021 Performance: A Positive, Yet Volatile, Year 2021 Performance: A Positive, Yet Volatile, Year 2021 Performance: A Positive, Yet Volatile, Year Before we begin our discussion of the model bond portfolio for 2022, we will take a final look back at the performance of the portfolio in 2021. Last year, the model bond portfolio delivered a small negative total return (hedged into US dollars) of -0.51%, but this still outperformed its custom benchmark index by +36bps (Chart 1).1 It was a very challenging year for global fixed income markets, in aggregate, with significant swings in bond yields (i.e. US Treasuries were up in Q1, down in Q2/Q3, up then down in Q4) and credit spreads (US high-yield spreads fell in H1/2021 and were rangebound in H2/2021, while EM hard currency spreads were stable in H1/2021 before steadily widening during the rest of the year). Over the full year, the government bond portion of the portfolio outperformed the custom benchmark index by +27bps while the spread product segment outperformed by +9bps (Table 2). The bulk of that government bond outperformance occurred during the first quarter of the year when global bond yields surged higher as COVID-19 vaccines began to be distributed and economic optimism improved in response – trends that benefited the below-benchmark duration tilt within the portfolio. The credit market outperformance was more evenly spread out during the final nine months of the year. Table 2GFIS Model Bond Portfolio Full Year 2021 Overall Return Attribution Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely Our Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely In terms of specific country exposures on government debt (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) generated virtually all of the full-year outperformance of the government bond portion of the portfolio (+38bps versus the benchmark). The biggest underperformer was the UK (-9bps), concentrated at the very end of the year as Gilt yields declined on the back of the Omicron surge, to the detriment of our underweight stance. All other country allocations provided little excess return, in aggregate, over the full year in 2021 – although there was significant variance of those returns during the year. Chart 2 Within spread product (Chart 3), the biggest gains were seen in US high-yield (+19bps) where we remained overweight throughout 2021. The largest drag on performance came from UK investment grade corporates (-9bps), although this all came in Q1/2021 where we maintained an overweight stance at the time and spreads widened. Other spread product sectors delivered little in the way of excess return, although that should not be a surprise as we maintained a neutral stance on US and euro area investment grade corporates – which have a combined 18% weighting within the model bond portfolio custom benchmark index – throughout 2021. Chart 3 In the end, our recommended portfolio tilts during 2021 were generally on the right side of the market, with our overweights outperforming in an overall down year for bond returns (Chart 4). The numbers would have been even better without the drag on performance in the fourth quarter (-17bps for the entire portfolio). That came entirely from our two biggest government bond underweights – US Treasuries and UK Gilts – which saw significant bond yield declines in response to the emergence of the Omicron variant. (the detailed breakdown of the Q4/2021 performance can be found in the Appendix on pages 19-23). Chart 4 Importantly, the surge in bond yields seen in the first week of 2022 has already resulted in a full recovery of that Q4/2021 underperformance, providing a good start to the new year for our model portfolio. Top-Down Bond Market Implications Of Our Key Views We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: BELOW BENCHMARK As we concluded in our 2022 Key Views report, longer-maturity government bond yields are now too low given the mix of very high inflation and very low unemployment seen in many countries. While we expect inflation to come down this year from the very rapid pace of 2021, it will not be by enough to force central banks off the path towards rate hikes that already began at the end of last year in places like the UK and New Zealand. The Fed is now signaling that multiple US rate hikes are likely in 2022, while even some European Central Bank (ECB) officials are expressing concern over very high European inflation. Longer maturity bond yields remain too low, in our view, because investors are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. (Chart 5). An upward adjustment of global interest rate expectations is likely this year as central banks like the Fed and the Bank of England (BoE) deliver on expected rate hikes, with more tightening necessary beyond 2022. This will be the primary driver of the rise in global bond yields that we expect this year - an outcome that has already begun in the first week of 2022. Chart 5Global Government Bond Yields Vulnerable To Hawkish Repricing Global Government Bond Yields Vulnerable To Hawkish Repricing Global Government Bond Yields Vulnerable To Hawkish Repricing ​​​​​​ Chart 6Staying Below-Benchmark On Overall Duration Exposure Staying Below-Benchmark On Overall Duration Exposure Staying Below-Benchmark On Overall Duration Exposure ​​​​​​ We ended 2021 with a model bond portfolio duration that was -0.65 years below that of the custom performance benchmark (Chart 6). We feel comfortable maintaining that position, in that size, to begin the new year. Government Bond Country Allocation: OVERWEIGHT THE EURO AREA (CORE & PERIPHERY), JAPAN & AUSTRALIA; UNDERWEIGHT THE US, UK & CANADA Our country allocation decisions within our model bond portfolio entering 2022 are based on a simple framework. We are overweighting countries where central banks are less likely to raise rates this year, and vice versa. We expect the largest increase in developed market bond yields in 2022 to occur in the US, as markets are still not priced for the cumulative tightening that the Fed will likely deliver over the next couple of years. Markets are also underpricing how much the Bank of England and Bank of Canada will need to raise rates over the full tightening cycle, even with multiple hikes discounted for 2022. We see the necessary upward repricing of post-2022 rate expectations in all three of those countries – the US, UK and Canada – justifying underweight allocations in our model portfolio. Chart 7Our Recommended DM Government Bond Allocations To Start 2022 Our Recommended DM Government Bond Allocations To Start 2022 Our Recommended DM Government Bond Allocations To Start 2022 The opposite is true in core Europe and Australia. Overnight index swap (OIS) curves are discounting multiple rate hikes this year from the Reserve Bank of Australia (RBA) and even an ECB rate hike later in 2022. As we discussed in our Key Views report, there is still not enough evidence pointing to rapid wage growth in Australia or Europe that would force the RBA and ECB to turn more hawkish than their current forward guidance which calls for no rate hikes in 2022. While both central banks may talk about the possibility that monetary policy will need to be tightened, we expect the actual rate hikes to occur in 2023 and not 2022. Thus, both markets justify overweight allocations in our model bond portfolio. We are also maintaining an overweight to Japanese government bonds, as Japanese inflation remains far too low – even in an environment of high energy prices and global supply chain disruption – for the Bank of Japan to contemplate any tightening of monetary policy. The country allocations within the model portfolio as of the end of 2021 all fit with the above analysis, thus we see no major changes that need to be made to begin 2022 (Chart 7).2 The only significant move made was to slightly bump up the size of the overweights in Italy and Spain, to be funded by the reduction in EM corporate bond exposure (as we discuss below). We continue to see a positive case for owning Peripheral European government bonds for the relatively high yields within Europe, with the ECB maintaining an overall dovish policy stance in 2022 even as it scales back the size of its bond buying activity starting in March. Inflation-Linked Bond Allocations: MAINTAIN A NEUTRAL OVERALL ALLOCATION TO GLOBAL LINKERS Chart 8Our Recommended Inflation-Linked Bond Allocations To Start 2022 Our Recommended Inflation-Linked Bond Allocations To Start 2022 Our Recommended Inflation-Linked Bond Allocations To Start 2022 Inflation-linked bonds have been a necessary part of bond investors' portfolios since the lows in global inflation breakeven spreads were seen in mid-2020. Now, with inflation expectations at or above central bank inflation targets in most developed market countries, and with realized inflation likely to subside from current levels this year, the backdrop no longer justifies structural overweights to linkers across all countries. We are sticking with our end-2021 overall neutral allocation to global inflation-linked bonds, focusing more on country allocations based on our inflation breakeven valuation indicators, as discussed in our 2022 Key Views report (Chart 8). This means maintaining a neutral stance on US TIPS and linkers (vs. nominal government bonds) in Canada, Australia and Japan. We are also staying with underweight positions in linkers (vs. nominals) in the UK, Germany, France and Italy where breakevens appear too high based on our indicators. Spread Product Allocation: MAINTAIN A SMALL OVERWEIGHT TO GLOBAL SPREAD PRODUCT FOCUSED ON EUROPEAN & US HIGH-YIELD CORPORATES, WHILE UNDERWEIGHTING EM CREDIT Chart 9Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability Our expectation of above-trend global growth in 2022, with still relatively high inflation (compared to pre-pandemic levels), should be positive for spread products like corporate bonds that benefit from strong nominal economic (and revenue) growth. However, the less accommodative global monetary policy backdrop we also expect is a potential negative for credit market performance - specially as rate hikes put upward pressure on deeply negative real interest rates, most notably in the US (Chart 9). Thus, we are entering 2022 with a cautious, but still positive, overall position on spread product in our model bond portfolio. We are focusing more on credit valuation, however - both in absolute terms and between countries and sectors – to try and generate outperformance for the credit portion of the portfolio. We are maintaining a neutral stance on investment grade corporates in the US, euro area and UK given the tight spread valuations in those markets. We prefer to focus our corporate credit exposure on overweights to high-yield bonds in the US and Europe, but with a marginal preference for European junk bonds over US equivalents as we discussed in our 2022 Key Views report (Chart 10). Within EM USD-denominated credit, we remain cautious entering 2022 given the poor fundamental backdrop for EM credit: slowing momentum of Chinese economic growth and global commodity prices, a firmer US dollar, and a less-accommodative global monetary policy backdrop (Chart 11). Thus, an underweight stance on EM credit is appropriate within the portfolio to start the year. Chart 10Increase Euro High-Yield Exposure Vs US High-Yield Increase Euro High-Yield Exposure Vs US High-Yield Increase Euro High-Yield Exposure Vs US High-Yield Chart 11Reduce EM USD-Denominated Corporate Debt Exposure To Underweight Reduce EM USD-Denominated Corporate Debt Exposure To Underweight Reduce EM USD-Denominated Corporate Debt Exposure To Underweight ​​​​​​ Chart 12   Finally, we are entering 2022 with the same relative tilt within US mortgage-backed securities (MBS) that we maintained during the latter half of 2021, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Based on our outlook for 2022, we are immediately making two marginal changes to the spread product allocations to the model bond portfolio: Reducing the size of our US high-yield overweight and using the proceeds to increase the size of the European high-yield overweight Reducing our EM USD-denominated corporate bond allocation to underweight from neutral, and placing the proceeds into Italian and Spanish government bonds (hedged into USD) to limit the reduction in the portfolio yield from the EM downgrade. The above moves will lower our overall credit overweight versus government bonds from 5% to 4%, all coming from the EM to Italy/Spain switch (Chart 12). Overall Portfolio Risk: MODERATE The changes made to our spread product allocations had no material impact on the estimated tracking error of the model portfolio – the relative volatility versus that of the benchmark. The tracking error is 78bps, still below our self-imposed limit of 100bps but above the lows seen in early 2021 (Chart 13). That higher tracking error is likely related to our underweight stance on US Treasuries, given the rise in bond volatility evident in measures like the MOVE index (bottom panel). Nonetheless, a moderate level of portfolio risk is reasonable given the combination of solid global economic growth, but with tighter global monetary policy, that we expect in 2022. Chart 13Keeping Overall Portfolio Risk At Moderate Levels Keeping Overall Portfolio Risk At Moderate Levels Keeping Overall Portfolio Risk At Moderate Levels ​​​​​​ Chart 14Positive Portfolio Carry Via Selective Spread Product Overweights Positive Portfolio Carry Via Selective Spread Product Overweights Positive Portfolio Carry Via Selective Spread Product Overweights ​​​​​​ The overweights to US high-yield, European high-yield and Italian government bonds all contribute to the model bond portfolio having a yield that begins 2022 modestly higher (+14bps) than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making all the changes to our model portfolio allocations, which can be seen in the tables on pages 24-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio during the first half of 2022. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). Chart Chart For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case Omicron related economic weakness is visible in some major economies (euro area, Canada), but the US stays resiliently strong and the US labor market continues to tighten. China is a growth laggard, but this will lead to policymakers providing more macro stimulus (credit, monetary, fiscal) starting in Q2/2022. Inflation pressures from supply chain disruption remain stubbornly strong and realized global inflation rates stay elevated for longer. Developed market central banks continue dialing back pandemic-era monetary policy accommodation, led by Fed tapering and a June 2022 liftoff of the funds rate. There is a mild initial bear steepening of the US Treasury curve with additional widening of US inflation breakevens in Q1/2022, leading to bear flattening in Q2 in the run-up to liftoff – the net effect is a parallel shift higher in the entire yield curve. The VIX index stays near current levels at 20, both the US dollar and oil prices are broadly unchanged and the fed funds rate is increased to 0.25%. Hawkish Fed The Omicron wave is short-lived with limited impact on global growth, which remains well above trend. Global inflation only declines moderately from current elevated levels, both from persistent supply squeezes and faster wage growth. China loosens monetary/credit policies and announces new fiscal stimulus in late Q1/2022 – a positive surprise for global growth expectations. Developed economy central banks turn even more hawkish. Fed liftoff is in March, with another hike in June. The US Treasury curve bear-flattens as US inflation breakevens reach their cyclical peak. The VIX index climbs to 25, the US dollar depreciates by -3% (pulled in opposing directions by strong global growth but relatively higher US interest rates), oil prices climb +10% and the fed funds rate is increased to 0.5%. Pessimistic Scenario The Omicron wave persists in many major countries (including the US) and leads to extended lockdowns and weaker consumer spending. Global growth momentum slows sharply. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration passes much smaller US fiscal stimulus. Supply chain disruptions persist and are made worse by Omicron, keeping inflation elevated even as growth slows (stagflation). Developed economy central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to economic weakness. The Fed goes for a slower taper that still ends in June, but liftoff is delayed until at least September. The US Treasury curve bull steepens modestly as the front end prices out 2022 hikes. US inflation breakevens remain sticky due to persistent realized inflation. The VIX index climbs to 30, the US dollar appreciates by +5% on a safe haven bid, oil prices fall -10% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Chart Chart Chart 15Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 16US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​ The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +54bps in the Base Case and +31bps in the Hawkish Fed scenario, but is projected to underperform by -9bps in the Pessimistic scenario. Importantly, there is virtually no expected excess return from the credit side of model bond portfolio in the Hawkish Fed scenario, even with strong global growth. A faster-than-expected pace of Fed rate hikes in the first half of 2022 would be a clear signal to downgrade exposure to the riskier parts of the fixed income universe like US high-yield. Although in that Hawkish Fed scenario, greater-than-expected China stimulus and a weaker US dollar would also represent signals to begin adding back emerging market credit exposure.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We also made very slight adjustments within the US, Japan, Germany and France allocations to refine our allocations across the various maturity buckets while keeping the overall portfolio duration unchanged entering 2022. Appendix Image Image Image Image Image Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Global growth will remain above-trend in 2022, although with more divergence between regions than at any time during the pandemic (US strong, Europe steady, China slowing). Global inflation will transition from being driven by supply squeezes towards more sustainable inflation fueled by tightening labor markets - a shift leading to tighter monetary policies that are not adequately discounted in the current low level of bond yields, most notably in the US. Maintain below-benchmark overall global duration exposure. Diverging growth and inflation trends will lead to a varying pace of monetary policy tightening between countries, resulting in greater opportunities to benefit from relative bond market performance and cross-country yield spread moves. Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). Deeply negative real bond yields reflect an implied path of nominal interest rates that is too low relative to inflation expectations in the majority of developed countries. Real bond yields will adjust higher in countries where rate hikes are more likely, resulting in more stable inflation breakevens compared to 2021. Stay neutral global inflation-linked bonds versus nominal government debt. A tightening global monetary policy backdrop and rising real interest rates will weigh on returns in global credit markets, even as strong nominal economic growth minimizes downgrade and default risks. Like government bonds, global growth and policy divergences will create relative investment opportunities between countries, especially later in 2022 when the Fed begins to hike rates and China begins to ease macro policies. Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2021. We wish you a very safe, happy and prosperous 2022. We look forward to continuing our conversation in the new year. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2022 report, “Peak Inflation – Or Just Getting Started?”, outlining the main investment themes for the upcoming year based on the collective wisdom of our strategists, was sent to all clients in late November. In this report, we discuss the broad implications of those themes for the direction of global fixed income markets, along with our main investment recommendations for 2022. A Brief Summary Of The 2022 BCA Outlook The tone of the 2022 Outlook report was quite positive on the prospects for global growth, even with the recent development of the rapid spread of the Omicron COVID-19 variant. It remains to be seen how severe this new variant will be in terms of hospitalizations and deaths compared to previous COVID waves. We assume that any negative economic impacts from Omicron in the developed economies will be contained to the first half of 2022, however, given more widespread vaccination rates (including booster shots) and greater access to anti-viral treatments. The baseline economic scenario in 2022 is one of persistent above-trend growth in the developed world (Chart 1) with a closing of output gaps in the US and euro area. The mix of spending in those economies will shift away from goods towards services, although Omicron may delay that transition until later in 2022. Chart 1Another Year Of Above Trend Growth Expected In 2022 Another Year Of Above Trend Growth Expected In 2022 Another Year Of Above Trend Growth Expected In 2022 ​​​​​ Chart 2Strong Fundamental Support For US Growth Strong Fundamental Support For US Growth Strong Fundamental Support For US Growth ​​​​​ Chart 3China In 2022: Deceleration Leading To Policy Easing China In 2022: Deceleration Leading To Policy Easing China In 2022: Deceleration Leading To Policy Easing The US looks particularly well supported to maintain a solid pace of economic activity. The US labor market is very strong. Monetary policy remains accommodative (although that is slowly changing). Financial conditions are still easy, with the lagged impact of elevated equity and housing values providing a robust tailwind to consumer spending that is already well supported by excess savings resulting from the pandemic (Chart 2). China starts the year as a “one-legged” economy supported only by external demand, and policy stimulus later in the year will eventually be needed for the Chinese government to reach its growth targets (Chart 3).That policy shift will have significant implications for the outlook of many financial assets as 2022 evolves, including emerging market (EM) fixed income, industrial commodity prices and the US dollar (as we discuss later in this report). Global inflation will recede from the overheated pace of 2021 as supply chain bottlenecks become less acute. Inflationary pressures in 2022 will come from more “normal” sources like tightening labor markets, rising wage growth and higher housing costs (rents). This constellation of lower unemployment with still-elevated underlying inflation will look most acute in the US, leading the Fed to begin a tightening cycle that is not fully discounted in US Treasury yields. The broad investment conclusions of the BCA 2022 Outlook are more positive for global equity markets relative to bond markets, although with elevated uncertainty stemming from Omicron and future China stimulus. The views are more nuanced for other assets, like the US dollar (stronger to start the year, weaker later) and oil prices (essentially flat from pre-Omicron levels). Our Four Key Views For Global Fixed Income Markets In 2022 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2022 BCA Outlook. Key View #1: Maintain below-benchmark overall global duration exposure. As we have noted in the title of our report, the investment outlook for 2022 is more complicated for investors to navigate than the relatively straightforward story from this time a year ago. Then, the development of COVID-19 vaccines led to optimism on reopening from 2020 lockdowns, but with no threat of the early removal of pandemic monetary and fiscal policy stimulus. The fixed income investment implications at the time were obvious, in the majority of developed countries - expect higher government bond yields, steeper yield curves, wider inflation breakevens and tighter corporate credit spreads. Today, the story is more complicated, but is still one that points to higher global bond yields. Take, for example, global fiscal policy. According to the IMF, the US is expected to see no fiscal drag in 2022 thanks to the Biden Administration’s spending initiatives, while Europe and EM will see significant fiscal drag (Chart 4). However, in the case of Europe, this should not be viewed negatively as it is the result of expiring pandemic era employment and income support programs that are no longer needed after economies emerged from wholesale lockdowns. So less fiscal stimulus is a sign of a healthier European economy that is more likely to put upward pressure on global bond yields, on the margin. The outlook for global consumer spending is also a bit more complicated, but still one that points to higher bond yields. Consumer confidence was declining over the final months of 2021 in the US, Europe, the UK, Canada and most other developed countries. This occurred despite falling unemployment rates and very strong labor demand, which would typically be associated with consumer optimism (Chart 5). High global inflation, which has outstripped wage gains and reduced real purchasing power, is why consumers have become gloomier in the face of healthy job markets. Chart 4Global Fiscal Policy Divergence In 2022 Global Fiscal Policy Divergence In 2022 Global Fiscal Policy Divergence In 2022 ​​​​​​ Chart 5Lower Inflation Will Help Boost Consumer Confidence Lower Inflation Will Help Boost Consumer Confidence Lower Inflation Will Help Boost Consumer Confidence ​​​​​​ The implication is that the expectation of lower inflation outlined in the 2022 BCA Outlook, which sounds bond-bullish on the surface, could actually prove to be bond-bearish if it makes consumers more confident and willing to spend. On that note, there are already signs that the some of the sources of the global inflation surge of 2021 are fading in potency. Commodity price inflation has rolled over, in line with slowing momentum in manufacturing activity and a firmer US dollar (Chart 6). Measures of global shipping costs, while still elevated, have stopped accelerating. The spread of the Omicron variant may delay a further easing of supply chain disruptions in the short-term, but on a rate of change basis, the upward pressure on global inflation from supply squeezes will diminish in 2022. The inflation story will also be more complicated next year. While there will be less inflation from the prices of commodities and durable goods, there will be more inflation from the elimination of output gaps, tightening labor markets and an overall dearth of global spare capacity. Put another way, expect the gap between global headline and core inflation rates to narrow in most countries, but with domestically generated core inflation rates remaining elevated (Chart 7). Chart 6Some Relief On Supply-Driven Inflation On The Way Some Relief On Supply-Driven Inflation On The Way Some Relief On Supply-Driven Inflation On The Way ​​​​​​ Chart 7Global Inflation Will Be Lower, But More Sustainable, In 2022 Global Inflation Will Be Lower, But More Sustainable, In 2022 Global Inflation Will Be Lower, But More Sustainable, In 2022 The more complicated investment story for 2022 extends to global bond yields themselves. Longer-maturity government bond yields remain far too low given the mix of very high inflation and very low unemployment in many countries. Chart 8Bond Markets Vulnerable To More Hawkish Repricing Bond Markets Vulnerable To More Hawkish Repricing Bond Markets Vulnerable To More Hawkish Repricing Even as major central banks like the Fed are tapering bond purchases and signaling more rate hikes in 2022, and others like the Bank of England (BoE) have actually raised rates, bond yields remain low. The reason for this is that markets are discounting very low terminal rates – the peak level of policy rates to be reached in the next monetary tightening cycle. We proxy this by looking at 5-year overnight index swap (OIS) rates, 5-years forward. A GDP-weighted aggregate of those forward OIS rates for the major developed economies (the US, Germany, the UK, Japan, Canada and Australia) is currently 0.9%. This compares to GDP-weighted 10-year government bond yield of 0.8% (Chart 8). Forward OIS rates and 10-year bond yields are typically closely linked, which suggests upward scope for longer-maturity bond yields as markets begin to discount a higher trajectory for policy rates. We see this as the primary driver of higher bond yields in 2022 – an upward adjustment of interest rate expectations as central banks like the Fed, BoE and Bank of Canada (BoC) promise, and eventually deliver, more rate hikes than markets currently expect. We therefore recommend maintaining a below-benchmark stance on overall interest rate (duration) exposure in global bond portfolios in 2022. Government bond yield curves will eventually see more flattening pressure as central banks tighten, most notably in the US, but not before longer-term yields rise to levels more consistent with the most likely peak levels of central bank policy rates. Key View #2: Underweight government bonds in countries where central banks are more likely to hike rates in 2022 (the US, the UK, Canada) versus overweights where monetary policy is more likely to remain unchanged (Germany, France, Italy, Australia, Japan). The more complicated fixed income investing story for 2022 also extends to country allocation decisions, with more opportunities to take advantage of diverging bond market performance and cross-country spread moves. Current pricing in OIS curves shows a very modest expected path for interest rates in the major developed economies (Chart 9). Some central banks, like the BoE, BoC and the Reserve Bank of New Zealand (RBNZ) are expected to be more aggressive with rate hikes in 2022 compared to the Fed. Yet there are not many rate hikes discounted beyond 2022, even in the US (Table 1). Chart 9Markets Are Pricing Short, Shallow Hiking Cycles Markets Are Pricing Short, Shallow Hiking Cycles Markets Are Pricing Short, Shallow Hiking Cycles Table 1Only Modest Tightening Expected Over The Next Three Years 2022 Key Views: The Story Gets More Complicated 2022 Key Views: The Story Gets More Complicated The US OIS curve is currently priced for an expectation that the Fed will struggle to hike the fed funds rate beyond 1.25% by the end of 2024, even with the latest set of FOMC rate forecasts calling for 75bps of rate hikes in 2022 alone. In the case of the UK, markets are pricing in lower rates in 2024 after multiple rate hikes in 2022/23, indicative of an expectation of a policy error of BoE “overtightening” even with the BoE Bank Rate expected to peak just above 1% The relative performance of government bond markets is typically correlated to changes in relative interest rate expectations. That was once again evident in 2021, where the UK, Canada and Australia significantly underperformed the Bloomberg Global Treasury aggregate in the third quarter as markets moved to rapidly price in multiple rate hikes (Chart 10). That volatility of bond market performance was particularly unusual Down Under, as the Reserve Bank of Australia (RBA) did not signal any desire to begin hiking rates in 2022, unlike the BoE and BoC. As rate expectations in those three countries stabilized in the fourth quarter, their government bonds began to outperform. On the other hand, relative government bond performance was more stable in the euro area, Japan and the US for most of 2021 (Chart 11). In the case of the US, rate hike expectations only began to move higher in September after the Fed signaled that tapering of bond purchases was imminent. Even then, markets have moved slowly to discount 2022 rate hikes. Now, the pricing in the US OIS curve is more in line with the median interest rate “dot” from the latest FOMC projections, calling for three rate hikes next year starting in June. Chart 10Rate Hike Expectations Driving Relative Bond Returns Rate Hike Expectations Driving Relative Bond Returns Rate Hike Expectations Driving Relative Bond Returns ​​​​​​ Chart 11Stay Underweight US Interest Rate Exposure Stay Underweight US Interest Rate Exposure Stay Underweight US Interest Rate Exposure ​​​​​​ Looking ahead to next year, we see the widening divergences on growth, inflation and monetary policies between countries leading to the following investible opportunities on country allocation in global bond portfolios. Underweight US Treasuries Chart 12Cyclical Upside Risk To Longer-Dated UST Yields Cyclical Upside Risk To Longer-Dated UST Yields Cyclical Upside Risk To Longer-Dated UST Yields The Fed has already begun to taper its bond buying, which is set to end by March 2022. As shown in Table 1, 79bps of rate hikes are discounted in the US by the end 2022, but only another 41bps are priced over the subsequent two years. Survey-based measures of interest rate expectations are similarly dovish, even with the US unemployment rate now at 4.2% - within the FOMC’s range of full employment (NAIRU) estimates between 3.5-4.5% - and wage inflation accelerating (Chart 12). Markets are underestimating how much the funds rate will have to rise over the next 2-3 years as the Fed belated catches up to a very tight US labor market and inflation persistently above the Fed’s 2% target. Stay below-benchmark on US interest rate risk, through both reduced duration exposure and lower portfolio allocations to Treasuries. Overweight Core Europe While interest rate markets are underestimating how much monetary tightening the Fed will deliver, the opposite is true in Europe. The EUR OIS curve is discounting 39bps of rate hikes to the end of 2024, even with cyclical growth indicators like the manufacturing PMI and ZEW expectations survey well off the 2021 highs (Chart 13). At the same time, there is little evidence to date indicating that the surge in European inflation this year, which has been narrowly concentrated in energy prices and durable goods prices, is feeding through into broader inflation pressures or faster wage growth. We recommend maintaining an overweight allocation to core European government bond markets (Germany, France), particularly versus underweights in US Treasuries. Our expectation of a wider 10-year US Treasury-German bund spread is one of our highest conviction views for 2022, playing on our theme of widening growth, inflation and monetary policy divergences (Chart 14). Chart 13Stay Overweight European Interest Rate Exposure Stay Overweight European Interest Rate Exposure Stay Overweight European Interest Rate Exposure ​​​​​​ Chart 14Expect More US-Europe Spread Widening In 2022 Expect More US-Europe Spread Widening In 2022 Expect More US-Europe Spread Widening In 2022 ​​​​​​ Overweight European Peripherals Chart 15Stay O/W European Peripheral Exposure To Begin 2022 Stay O/W European Peripheral Exposure To Begin 2022 Stay O/W European Peripheral Exposure To Begin 2022 The ECB will be allowing its Pandemic Emergency Purchase Program, or PEPP, to expire at the end of March 2022. Beyond that, the ECB has announced that the pace of buying in the existing pre-pandemic Asset Purchase Program (APP) will be upsized from €20bn per month to between €30-40bn until at least the third quarter of 2022. This represents a meaningful slowing of the pace of ECB bond purchases, which were nearly €90bn per month under PEPP. Nonetheless, unlike most other developed economy central banks that are ending pandemic-era quantitative easing (QE) programs, the ECB will still be buying bonds on a net basis and expanding its balance sheet in 2022 (Chart 15). The central bank has taken great care in signaling that no rate hikes should be expected in 2022, likely to avoid any unwanted surges in Peripheral European bond yields or the euro. A continuation of asset purchases reinforces that message, leaving us comfortable in maintaining an overweight recommendation on Italian and Spanish government bonds for 2022. Underweight the UK and Canada Chart 16Stay U/W UK & Canadian Interest Rate Exposure Stay U/W UK & Canadian Interest Rate Exposure Stay U/W UK & Canadian Interest Rate Exposure A combination of rapidly tightening labor markets and soaring inflation is almost impossible for any inflation-targeting central bank to ignore. That is certainly the case in the UK, where the unemployment rate is 4.2% with two job vacancies available for every unemployed person – a series high for that ratio (Chart 16, top panel). UK headline CPI inflation is at a 10-year high of 5.2% and the BoE expects inflation to peak around 6% in April 2022. Medium-term inflation expectations, both market based and survey based, are also elevated and well above the BoE’s 2% inflation target. The BoE surprised markets a couple of times at the end of 2021, not delivering on an expected hike in November and actually lifting rates in December in the midst of the intense UK Omicron wave. We see the latter decision as indicative of the central bank’s growing concern over high UK inflation becoming embedded in inflation expectation. The BoE will likely have to eventually raise rates to a level higher than the 2023 peak of 1.1% currently discounted in the GBP OIS curve. That justifies an underweight stance on UK interest rate exposure (both duration and country allocation) in 2022. A similar argument applies to Canada. The Canadian unemployment rate now sits at 6.0%, closing in on the February 2020 pre-COVID low of 5.7%. The BoC’s Q3/2021 Business Outlook Survey showed a net 64% of respondents reporting intensifying labor shortages (the highest level in the 20-year history of the survey). Wage growth is accelerating, headline CPI inflation is running at 4.7% and underlying inflation (trimmed mean CPI) is now at 3.4% - the latter two are well above the BoC inflation target range of 1-3%. The CAD OIS curve currently discounts 147bps of rate hikes in 2022, which is aggressively hawkish, but very little is priced beyond that in 2023 (another 19bp hike) and 2024 (a rate cut of 24bps). The BoC estimates that the neutral interest rate in Canada is between 1.75% and 2.75%. Thus, markets do not expect the BoC to lift rates to even the low end of that range over the next three years, despite a very tight labor market and an inflation overshoot. We see this as justifying a continued underweight stance on Canadian interest rate exposure (both duration and country allocation) in 2022, even with markets already discounting significant monetary tightening next year. Overweight Australia and Japan Outside of Europe, we recommend overweights on Australian and Japanese government bonds entering 2022 (Chart 17). The RBA has been quite clear in what needs to happen before it will begin to lift rates. Australian wage growth must climb into the 3-4% range that has coincided with underlying Australian inflation sustainably staying in the RBA’s 2-3% target range. Wage growth and trimmed mean CPI inflation only reached 2.2% and 2.1%, respectively, for the latest available data from Q3/2021. As Australian wage and inflation data is only released on a quarterly basis, the RBA will not be able to assess whether wage dynamics are consistent with reaching its inflation target until the latter half of 2022. The AUD OIS curve is currently discounting 119bps of rate hikes in 2022 and an additional 86bps of hikes in 2023. Those are both far too aggressive for a central bank that is unlikely to begin lifting rates until the end of 2022, at the very earliest. Thus, we recommend an overweight stance on Australian bond exposure in global bond portfolios in 2022. The case for overweighting Japanese government bonds is a simple one. There are none of the inflation or labor market pressures seen in other countries to justify a hawkish turn by the Bank of Japan (bottom panel). Japanese core CPI is shockingly in deflation (-0.7%), bucking the trend seen in other countries and showing no pass-through from rising energy prices of global supply chain disruptions. This makes Japan a good defensive “safe haven” bond market against the backdrop of rising global bond yields that we expect in 2022. Chart 17Stay O/W Australian & Japanese Interest Rate Exposure Stay O/W Australian & Japanese Interest Rate Exposure Stay O/W Australian & Japanese Interest Rate Exposure ​​​​​​ Chart 18Our Recommended DM Government Bond Country Allocations Our Recommended DM Government Bond Country Allocations Our Recommended DM Government Bond Country Allocations ​​​​​​ In summary, our government allocations reflect the growing gap between expected monetary policy changes in 2022. This gives us a bias to favor lower-yielding markets, with Australia being the notable exception (Chart 18). However, in an environment where global bond volatility is expected to increase as multiple central banks exit QE and begin rate hiking cycles, carry/yield considerations play a secondary role in determining optimal country allocations. Key View #3: Stay neutral global inflation-linked bonds versus nominal government debt Another part of the global fixed income universe where the investment story has become more complicated is inflation-linked bonds. Overweighting inflation-linked bonds versus nominal government debt was the right strategy for bond investors as economies reopened from 2020 COVID lockdowns and global growth recovered. Booming commodity prices and supply chain squeezes added to the positive backdrop for linkers in 2021, as realized inflation soared to levels not seen in over a generation in many countries. Yet now, there is much less upside potential for inflation breakevens from current levels. Our Comprehensive Breakeven Indicators (CBI) are one of our preferred tools to assess the attractiveness of inflation-linked bonds versus nominals within the developed markets. For each country, the CBI reflects the distance of 10-year inflation breakevens from three different measures – the fair value from our breakeven spread model, medium-term survey-based inflation expectations and the central bank inflation target. The further breakevens are from these three measures, the less scope there is for additional increases in breakevens. As can be seen in Chart 19, there is limited upside potential for breakevens in almost all countries. Only Canada has a CBI below zero, with the CBIs for the UK, US, Germany and Italy well above zero. Chart 19 With central banks belated starting to respond to high realized inflation with tapering and rate hikes, it is still too soon to move to a full-blown underweight stance on global inflation-linked bond exposure versus nominal government debt. Instead, we recommend no more than a neutral exposure in countries where our CBIs are relatively lower – Canada, Australia, Japan – and underweight allocations where the CBIs are relatively higher – the UK, Germany, Italy and France (Chart 20). One country where we are deviating from our CBI signal is the US. We are keeping the recommended US TIPS exposure at neutral to begin 2022, but we anticipate downgrading TIPS later in 2022 if the Fed begins to lift rates sooner and more aggressively than expected. We do recommend positioning within that neutral overall TIPS allocation by underweighting shorter maturities versus longer-dated TIPS, A more hawkish Fed and some likely deceleration of realized US inflation should result in a steeper TIPS breakeven curve and a flatter TIPS real yield curve. Beyond looking at inflation breakevens, the outlook for real bond yields may be THE most complicated part of the 2022 investment story. Perhaps no single topic generates a greater debate among BCA’s strategists than real bond yields, which remain negative across the developed world (Chart 21). Determining why real yields are negative is critical for making calls across other asset classes beyond just government bonds. Valuations for equities and corporate credit have become more closely correlated with real yields in recent years. Real yield differentials are also an important factor driving currency levels. Chart 20Our Recommended Inflation-Linked Bond Allocations Our Recommended Inflation-Linked Bond Allocations Our Recommended Inflation-Linked Bond Allocations We see negative real yields as a reflection of persistent central bank policy dovishness that looks increasingly unrealistic. Chart 22 should look familiar to regular readers of Global Fixed Income Strategy. We show real central bank policy rates (adjusted for realized inflation) and the market-implied expectations for those real rates derived from the forward curves for OIS rates and CPI swap rates. Chart 21Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability Negative Real Yields: Global Bonds' Biggest Vulnerability ​​​​​​ Chart 22 In the US, UK and Europe, markets are pricing a future path for nominal short-term interest rates that is consistently lower than the expected path of inflation. If markets believe that central banks will be unwilling (or unable) to ever lift policy rates above inflation, or that neutral medium-term real interest rates are in fact negative in most developed countries, then it should come as no surprise that longer-maturity real bond yields should also be negative. We do not subscribe to the view that neutral real rates are negative across the developed world, especially in the US. Even if we did, however, such a view is already reflected in the future pricing of bond yields and interest rates. As outlined earlier, OIS curves in many countries are underestimating how high nominal policy rates will go in the next 2-3 years. The potential for a “real rate shock”, where central banks tighten policy at a faster pace than markets expect, is a significant risk for global financial markets in the coming years. We see this as more of a risk for markets in 2023, with the Fed likely to become more aggressive on rate hikes and even the ECB likely to begin considering an interest rate adjustment. For 2022, however, we do expect global real yields to stabilize and likely begin to turn less negative as central banks continue to tighten policy. Key View #4: Overweight euro area high-yield and investment grade corporates versus US equivalents. Limit exposure to EM hard-currency debt until there are clear signals of China policy stimulus and upside momentum on the US dollar fades. The outlook for global credit markets in 2022 has also become more complicated, particularly for corporate bonds and EM hard currency debt. On the one hand, the levels of index yields (Chart 23) and spreads (Chart 24) for investment grade and high-yield corporate debt in the US, euro area and UK have clearly bottomed. The Omicron threat to global growth may be playing a role in the recent increases, but the more likely culprit is growing central bank hawkishness and fears of tighter monetary policy. Chart 23Global Corporate Bond Yields Have Reached A Cyclical Bottom Global Corporate Bond Yields Have Reached A Cyclical Bottom Global Corporate Bond Yields Have Reached A Cyclical Bottom ​​​​​​ Chart 24Global Corporate Bond Spreads Have Reached A Cyclical Bottom Global Corporate Bond Spreads Have Reached A Cyclical Bottom Global Corporate Bond Spreads Have Reached A Cyclical Bottom ​​​​​​ On the other hand, the fundamental backdrop for corporate debt is not conducive to major spread widening. As outlined at the start of this report, nominal economic growth in the major developed economies remains solid, which supports the expansion corporate revenues. Combined with still-low borrowing rates, this creates a relatively positive backdrop that limits risks from downgrades and defaults. Chart 25Monetary Policy Backdrop Turning More Negative For Credit Markets Monetary Policy Backdrop Turning More Negative For Credit Markets Monetary Policy Backdrop Turning More Negative For Credit Markets Corporate bond performance, both absolute returns and excess returns versus government debt, has worsened on a year-over-year basis for the latter half of 2021 (Chart 25). That has coincided with slowing growth in the balance sheets of the Fed and other major central banks and, more recently, the flattening trend of government bond yield curves as markets have discounted 2022 rate hikes. This suggests that monetary policy tightening expectations are dominating the still relatively positive fundamental backdrop for corporate credit. Looking ahead to 2022, we see a greater need to focus on relative value and cross-country valuation considerations when allocating to developed market corporate debt – particularly when looking the biggest markets in the US and euro area. We see a strong case for favoring euro area corporates over US equivalents, both for investment grade and particularly for high-yield. Our preferred method of corporate bond valuation is looking at 12-month breakevens. Breakevens measure the amount of spread widening that would need to occur over a one year horizon to eliminate the yield advantage of owning corporate bonds over government bonds of similar duration. We calculate this as the ratio of the index spread to the index duration for a particular credit market, like US investment grade. We then take a percentile ranking of those 12-month breakevens to determine the attractiveness of spreads versus its own history. On that basis, the 12-month breakeven for US investment grade corporates looks very unattractive, sitting near the bottom of the historical distribution (Chart 26). This reflects not only tight spreads but also the high durations of investment grade credit. US high-yield corporate spreads are not as stretched, but are also not particularly cheap, with the 12-month breakeven sitting at the 34th percentile of its distribution. In the euro area, the 12-month breakeven for investment grade is not as stretched as in the US, sitting in the 36th percentile (Chart 27). The euro area high-yield 12-month breakeven looks similar to the US, at the 24th percentile of its historical distribution. Chart 26US Corporate Spread Valuations Are Not Compelling US Corporate Spread Valuations Are Not Compelling US Corporate Spread Valuations Are Not Compelling ​​​​​​ Chart 27Euro Area Corporate Spread Valuations Are Also Stretched Euro Area Corporate Spread Valuations Are Also Stretched Euro Area Corporate Spread Valuations Are Also Stretched ​​​​​​ Our current recommended strategy on US corporate exposure is to be neutral investment grade and overweight high-yield. We see no reason to change that view to begin 2022. However, we do anticipate downgrading US corporate exposure later in the year when the Fed begins to lift interest rates and the US Treasury curve flattens more aggressively. Earlier, we recommended positioning for a wider US Treasury-German bund spread as a way to play for the growing policy divergence between a more hawkish Fed and a still dovish ECB. Another way to do that is to overweight euro area corporate debt versus US equivalents, for both investment grade and especially for high-yield. In terms of potential default losses, the outlook is positive on both sides of the Atlantic. Moody’s is projecting a 2022 default rate of 2.3% in the US and 2.2% in the euro area (Chart 28). The last two times that the default rates were so similar, in 2014/15 and 2017/18, also coincided with a period of euro area high-yield outperforming US high-yield (on a duration-matched and currency-matched performance). We see that pattern repeating in 2022. Chart 28Favor Euro Area High-Yield Over US Equivalents In 2022 Favor Euro Area High-Yield Over US Equivalents In 2022 Favor Euro Area High-Yield Over US Equivalents In 2022 ​​​​​​ Chart 29 When looking within credit tiers, we see the best value in favoring Ba-rated euro area high-yield versus US equivalents when looking at 12-month breakeven percentile rankings (Chart 29). Yet even looking at just yields rather than spread, lower-rated euro area high-yield corporates offer more attractive yields than US equivalents, on a currency-hedged basis (Chart 30). Chart 30 Chart 31Stay Cautious On EM Hard Currency Debt Stay Cautious On EM Hard Currency Debt Stay Cautious On EM Hard Currency Debt Turning to EM hard currency debt, we recommend a cautious stance entering 2022. EM fundamentals that typically need to in place to produce tighter EM credit spreads are currently not in place. Chinese economic growth is slowing, commodity price momentum is fading and the US dollar is appreciating versus EM currencies (Chart 31). An improvement in non-US economic growth will help turn around all three trends, especially the strengthening US dollar which typically trades off US/non-US growth differentials. The key to any non-US growth acceleration in 2022 will come from China. When Chinese policymakers announce more aggressive stimulus measures in 2022, as we expect, that would represent an opportunity to turn more positive on EM USD-denominated debt. Until that happens, we recommend staying underweight EM hard currency debt, with a slight bias to favor sovereigns over corporates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights The last two years have taught us to live with Covid-19. This means global growth will remain strong in 2022. That is not reflected in a strong dollar. The RMB will be a key arbiter between a bullish and bearish dollar view. This is because a weak RMB will be deflationary for many commodity currencies, especially if it reflects weak Chinese demand. Inflation in the US will remain stronger than in other countries. The key question is what the Federal Reserve does next year. In our view, they will stay patient which will keep real interest rates in the US very low. Upside in the DXY is nearing exhaustion according to most of our technical indicators. We upgraded our near-term target to 98. Over a longer horizon, we believe the DXY will break below 90, towards 85 in the next 12-18 months. A key theme for 2022 will be central bank convergence. Either inflation proves sticky and dovish central banks turn a tad more hawkish, or inflation subsides and aggressive rate hikes priced in some G10 OIS curves are revised a tad lower. The path for bond yields will naturally be critical. Lower bond yields will initially favor defensive currencies such as the DXY, CHF and JPY. This is appropriate positioning in the near-term. Further out in 2022, as bond yields rise, the Scandinavian currencies will be winners. Portfolio flows into US equities have been a key driver of the dollar rally. This has been because of the outperformance of technology. Should this change, equity flows could switch from friend to foe for the dollar. A green technology revolution is underway and this will benefit the currencies of countries that will supply these raw materials. The AUD could be a star in 2022 and beyond. The rise in cryptocurrencies will continue to face a natural gravitational pull from policy makers.    Gold and silver will rise in 2022, but silver will outperform gold. Feature 2022 has spooky echoes of 2020. In December 2019, we were optimistic about the global growth outlook, positive on risk assets, and bearish the US dollar. That view was torpedoed in March 2020, when it became widely apparent that COVID-19 was a truly global epidemic. More specifically, the dollar DXY index (a proxy for safe-haven demand) rose to a high of 103. US Treasury yields fell to a low of 0.5%. Chart 1Covid-19 And The Dollar Covid-19 And The Dollar Covid-19 And The Dollar Today, the DXY index is sitting at 96, exactly the midpoint of the March 2020 highs and the January 2021 lows. Once again, the dollar is discounting that the new Omicron strain will be malignant – worse than the Delta variant, but not as catastrophic as the original outbreak (Chart 1). Going into 2022, we are cautiously optimistic. First, we have two years of data on the virus and are learning to live with it. This suggests the panic of March 2020 will not be repeated. Second, policymakers are likely to stay very accommodative in the face of another exogenous shock. This will especially be the case for the Fed. Our near-term target for the DXY index is 98, given that the macro landscape remains fraught with risks. This is a speculative level based on exhaustion from our technical indicators (the dollar is overbought) and valuation models (the dollar is expensive). Beyond this level, if our scenario analysis plays out as expected, we believe the DXY index will break below 90 in 2022. Omicron And The Global Growth Picture Chart 2Global Growth And The Dollar Global Growth And The Dollar Global Growth And The Dollar Our golden rule for trading the dollar is simple – sell the dollar if global growth will remain robust, and US growth will underperform its G10 counterparts. Historically, this rule has worked like clockwork. Using Bloomberg consensus growth estimates for 2022, US growth is slated to stay strong, but give way to other economies (Chart 2).  News on the Omicron variant continues to be fluid. As we go to press, Pfizer suggests a third booster dose of its vaccine results in a 25-fold increase in the antibodies that attack the virus. Additionally, a new vaccine to combat the Omicron variant will be available by March. If this proves accurate, it suggests the world population essentially has protection against this new strain. The good news is that vaccinations are ramping up around the world, especially in emerging markets. Countries like the US and the UK were the first countries to see a majority of their population vaccinated. Now many developed and emerging market countries have a higher share of their population vaccinated compared to the US (Chart 3). Chart 3ARising Vaccinations Outside The US Rising Vaccinations Outside The US Rising Vaccinations Outside The US Chart 3BRising Vaccinations Outside The US Rising Vaccinations Outside The US Rising Vaccinations Outside The US This has resulted in a subtle shift – growth estimates for 2022 are increasingly favoring other countries relative to the US (Chart 4). Let us consider the case of Japan - just in June this year, ahead of the Olympics, only 25% of the population was vaccinated. Today, Japan has vaccinated 77% of its population and new daily infections are near record lows. While Omicron is a viable risk, the starting point for Japan is very encouraging and should open a window for a recovery in pent-up demand and a pickup in animal spirits. Chart 4ARising Growth Momentum Outside The US Rising Growth Momentum Outside The US Rising Growth Momentum Outside The US Chart I-4 This template could very much apply to other countries as well. This view is not embedded in the dollar, which continues to price in an outperformance of US growth (Chart 5). The Risks From A China Slowdown China sits at the epicenter of a bullish and bearish dollar view. If Chinese growth is bottoming, then the historical relationship between the credit impulse and pro-cyclical currencies will hold (Chart 6). This will benefit the EUR, the AUD, the CAD and even the SEK which that track the Chinese credit impulse in real time. As an expression of this view, we went long the AUD at 70 cents. Chart 5Economic Surprises Outside The US Economic Surprises Outside The Us Economic Surprises Outside The Us Chart 6Chinese Credit Demand And Currencies Chinese Credit Demand And Currencies Chinese Credit Demand And Currencies Just as global policy makers are calibrating the risk from the Omicron variant, the Chinese authorities are also acknowledging the risk of an avalanche from a property slowdown. They have already eased monetary policy on this basis. Specific to the dollar, a key arbiter of a bullish or bearish view will be the Chinese RMB. So far, markets have judiciously separated the risk, judging that the Chinese authorities can surgically diffuse the real estate market, without broad-based repercussions in other parts of the economy (such as the export sector). Equities and corporate credit prices have collapsed in specific segments of the Chinese market but the RMB remains strong (Chart 7). Correspondingly, inflows into China remain very robust, a testament to the fact that Chinese growth (while slowing) remains well above that of many other countries (Chart 8). Chart 7The RMB Has Diverged From The Carnage In China The RMB Has Diverged From The Carnage In China The RMB Has Diverged From The Carnage In China Chart 8Strong Portfolio Inflows Into China Strong Portfolio Inflows Into China Strong Portfolio Inflows Into China China contributed 20% to global GDP in 2021 and will likely contribute a bigger share in 2022, according to the IMF (Chart 9). This suggests that foreign direct investment in China will remain strong . This will occur at a time when the authorities could have diffused the risk from a property market slowdown. Chart I-9 The commodity-side of the equation will also be important to monitor, especially as it correlates strongly with developed-market commodity currencies. It is remarkable that despite the slowdown in Chinese real estate, commodity prices remain resilient (Chart 10). This has been due to adjustment on the supply side, as our colleagues in the Commodity & Energy Strategy team have been writing. Finally, China offers one of the best real rates in major economies. It also runs a current account surplus. This suggests there is natural demand and support for the RMB (Chart 11). A strong RMB limits how low developed-market commodity currencies can fall. Chart 10Commodity Prices Remain Well Bid Commodity Prices Remain Well Bid Commodity Prices Remain Well Bid Chart 11Real Interest Rates Favor The RMB Real Interest Rates Favour The RMB Real Interest Rates Favour The RMB Inflation And The Policy Response Output gaps are closing around the world as fiscal stimulus has helped plug the gap in aggregate demand. This suggests that while inflation has been boosted by idiosyncratic factors (supply bottlenecks) that could soon be resolved, rising aggregate demand will start to pose a serious problem to the inflation mandate of many central banks. Chart 12A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally As we wrote a few weeks ago, there have been consistencies and contradictions with the market response to higher inflation. The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year. Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent) (Chart 12). The reality is that outside the ECB and the BoJ, other central banks have actually been more proactive compared to the Federal Reserve. The Bank Of Canada has ended QE and will likely raise interest rates early next year, the Reserve Bank of New Zealand has ended QE and raised rates twice, and the Reserve Bank of Australia has already been tapering asset purchases. The Bank of England will also be ahead of the Fed in raising interest rates, according to our Global Fixed Income Strategy colleagues. This suggests that the pricing of a policy divergence between the Fed and other G10 central banks could be a miscalculation and a potential source of weakness for the dollar. Chart 13The US Is Generating Genuine Inflation The US Is Generating Genuine Inflation The US Is Generating Genuine Inflation Rising inflation is a global phenomenon and not specific to the US (Chart 13). So either inflation subsides and the Fed turns a tad more accommodative, or inflation proves sticky and other central banks turn a tad more hawkish to defend their policy mandates. We have two key short-term trades penned on this view – long EUR/GBP and long AUD/NZD. While the European Central Bank will lag the Bank of England (and the Fed) in raising interest rates, expectations for the path of policy are too hawkish in the UK, with 4 rate hikes priced in by the end of 2022. Similarly, hawkish expectations for the Reserve Bank of New Zealand are likely to be revised lower, relative to the Reserve Bank of Australia. As for the US, the Fed is likely to hike interest rates next year but real rates will remain very low relative to history (Chart 14A and 14B). Low real rates will curb the appeal of US Treasuries. Chart 14AReal Interest Rates In The US Are Very Negative Real Interest Rates In The US Are Very Negative Real Interest Rates In The US Are Very Negative Chart I-14 The Dollar And The Equity Market Chart 15The US Stock Market And The Dollar The US Stock Market And The Dollar The US Stock Market And The Dollar One of the biggest drivers of a strong dollar this year (aside from rising interest rate expectations), has been equity inflows. The greenback tends to do well when US bourses are outperforming their overseas peers (Chart 15). It is also the case that value tends to underperform growth in an environment where the dollar is rising. We discussed this topic in depth in our special report last summer. Flows tend to gravitate to capital markets with the highest expected returns. So if investors expect the pandemic winners (technology and healthcare) to keep driving the market in an Omicron setting, the US bourses that are overweight these sectors will do well. We will err on the other side of this trade for 2022. Part of that is based on our analysis of the global growth picture in the first section of this report. If growth rotates from the US to other economies, their bourses should do well as profits in these economies recover. Earnings revisions in the US have been sharply revised lower compared to other countries (Chart 16). This has usually led to a lower dollar eventually. In the case of the euro area, there has been a strong and consistent relationship between relative earnings revisions vis-à-vis the US, and the performance of the euro (Chart 17). Chart 16Earnings Revisions Are Moving Against US Companies Earnings Revisions Are Moving Against US Companies Earnings Revisions Are Moving Against US Companies Chart 17Earnings Revisions Are Moving In Favor Of Euro Area Companies Earnings Revisions Are Moving In Favor Of Euro Area Companies Earnings Revisions Are Moving In Favor Of Euro Area Companies In a nutshell, should profits in cyclical sectors recover on the back of rising bond yields, strong commodity prices and a tentative bottoming in the Chinese economy, value sectors that are heavily concentrated in countries with more cyclical currencies such as Australia, Norway, Sweden, and Canada, will benefit. Ditto for their currencies. The Outlook For Petrocurrencies Chart I-18 When the pandemic first hit in 2020, oil prices (specifically the Western Texas Intermediate blend) went negative. This drop pushed the Canadian dollar towards 68 cents and USD/NOK punched above 12. This time around, the drop in oil prices (20% from the peak for the Brent blend) has been more muted. We think this sanguine market reaction is more appropiate in our view for two key reasons. First, as our colleagues in the Commodity & Energy Stategy team have highlighted, investment in the resource sector, specifically oil and gas, has been anemic in recent years. In Canada, investment in the oil and gas sector has dropped 68% since 2014 at the same time as energy companies are becoming more and more compliant vis-à-vis climate change (Chart 18). Second, if we are right, and Omicron proves to be a red herring, then transportation demand (the biggest source of oil demand) will keep recovering. In terms of currencies, our preference is to be long a petrocurrency basket relative to oil consumers. As the US is the biggest oil producer in the world (Chart 19), being long petrocurriences versus the dollar has diverged from its historical positive relationship with oil prices. Chart 20 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with oil prices and has outperformed a traditional petrocurrency basket. Chart 19The US Is Now A Major Oil Producer The US Is Now A Major Oil Producer The US Is Now A Major Oil Producer Chart 20Hold A Basket Of Oil Consumers Versus Producers Hold A Basket Of Oil Consumers Versus Producers Hold A Basket Of Oil Consumers Versus Producers Technical And Valuation Indicators The dollar tends to be a momentum-driven currency. Past strength begets further strength. We modelled this when we published our FX Trading Model, which showed that a momentum strategy outperformed over time (Chart 21).  The problem with momentum is that it works until it does not. Net speculative long positions in the dollar are approaching levels that have historically signaled exhaustion (Chart 22). There is a dearth of dollar bears in today’s environment. That is positive from a contrarian standpoint. Meanwhile, our capitulation index (a measure of how overbought or oversold the dollar is) is approaching peak levels. Chart 21The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency Chart 22Long Dollar Is A Consensus Trade Long Dollar Is A Consensus Trade Long Dollar Is A Consensus Trade Valuation is another headwind for the dollar. According to all of our in-house models, the dollar is expensive. That is the case according to both our in-house curated PPP model (Chart 23) and a simple one based on headline consumer prices (Chart 24). Chart I-23 Chart 24The Dollar is Expensive The Dollar is Expensive The Dollar is Expensive     In a broader sense, we have built an attractiveness ranking for currencies (Chart 25). This ranks G10 currencies on a swathe of measures, including their basic balances, our internal valuation models, sentiment measures, economic divergences, and external vulnerability. The ranking is in order of preference, with a lower score suggesting the currency is sitting in the top/most attractive quartile of the measures. The Norwegian krone and Swedish krona are especially attractive as 2022 plays. Chart I-25 More specifically, the Scandinavian currencies have been one of the hardest hit this year. The Norwegian krone will benefit from the reopening of economies, particularly through the rising terms-of-trade. The Swedish krona will benefit from a pickup in the industrial sector, and continued strength in global trade. The least attractive G10 currencies are the New Zealand dollar and the greenback. This is mostly due to valuation. As we have highlighted in previous reports, valuation is a poor timing tool in the short term but over a longer-term horizon, currencies tend to revert towards fair value. Where Next For EUR/USD? Our bias is that the euro has bottomed. The ECB will lag the Fed in raising interest rates, but the spread between German bund yields and US Treasuries does not justify the current level of the euro. More importantly, if European growth recovers next year, this will sustain portfolio flows into the eurozone, which are cratering (Chart 26). Our 2022 target for EUR/USD is 1.25, a level that will unwind 10.6% of the undervaluation versus the dollar. Beyond valuation,s a few key factors support the euro: As a pioneer in green energy and a pro-cyclical currency, the euro will benefit from portfolio flows into renewable energy companies, as well as foreign direct investment. A close proxy for these flows are copper prices, that have positively diverged from the performance of the euro (Chart 27). Chart 26The Euro And Portfolio Flows The Euro And Portfolio Flows The Euro And Portfolio Flows Chart 27EUR/USD And Copper EUR/USD And Copper EUR/USD And Copper ​​​​​ Inflation in the euro area is lagging the US, but is undeniably strong. As such, while the ECB will lag the Fed in tightening monetary policy, the divergence in monetary policy will not widen. Earnings revisions are moving in favor of European companies, as we have shown earlier. Historically, this has put a floor under the euro. Safe-Haven Demand: Long JPY Safe-haven currencies will perform well in the near term. We are long the yen, which is the cheapest currency according to our models and also one of the most shorted. CHF will also do well in the near term, though as we have argued, will induce more intervention from the Swiss National Bank. Chart I-28 We are long both the yen and CHF/NZD as short-term trades, but our preference is for the yen. First, Japan has one of the highest real rates in the developed world. So, outflows from JGBs are going to be curtailed. Second, the DXY and USD/JPY have a strong positive correlation, and this places the yen in a very enviable position as the dollar weakens in 2022 (Chart 28). A Final Word On Gold, Silver, And Precious Metals Chart 29Hold Some Gold Hold Some Gold Hold Some Gold Along with our commodity strategists, we remain bullish precious metals. In our view, inflation could prove stickier than most investors expect. This will depress real rates and support precious metals. Within the precious metals sphere, we particularly like silver and platinum.  Almost every major economy now has negative real interest rates. Gold (and silver) have a long-standing relationship with negative interest rates (Chart 29). Central banks are also becoming net purchasers of gold, which is bullish for demand. The true precious metals winner in 2022 could be silver. The Gold/Silver ratio (GSR) tends to track the US dollar quite closely, so a bearish view on the dollar can be expressed by being short the GSR (Chart 30). Second, gold is very expensive compared to silver (Chart 31). In general, when gold tends to make new highs (as it did in 2020), silver tends to follow suit. This means silver prices could double from current levels over the next few years, to reclaim their 2011 highs. Finally, the bullish case for platinum is the same as for silver. It has lagged both gold and palladium prices. Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters. Chart 30Hold Some Silver Hold Some Silver Hold Some Silver Chart 31Stay Short The GSR Stay Short The GSR Stay Short The GSR Concluding Thoughts Our currency positions, as we enter 2022, are biased towards a lower dollar, but we also acknowledge that there are key risks to the view. Our recommendations are as follows: The DXY will could touch 98 in the near term, but will break below 90 over the next 12-18 months. An attractiveness ranking reveals the most appealing currencies are JPY, SEK, and NOK, while the least attractive are USD and NZD. Chart 32Hold Some AUD Hold Some AUD Hold Some AUD Policy convergence will be a key theme at the onset of 2022. Stay long EUR/GBP and AUD/NZD as a play on this theme. Look to buy a basket of oil producers versus consumers once volatility subsides. We went long the AUD at 70 cents. Terms of trade are likely to remain a tailwind for the Australian dollar (Chart 32). The AUD will benefit specifically in a green revolution.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com​​​​​​​ Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary