Gov Sovereigns/Treasurys

Highlights Below-Benchmark Portfolio Duration: Bond investors should keep portfolio duration low in 2022. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Own Treasury Curve Steepeners: The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Sell Short-Maturity TIPS: Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. We also recommend an outright short position in 2-year TIPS, as short-maturity real yields have a lot of upside in 2022. Overweight Corporate Bonds Versus Treasuries … For Now: We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. Overweight Emerging Market Bonds Versus US Corporates: EM bonds offer an attractive spread advantage versus US corporates, and a weakening US dollar will help boost returns in 2022. A Maximum Overweight Allocation To Municipal Bonds: Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. Underweight Agency MBS: Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. Feature BCA published its 2022 Outlook on December 1st. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer seven key US fixed income views for 2022. This report is limited to the seven key investment views, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2022” report that will delve into our outlook for the Fed next year. Outlook Summary First, a summary of the main economic views presented in BCA’s 2022 Outlook.1   On Economic Growth: The COVID-19 pandemic will recede in importance in 2022 allowing US economic growth to remain above trend. Sizeable household savings and wealth will support consumer spending, the composition of which will shift away from goods and towards services. Corporate capital expenditures also look set to surge. On Inflation: A transition in consumer spending from goods to services and an increase in labor supply will cause US inflation to fall in 2022, though it will remain above the Fed’s target. On Fed Policy: The first Fed rate hike will occur between June and December 2022, depending on the paths of inflation and inflation expectations during the next few months. Fed tightening will continue into 2023. On China and Emerging Markets: Further policy easing in H1 2022 will lead to a reacceleration in Chinese economic activity in the back half of the year. The BCA house view is negative on EM equities for now but will turn more bullish when clearer signs of Chinese policy easing emerge. Risks To The Outlook: The greatest risk to the outlook is that the spread of the Omicron variant leads to the re-imposition of public health measures that will weigh on economic activity. The effect of the Omicron variant remains uncertain, but increasingly widespread vaccination and the advent of anti-viral treatments should help mitigate any negative economic impacts. Key View #1: Below-Benchmark Portfolio Duration Bond investors should keep portfolio duration low in 2022, favoring the 2-year maturity over the 10-year. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Our recommendation to keep portfolio duration low in 2022 stems directly from our assessment of Federal Reserve policy. Without going into too much detail – we will do that in next week’s “Fed In 2022” report – the Fed appears to have adopted a more hawkish reaction function during the past month. The Fed’s official forward guidance says that it will not lift rates until the labor market reaches “maximum employment”. However, Fed Chair Jay Powell weakened that commitment in recent Senate testimony. Powell said that persistently high inflation threatens the economic recovery and implied that to reach its maximum employment goal the Fed may need to act pre-emptively to tame inflation. To us, this means that the Fed’s “maximum employment” condition for lifting rates is no longer binding. The Fed will accelerate the pace of tapering when it meets this week and will start lifting rates between June and December of next year, depending on the interim trends in inflation and inflation expectations. After liftoff, Fed rate hikes will proceed at a predictable pace of 75-100 bps per year until economic growth slows significantly. We expect the fed funds rate to reach at least 2% before that occurs, consistent with survey estimates of the long-run neutral fed funds rate. Let’s compare our estimate of the future fed funds rate path with what is currently priced in the bond market (Chart 1). Chart 1The Market's Rate Expectations The Market's Rate Expectations The Market's Rate Expectations Liftoff The overnight index swap (OIS) curve is priced for Fed liftoff in May 2022. This is a tad early compared to our projections, but not by much. Pace After liftoff, the OIS curve is priced for the fed funds rate to rise 79 bps during the subsequent 12 months. Again, this is roughly consistent with our own expectations that the Fed will deliver three or four 25 basis point rate hikes per year. Terminal Rate It is the market’s pricing of the endpoint of the next tightening cycle – the terminal fed funds rate – that disagrees significantly with our forecast. The OIS curve is priced for the funds rate to reach 1.5% in 2024 and then stabilize. This is too low. It is too low compared to the last tightening cycle when the fed funds rate reached 2.45% in 2019. It is also too low compared to survey estimates from market participants and primary dealers. The median respondent to the New York Fed’s Survey of Market Participants estimates that the long-run neutral fed funds rate is 2%. The median response to the same question from the Survey of Primary Dealers is 2.25% and the median FOMC participant pegs the long-run neutral rate at 2.5%. Meanwhile, the 5-year/5-year forward Treasury yield – a rough proxy for the long-run neutral interest rate that’s priced in the Treasury market – sits at only 1.73%. Historically, the 5-year/5-year forward yield converges with survey estimates of the long-run neutral rate as the Fed moves toward tightening (Chart 2). This means the 5-year/5-year forward Treasury yield has at least 27-52 bps of upside in 2022. Chart 25y5y Has Room To Rise 5y5y Has Room To Rise 5y5y Has Room To Rise Treasury Yield Forecasts Chart 3Treasury Yield Forecasts Treasury Yield Forecasts Treasury Yield Forecasts Chart 3 shows the 2-year, 5-year and 10-year Treasury yields along with the expected paths that are discounted in the forward curve for the next 12 months. The shaded regions in each panel represent our fair value estimates of where those yields will trade if the market moves to price-in our expected future path for the fed funds rate. The upper bound of the fair value range represents the most hawkish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in June, that rate hikes proceed at a pace of 100 bps per year and that the fed funds rate levels-off at a terminal rate of 2.08% (8 bps above the lower-end of a 2%-2.25% target range). The lower bound of the fair value range represents the most dovish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in December 2022, that rate hikes proceed at a pace of 75 bps per year and that the fed funds rate levels-of at a terminal rate of 2.08%. Chart 3 shows that the 10-year Treasury yield is well below even the lower-end of our fair value range. The 5-year Treasury yield is a bit too low compared to our target range and the 2-year yield is consistent with our fair value range, though at the very upper-end. The investment conclusions are obvious. Bond investors should keep portfolio duration low in 2022. They should avoid the 10-year maturity and allocate most funds to shorter maturities like the 2-year. It should be noted that we used a conservative 2.08% terminal rate estimate in the scenarios presented in Chart 3. This is at the low-end of most survey estimates. What’s more, the BCA Outlook makes a strong case that those survey estimates will be revised higher once it becomes apparent that interest rates will have to rise to well above 2% to contain inflation. We agree that survey estimates of the long-run fed funds rate are probably too low, but we don’t expect them to be revised higher in 2022. Upward terminal rate revisions are probably a story for 2023 or 2024, sometime after the Fed has delivered a few rate hikes and it becomes apparent that more will be needed to slow an overheating economy. Appendix A at the end of this report translates different fed funds rate scenarios into 12-month expected returns for every Treasury maturity. We show scenarios where the liftoff date varies between June 2022 and December 2022, where the pace of rate hikes varies between 75 bps and 100 bps per year and where the terminal fed funds rate varies between 2.08% and 2.58%. The 10-year Treasury note is projected to deliver negative returns in every scenario we tested. Meanwhile, the 2-year Treasury note is projected to deliver a small positive return in every single scenario. These results support our conclusion from Chart 3. Investors should maintain below-benchmark portfolio duration and favor short maturities over long maturities. Risks To The View The first risk to our bearish view on US Treasuries is a resurgence of the pandemic. The 10-year Treasury yield continues to track the “pandemic trade” in the stock market. That is, the 10-year yield rises when a basket of equities that benefit from economic re-opening outperforms a basket of equities that benefit from lockdowns, and vice-versa (Chart 4). So far, the news about the virulence of the Omicron COVID variant has been encouraging, and our base case scenario assumes a further easing of pandemic concerns over the course of 2022. The second risk to our view is that the Fed moves too aggressively toward rate hikes causing an abrupt tightening of financial conditions that weighs on economic growth and sends long-dated bond yields lower. The shaded region in Chart 5 shows that this exact dynamic played out in 2018. Fed rate hikes started to pressure the dollar higher and weigh on equities. This led to tighter financial conditions and slower economic growth. The impact of tighter financial conditions was not immediately evident in the bond market, but slower growth eventually caused the Fed to back away from rate hikes leading to a late-2018 peak in the 10-year yield. Chart 410yr Tracks The "Pandemic Trade" 10yr Tracks The "Pandemic Trade" 10yr Tracks The "Pandemic Trade" Chart 5Watch Financial Conditions In 2022 Watch Financial Conditions In 2022 Watch Financial Conditions In 2022 Compared to the 2018 scenario, we see less risk of Fed over-tightening in 2022 mainly because the fed funds rate is starting out at a much lower level. However, it will be important to track financial conditions as the Fed moves toward liftoff. Undue tightening would cause us to reverse our positioning. Key View #2: Own Treasury Curve Steepeners The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. We also recommend buying the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond as an attractive duration-neutral carry trade. The scenarios presented in the prior section show that the 2-year Treasury yield is priced within the bounds of our estimated fair value range while the 10-year Treasury yield looks too low. Logically, it makes sense to position for a steepening of the 2/10 Treasury curve to profit from this divergence. Chart 6 illustrates the implications of the prior section’s fair value estimates for different Treasury slopes. Our fair value range projects that the 2/10 Treasury slope will be between 38 bps and 89 bps in 12 months, above the 37 bps that is currently priced into the forward curve. The forward curve is also priced for too much flattening in the 2/5 Treasury slope, while the 5/10 slope is consistent with the lower end of our fair value range.   The conclusion is that investors should implement 2/10 Treasury curve steepeners in 2022 on the expectation that the 2/10 slope will flatten by less than what is currently discounted in the forward curve. A comparison of the 5-year/5-year forward Treasury yield with a target range based on survey estimates of the long-run neutral fed funds rate also supports the case for 2/10 steepeners. Historically, an increase in the 5-year/5-year forward yield towards its target range corresponds with a steepening of the 2/10 slope (Chart 7). Bear-flattening moves in the 2/10 slope only occur when the 5-year/5-year forward is within its target band, as was the case in 2017/18. Given that the 5-year/5-year forward yield is currently well below its survey-derived target range, there is room for some 2/10 steepening as yields rise. Chart 6Treasury Slope Forecasts Treasury Slope Forecasts Treasury Slope Forecasts Chart 7A Rising 5y5y Will Steepen The Curve A Rising 5y5y Will Steepen The Curve A Rising 5y5y Will Steepen The Curve One way to position for a steeper 2/10 curve is to go long the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Presently, this trade looks very attractive. The 2/5/10 butterfly spread shows a significant yield advantage in the 5-year bullet over the 2/10 barbell, both in absolute terms and relative to our fair value model (Chart 8). While we view this as a good trade, we don’t think it’s the best way to position for 2/10 steepening. We prefer a position long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. This trade gives you long exposure at the 2-year maturity instead of the 5-year maturity which will boost returns if the 2/5 slope steepens, as we anticipate it will (Chart 6, panel 2). Chart 8Curve Steepeners Are Cheap Curve Steepeners Are Cheap Curve Steepeners Are Cheap In addition to our recommended 2/10 steepener, we advise clients to favor the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. While we’d expect some flattening of the 10/30 slope in 2022, this trade should still perform well because of its huge carry advantage. The tables in Appendix A show that the 20-year bond earns a massive 12-month carry (income plus rolldown return) of 3.05% compared to 1.85% for the 10-year note and 1.80% for the 30-year bond. Key View #3: Sell Short-Maturity TIPS Chart 9TIPS Breakevens TIPS Breakevens TIPS Breakevens Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Other attractive positions include: an outright short position in 2-year TIPS, an inflation curve steepener (short 2yr TIPS/long 2yr nominal/long 10yr TIPS/short 10yr nominal), and a TIPS curve flattener (short 2yr TIPS/long 10yr TIPS). As noted at the beginning of this report, we see inflation trending down in 2022. Inflation will remain high enough for the Fed to feel comfortable lifting rates, but it won’t match the elevated readings that are currently discounted in TIPS. Interestingly, long-maturity TIPS breakeven inflation rates are roughly consistent with the Fed’s 2.3%-2.5% target range (Chart 9). The 5-year/5-year forward TIPS breakeven inflation rate is a bit too low, at 2.13%, and the 10-year TIPS breakeven inflation rate is currently 2.47%. With long-dated TIPS breakevens so close to the Fed’s target, we recommend a neutral allocation to long-maturity TIPS versus long-maturity nominal Treasuries heading into 2022. In our view, the mispricing in TIPS lies at the front-end of the curve. The 2-year TIPS breakeven inflation rate has risen to 3.23%, well above the Fed’s 2.3%-2.5% target range. This year’s surge in short-maturity TIPS breakevens has also resulted in a deeply inverted inflation slope (Chart 9, bottom panel). Table 1Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present) 2022 Key Views: US Fixed Income 2022 Key Views: US Fixed Income Short-maturity inflation expectations are highly sensitive to changes in CPI inflation, much more so than long-maturity expectations. In fact, monthly changes in the 2-year CPI swap rate are more than twice as sensitive to headline inflation than are monthly changes in the 10-year CPI swap rate (Table 1). This means that the cost of short-maturity inflation compensation will decline as inflation moderates in 2022. We recommend an underweight allocation to short-maturity TIPS versus short-maturity nominal Treasuries. We also think an outright short position in 2-year TIPS will be highly profitable in 2022. If we assume that the 2-year TIPS breakeven inflation rate falls to the middle of the Fed’s target range during the next 12 months, and additionally that the 2-year nominal Treasury yield converges with our fair value estimate using the scenario of a September Fed liftoff, 100 bps per year hike pace and 2.08% terminal rate, then we calculate that the 2-year TIPS yield will rise from its current -2.56% to -0.98% during the next 12 months (Chart 10). Chart 10A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS Chart 10 also shows that the anticipated rise in the 2-year TIPS yield greatly outpaces the modest expected increase in the 10-year TIPS yield. This means that a position in 2/10 TIPS curve flatteners will turn a profit in 2022 (Chart 10, bottom panel). Key View #4: Overweight Corporate Bonds Versus Treasuries … For Now We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. A key pillar of our corporate bond investment process is to split the economic cycle into three phases based on the slope of the yield curve (Chart 11). Phase 1 of the cycle is defined as the period from the end of the last recession until the 3-year/10-year Treasury slope breaks below 50 bps. Phase 2 of the cycle spans the period when the slope is between 0 bps and 50 bps. Phase 3 lasts from when the yield curve inverts until the start of the next recession. Chart 11The Three Phases Of The Economic Cycle The Three Phases Of The Economic Cycle The Three Phases Of The Economic Cycle Our historical analysis shows that excess corporate bond returns versus duration-matched Treasuries tend to be strongest in Phase 1. They are usually positive, but much lower, in Phase 2 and are often negative in Phase 3 (Table 2). Table 2Corporate Bond Returns Across The Three Phases Of The Cycle 2022 Key Views: US Fixed Income 2022 Key Views: US Fixed Income We have been firmly in Phase 1 since April 2020 and, as we would expect, excess corporate bond returns have been strong. However, we will not remain in Phase 1 much longer. The 3-year/10-year Treasury slope is currently 50 bps, right on the precipice between Phase 1 and Phase 2. We recommend an overweight allocation to corporate bonds versus Treasuries for now, but we will adopt a more defensive posture toward corporates once we transition into Phase 2. We expect this will happen sometime in the first half of 2022. Why Are We Not In Phase 2 Already? Chart 12Curve Flattening Is Overdone Curve Flattening Is Overdone Curve Flattening Is Overdone The 3-year/10-year Treasury slope is hovering right around 50 bps. However, as is noted earlier in this report, we think that recent yield curve flattening is overdone and expect it to reverse somewhat in the coming months. Chart 12 shows the 3-year/10-year slope along with an expected fair value range. This range is based on a 100 bps Fed rate hike pace, a 2.08% terminal rate and varying the liftoff date between June 2022 and December 2022. This fair value range only breaks below 50 bps between March and September of next year. Given our yield curve view, we are positioned for one last period of strong corporate bond outperformance during the next few months. But we will turn more defensive once we judge that we have sustainably transitioned into a Phase 2 environment. Why Turn More Defensive In Phase 2? Chart 13IG Corporate Valuations IG Corporate Valuations IG Corporate Valuations It’s correct to point out that excess corporate bond returns are still generally positive in Phase 2 environments, so ideally, we would remain overweight corporate bonds versus Treasuries throughout Phase 2. This makes sense theoretically, but strategically we think it will be wise to adopt a different approach this cycle. The main reason to err on the side of caution is that corporate bond valuations are extremely stretched. The 12-month breakeven spread for the investment grade corporate bond index is at its 6th percentile since 1995. This means that the investment grade corporate bond index has only been more expensive than today 6% of the time since 1995 (Chart 13). Tight spreads mean that expected returns will be modest, even in a favorable cyclical environment. In other words, we are not sacrificing much expected return by reducing exposure early in the cycle. Given that we can’t predict the start of the next Phase 3 period with exact precision, we think it makes sense to be more defensive this cycle. We will sacrifice some modest expected returns to ensure that we are well positioned for the next period of significant spread widening. Our corporate bond strategy is supported by an empirical study of historical returns. Table 3A shows average 12-month excess returns for the investment grade corporate bond index after certain combinations of the 3/10 Treasury slope and average index option-adjusted spread (OAS) are observed. Table 3B shows 90% confidence intervals for the averages presented in Table 3A. Chart Chart The tables show that a strategy of remaining overweight corporate bonds versus Treasuries after the yield curve transitions into Phase 2 only works when the corporate index OAS is above 100 bps. A transition into Phase 2 portends negative excess corporate bond returns when the OAS is below 100 bps, as it is today. Favor High-Yield Over Investment Grade Chart 14HY Corporate Valuations HY Corporate Valuations HY Corporate Valuations While investment grade corporate bonds look extremely expensive compared to history, high-yield corporate bonds look somewhat expensive, but much less so. The average High-Yield index OAS is 1 bp below its pre-COVID low, but investors still get a nice spread pickup for moving out of the Baa-rated credit tier and into the Ba-rated tier (Chart 14). Our prior research has shown that high-yield corporates tend to outperform duration-matched Treasuries when the excess index spread after accounting for default losses is above 100 bps.2 If we assume a minimum required excess spread of 100 bps and a 40% recovery rate on defaulted debt, we can calculate that the junk index is priced for a default rate of 3.4% during the next 12 months (Chart 14, bottom panel). All available evidence suggests that the default rate will come in below 3.4% during the next 12 months, leading to positive excess returns for high-yield corporate bonds. The default rate came in at 1.8% for the 12-month period ending in November and it has been dropping like a stone, consistent with the reading from our Default Rate Model (Chart 15). We also recently wrote about the exceptionally good health of corporate balance sheets.3 We expect the default rate will be in the mid-2% range in 2022, below what is priced into the junk index. Chart 15Corporate Defaults Will Stay Low In 2022 Corporate Defaults Will Stay Low In 2022 Corporate Defaults Will Stay Low In 2022 Junk’s valuation advantage leads us to recommend that investors maintain a preference for high-yield corporates over investment grade. We will turn more defensive on both investment grade and high-yield corporates once we transition into a Phase 2 environment, but we may still retain our preference for high-yield over investment grade at that time, as long as junk stays relatively cheap. Key View #5: Overweight Emerging Market Bonds Versus US Corporates Investment grade USD-denominated Emerging Market bonds (both sovereigns and corporates) will outperform US corporate bonds with the same credit rating and duration in 2022. EM bonds offer an attractive spread advantage versus US corporates, and 2022 returns will be boosted by a weakening US dollar. We see an opportunity in Emerging Market (EM) bonds for US investors in 2022. Note that we are only referring to investment grade EM bonds denominated in US dollars. We consider both investment grade USD-denominated EM sovereign bonds and investment grade USD-denominated EM corporate & quasi-sovereign bonds. EM Sovereigns Chart 16EM Sovereigns EM Sovereigns EM Sovereigns EM sovereigns have modestly outperformed Treasuries so far this year (see Appendix B for a complete breakdown of year-to-date performance for different corporate bond sectors), and yet the sector remains attractively valued in the sense that the average index OAS has still not recovered its pre-COVID low (Chart 16). A look at recent performance trends shows that EM sovereigns outperformed credit rating and duration-matched US corporates in H2 2020 when the sector benefited from a huge yield advantage and a rapidly depreciating US dollar.4 This year, EM sovereigns lagged US corporates as the dollar strengthened. Looking ahead to 2022, we think that the recent bout of dollar strength is close to its end as the bond market has already moved to price-in an extremely hawkish Fed outlook at the front-end of the curve. A flat or depreciating dollar will benefit EM bonds in 2022, as will the yield advantage in EM sovereigns versus credit rating and duration-matched US corporates (Chart 16, panel 4). This yield advantage will only look more attractive as the Treasury curve flattens and the outlook for US corporate spreads deteriorates. At the country level, we see the best EM sovereign opportunities in Mexico, Russia, Chile, UAE, Qatar and Saudi Arabia. The bonds of all these countries outperformed credit rating and duration-matched US corporate bonds during the past 12 months, and they continue to offer a sizeable spread advantage (Chart 17). Chart 17 EM Corporates & Quasi-Sovereigns The investment grade USD-denominated EM Corporate & Quasi-Sovereign index shows a similar relative return pattern to the EM Sovereign index, though overall performance has been better (Chart 18). We see that the index outperformed credit rating and duration-matched US corporates dramatically in H2 2020 when the dollar was under pressure. Relative returns have been more stable this year as the dollar has strengthened. Chart 18EM Corporates & Quasi-Sovereigns EM Corporates & Quasi-Sovereigns EM Corporates & Quasi-Sovereigns EM corporates & quasi-sovereigns should continue to outperform credit rating and duration-matched US corporates in 2022. A weaker dollar will certainly help, but the main driver of outperformance will be the very attractive yield advantage (Chart 18, panel 4). Key View #6: A Maximum Overweight Allocation To Municipal Bonds Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. US bond investors should favor tax-exempt municipal bonds relative to both Treasuries and equivalently-rated corporate bonds. Long-maturity tax-exempt municipal bonds continue to be one the most attractively priced assets in the US fixed income space. As we discussed in a recent report, one big reason for the attractive valuation is that municipal bonds tend to pay premium coupon rates.5 This significantly reduces the duration risk in long-dated munis. The first two columns of Table 4 show the yield ratios and breakeven tax rates between different municipal bond sectors and duration-matched Treasury securities. We see that the breakeven tax rate – the tax rate that equalizes after-tax yields between the two sectors – is a mere 11% for 12-17 year general obligation munis. The breakeven tax rate between 12-17 year revenue munis and duration-matched Treasuries is only 3%, and the longest-maturity munis actually offer a before-tax yield advantage versus Treasuries! Table 4Muni/Treasury And Muni/Credit Yield Ratios 2022 Key Views: US Fixed Income 2022 Key Views: US Fixed Income Table 4 shows that munis also offer excellent value compared to corporate bonds with the same credit rating and duration, especially at the long-end of the curve. Breakeven tax rates between munis and corporate credit range from 3% to 21% for maturities longer than 12 years. What’s even more impressive about municipal bonds is that their attractive valuations are buttressed by extremely high credit quality. State & local government balance sheets have received a huge boost from federal stimulus during the past two years, and this has sent net state & local government savings (revenues minus expenditures) surging into positive territory (Chart 19). But it’s not just federal stimulus that has aided state & local governments. Even if we exclude transfer payments altogether, we find that the difference between tax receipts and consumption expenditures is rising sharply relative to interest expense (Chart 19, panel 2). Ratings agencies have noticed the improvement in state & local government budgets and ratings upgrades have far outpaced downgrades during the past year (Chart 19, bottom panel). Chart 19State & Local Balance Sheets In Good Shape State & Local Balance Sheets In Good Shape State & Local Balance Sheets In Good Shape Key View #7: Underweight Agency MBS Chart 20Poor MBS Performance Will Continue Poor MBS Performance Will Continue Poor MBS Performance Will Continue Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. We noted in a recent report that Agency Mortgage-Backed Securities have performed poorly in 2021.6 The main reason for the poor performance is that the compensation for prepayment risk embedded in MBS spreads (aka option cost) started the year at a very low level, but mortgage refinancing activity has been much higher than expected (Chart 20). The conventional 30-year MBS option cost has been rising, but it is still only back to where it was in 2019 (Chart 20, panel 2). This is not sufficiently attractive for us to advocate buying MBS. While rising bond yields will be a tailwind for refi activity in 2022, we still expect the pace of refinancings to be relatively strong because the rapid run-up in home prices has made it extremely enticing for households to tap the equity in their homes through cash-out refis. Within a recommended underweight allocation to MBS, we recommend that investors favor higher coupon securities over lower coupon ones. Higher-coupon MBS carry less duration than lower-coupon MBS and also wider OAS and greater convexity. This means that high-coupon MBS will outperform low-coupon MBS if bond yields rise in 2022, as we expect they will. Appendix A: Treasury Return Forecasts Image Image Image Image Image Image Image Image Image Image Image Image   Appendix B: US Bond Sector Year-To-Date Performance Image Image Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2022: Peak Inflation – Or Just Getting Started?”, dated December 1, 2021. 2 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020. 3 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4 A weaker dollar tends to benefit USD-denominated EM bonds because it makes it easier for foreign issuers to service their dollar denominated debts. 5 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 6 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights The risk to European stocks from higher yields is overstated for 2022. Not only do equities possess a valuation cushion compared to bonds, but also the stock returns/bond yields correlation remains positive. This positive correlation is only two decades old, and it is a consequence of the stabilization of inflation and inflation expectations, which caused bond yield changes to mostly reflect adjustment in anticipated economic activity. As long as the recent inflation upsurge peters off next year, the equity/yield correlation will remain positive in 2022. Despite this sanguine short-term view, the long-term outlook is fraught with risks because next year’s inflation decline will be temporary; inflation is on a secular uptrend. The equity returns/bond yield correlation will become negative toward the middle of the decade, which will create a major headwind for the secular returns of both stocks and bonds. Feature Extremely low yields and elevated valuations constitute a potentially toxic mix for the equity outlook next year. The logic is straightforward: if yields rise enough, nosebleed multiples will become unjustifiable and the stock market will crash. Chart 1Protection Against Higher Yields Protection Against Higher Yields Protection Against Higher Yields The picture is more complex and instead, European equities are likely to withstand higher yields. To begin with, BCA Research’s US Bond strategists anticipate a modest rise in Treasury yields to 2.25% in 2022,  and our Global Fixed-Income strategists foresee an even more limited increase in German rates. Moreover, as we showed in our 2022 Key Views piece published last week, European equities embed a large valuation cushion in the form of a significant premium in their dividend yield relative to Bund yields (Chart 1). The correlation between yields and equities is another facet that will impact the effect of higher yields on the equity bull market. For now, it is premature to conclude that the positive correlation between yields and the absolute performance of European equities is poised to turn negative again in 2022. However, over the next couple of years, such a correlation reversal will take place, because inflation expectations are increasingly likely to become unmoored to the upside. Stocks Like Higher Yields Over the past two decades, one of the major financial market paradoxes has been the relationship between equity prices and bonds yields. Since 1998, the weekly returns of the MSCI Euro Area equity benchmark have correlated positively with the change in 10-year German yields (Chart 2). However, prior to the late 1990s, changes in bond yields and stocks prices were negatively correlated. Chart 2For Two Decades, Bond Yields And Stocks Prices Have Moved Together For Two Decades, Bond Yields And Stocks Prices Have Moved Together For Two Decades, Bond Yields And Stocks Prices Have Moved Together The key to the shifting relationship between stocks and bonds is the link between yields and economic activity. Stock returns have always been procyclical because earnings are the most important driver of equity returns (Chart 3). However, bond yields have become increasingly pro-cyclical over time. Today, Bund yields and the German LEI move in tandem, but, prior to 1986, their five-year rolling correlation was negative (Chart 4). Chart 3Stocks Follow Earnings Who Follow Growth Stocks Follow Earnings Who Follow Growth Stocks Follow Earnings Who Follow Growth Chart 4Shifting Link Between Bunds And German Growth Shifting Link Between Bunds And German Growth Shifting Link Between Bunds And German Growth The positive correlation between German growth and German yields sheds light on why the correlation between yields and stocks is now positive, but it does not explain why this positive link emerged in the late 1990s and not earlier. Financial asset prices reflect global phenomena. Stock indices in advanced economies overrepresent multinationals which are affected by global economic fluctuations. Meanwhile, capital is fungible and flows freely across borders. As a result, German bond yields are not the unique factor that matters to the correlation between equities and stock. Instead, the behavior of global yields and equities is critical. Chart 5Living In The Shadow Of The Asian Crisis Living In The Shadow Of The Asian Crisis Living In The Shadow Of The Asian Crisis According to this logic, the correlation between global yields and global growth becomes important. As Chart 5 illustrates, the relationship between global bond returns and global economic activity became much closer around 1998 than it was prior to this date. The key turning point was the Asian crisis of 1997/98. Why was the Asian crisis so fundamental? It was the end state of the disinflationary trend started under Federal Reserve Chairman Paul Volker. After the Asian crisis, the region’s newly industrialized economies switched from chronic current account deficits to chronic surpluses, which added to the global supply of savings. Moreover, Asian economies became hypercompetitive because of severely devalued exchange rates, which limited pricing power around the world. Finally, the Chinese economy became a force to be reckoned with and its share of global trade expanded massively. Together, these forces amplified competitive pressure around the world and made every inflation uptick self-limiting. The impact of the shock is visible in the inflation data. As Chart 6 shows, core inflation in the US and in the G7 has been stable since 1998, capped near 2.5%, except for 2021. Additionally, after the Asian crisis, the volatility of core inflation collapsed among both the G7 and Eurozone economies (Chart 7). Chart 62.5%, A 20-Year Old Ceiling 2.5%, A 20-Year Old Ceiling 2.5%, A 20-Year Old Ceiling Chart 71998: RIP CPI Volatility 1998: RIP CPI Volatility 1998: RIP CPI Volatility The effect of this steady inflation was to stabilize inflation expectations. Thus, after 1998, the most important driver of bond price annual changes has been fluctuations in anticipated real economic activity, which explains why the relationship between global bond returns and the global LEI became much tighter afterward (Chart 5, on page 4). This result is crucial to understand the impact of higher yields for equities. It suggests that, if rising yields reflect improving economic growth, then the correlation between yields and stocks will remain positive and equities may climb higher along with mounting long-term interest rates. Bottom Line: Higher yields do not necessarily portend the end of the equity bull market. Stock prices and bond yields have been positively correlated since the Asian crisis of 1997/98 because fluctuating growth expectations drive most of the change in yields. As long as this remains the case, equities can handle higher yields. Can The Correlation Shift Sign Again? The correlation between equities and bonds is not static. There are threats that could restore both temporarily or permanently the negative correlation between changes in bond yields and stock returns that prevailed prior to 1998. A Temporary Correlation Shift? Since their March 2020 lows, 10-year yields have increased 94bps and 51bps in the US and Germany, respectively. Meanwhile, the MSCI Eurozone equity benchmark is up 78%. We are clearly not yet in an environment in which rising long-term interest rates hurt stocks. In the short term, the correlation between yield changes and equity returns may turn negative if yield moves into constraining territory—this is to say, if they rise enough to risk a recession. In more academic terms, this equates to rates moving above the neutral rate of interest, or r-star. Chart 8A Long Way To Go Before Policy Becomes Tight A Long Way To Go Before Policy Becomes Tight A Long Way To Go Before Policy Becomes Tight There is little indication that interest rates are moving above this level in the short term. US and European policy rates remain well below Taylor rule estimates of equilibrium (Chart 8), which suggests that policies are still highly accommodative. The most worrisome signal comes from the slope of the yield curve. Since March 2021, the US 2-/10-year yield curve has flattened by 76bps to 81bps and, since October 2021, the same yield curve has flattened by 23bps to 35bps in Germany. Moreover, the 20-/30-year US yield curve became inverted in October 2021. These dynamics may indicate that policy is already on the verge of becoming too tight, even if only five interest rate hikes are expected in the US over the next two years.  Chart 9Term Premia Are Still Negative Term Premia Are Still Negative Term Premia Are Still Negative A curve flattening episode is the normal course of events when central banks become less accommodative; it is not a sign of impending doom. Instead, an inverted yield curve is the indication that the policy rate is above r-star. After all, if interest rates genuinely constrain growth, they will slow economic activity in the future, which will necessitate lower rates and generate a negative curve slope. We are not there yet. Moreover, the term-premium remains negative across major advanced economies, which suggests that a recessionary signal will come from a deeper yield-curve inversion than in the past (Chart 9). Chart 10Upside To The Terminal Rate Upside To The Terminal Rate Upside To The Terminal Rate Another factor likely to allow yields to rise without killing the equity market is that the expected terminal rate of interest remains too low, as we wrote in our 2022 Key Views piece last week. Historically, it is common for the expected terminal rate to rise as central banks begin to lift interest rates, especially if the economy handles the first hikes well. Today, the expected terminal rate is below the levels that prevailed after the GFC, despite a much firmer economy unburdened by private sector deleveraging and excessive fiscal tightening (Chart 10). As such, we anticipate the expected terminal rate to increase, which will limit how quickly the yield curve will flatten next year even if the Fed elevates interest rates and the ECB aggressively downshifts its pace of asset purchases once the PEPP ends. Chart 11Long-Term Inflation Expectations Are Not A Concern, Yet Long-Term Inflation Expectations Are Not A Concern, Yet Long-Term Inflation Expectations Are Not A Concern, Yet Under this aperture, the biggest risk for stocks remains inflation. Further acceleration in inflation, especially if it pushes the 5-year/5-year forward inflation breakeven rate above the Fed’s comfort zone (Chart 11), could hurt stocks. Essentially, investors would price in a shift in the monetary policy environment whereby risks of a severe tightening would increase. However, as we recently wrote, the odds are mounting that short-term inflation will soon peak. Oil inflation is ebbing, while transportation costs are declining and supply bottlenecks are beginning to ease. Moreover, money growth in the US and the Eurozone, which proved relevant variables to explain inflation this year, is also waning (Chart 12). Finally, a mounting number of global central banks are tightening policy, which implies that maximum accommodation is behind us (Chart 13) In this context, we expect the positive correlation between stock returns and yield changes to remain broadly positive. A short-term rise in yields could easily contribute to equity market volatility and may even cause a deeper stock market correction than any experienced since April 2020. However, this will prove to be a temporary phenomenon, and thus we remain buyers of the dip. Chart 12Slowing Money Supply Growth, At Last Slowing Money Supply Growth, At Last Slowing Money Supply Growth, At Last Chart 13Global Policy Is Becoming Less Easy Global Policy Is Becoming Less Easy Global Policy Is Becoming Less Easy A Longer-Term Correlation Shift? A shift in the long-term correlation between equity returns and bond yield changes is a much more meaningful risk to stocks than short-term changes. BCA expects inflation to peak in the short term, but this will only be part of a stop-and-go process. Inflation is on a structural uptrend and so, any decline in 2022 and early 2023 will morph into renewed pressure, after the global output gap becomes positive again by the end of next year. Chart 14A Deflationary Tailwind Is Gone A Deflationary Tailwind Is Gone A Deflationary Tailwind Is Gone Many structural forces are moving away from deflationary to inflationary. True, technological progress remains a deflationary anchor. However, this downward pressure on inflation is no longer buttressed by a deepening of globalization (Chart 14). Moreover, because of the rise of populism around the world over the past five years, fiscal policy is unlikely to move back to the austere Washington Consensus that dictated governance from President Reagan up to the moment President Trump took power. Additionally, ageing across advanced economies and China, as well as the so-called “Great Resignation,” will constrain the expansion of the global supply side. This background suggests that the period of flat inflation that prevailed from 1998 to 2020 is ending. As a corollary, inflation expectations will embark on a multi-year upward drift. This process is likely to loosen the correlation between economic activity and yields. As a result, the period of positive correlation between yield changes and equity returns is in its last innings. This will represent a major difficulty for asset allocators over the next ten to twenty years, as it points to poor long-term real returns for both bonds and stocks. Bottom Line: The correlation between stock returns and bond yield changes is likely to remain positive in 2022, which implies that European stocks will eke out another year of positive returns, despite BCA’s house view that yields will rise. However, the long-term outlook is more problematic. The growing likelihood that inflation is making a secular upturn means that the two-decades old positive correlation between equity returns and bond yield change will become negative again around the middle of the decade. This shift will have a profound and deleterious impact on both stocks’ and bonds’ secular returns.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations The Correlation Convolution The Correlation Convolution Cyclical Recommendations The Correlation Convolution The Correlation Convolution Structural Recommendations The Correlation Convolution The Correlation Convolution Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Omicron vs. The Fed: The new COVID variant has thrown a growth scare into markets, but the bigger concern is the Fed belated playing catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year with the Fed threatening to taper faster, and potentially hike sooner, than markets expect. New Zealand: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade. A Year-End Bout Of Uncertainty Chart of the WeekMarkets Have Been Worried About The Fed Since September Markets Have Been Worried About The Fed Since September Markets Have Been Worried About The Fed Since September Over the past two weeks, we have published Special Reports and thus have not had an opportunity to comment on market moves and news. Needless to say, it has been an eventful period! The emergence of the new Omicron variant, and the hawkish shift in the Fed’s guidance on future policy moves, have injected fresh uncertainty and volatility into global financial markets. Since the existence of Omicron was revealed to the world on Nov 26, 30-year US Treasury yields have fallen by as much as -23bps and the S&P 500 index has been down by as much as -4.4%. Yet the evolving Fed stance, with Fed Chair Jerome Powell hinting last week that the end of tapering and start of rate hikes could begin sooner than expected next year, is having a more lasting influence on risk asset performance. Dating back to the September 23 FOMC meeting, when the Fed first signaled an imminent tapering of bond purchases and pulled forward the timing of liftoff into 2022, the 2-year US Treasury yield has gone up from 0.22% to 0.63%. Importantly, there has been little pullback on the pricing at the front-end of the US Treasury curve due to the Omicron shock. That pre-September-FOMC low in the 2-year Treasury yield also marked the peak in riskier fixed income market performance for 2021, with the Bloomberg Global High-Yield and Emerging Market USD-Denominated Sovereign total return indices down -2.0% and -1.8%, respectively, since Sept 23 (Chart of the Week). Other risk assets also appear to be responding more to news about the Fed than Omicron. Equity markets stopped climbing since the Fed announced the first taper of bond purchases at the November 3 FOMC meeting – three weeks before the world knew of Omicron - which also coincided with troughs in the VIX index and corporate credit spreads, not only in the US but in Europe and emerging markets as well (Chart 2). Of course, it is difficult to disentangle which is having a greater impact, the variant or the Fed, when details on both are evolving at the same time. Omicron Investors are understandably right to be nervous about a new COVID variant that can reportedly evade existing vaccines and even infect those who have had COVID previously. The whole idea of “putting COVID in the rearview mirror’ that has helped fuel booming equity and credit markets was predicated on vaccines being both effective and widely available. However, when investors see COVID case numbers start to pick up in the US and Europe, with vaccination rates twice that of South Africa where Omicron was first detected (Chart 3), this raises concern about a return to pre-vaccine economic restrictions and uncertainty. Chart 2A Typical Risk-Off Response To The Emergence Of Omicron A Typical Risk-Off Response To The Emergence Of Omicron A Typical Risk-Off Response To The Emergence Of Omicron Chart 3Omicron Putting A Dent In Vaccine Optimism Omicron Putting A Dent In Vaccine Optimism Omicron Putting A Dent In Vaccine Optimism The “Omicron effect” on fixed income markets has been most evident in the repricing of interest rate expectations. Since the presence of Omicron was revealed on November 26, there has been a reduction in the cumulative amount of tightening discounted to the end of 2024 in the overnight index swap (OIS) curves of the major developed economies (Table 1). The moves were most evident in the US (32bps of hikes priced out), Canada (37bps) and Australia (37bps). Table 1Pricing Out Some Rate Hikes Because Of Omicron Blame The Fed, Not Omicron, For More Volatile Markets Blame The Fed, Not Omicron, For More Volatile Markets Much is still unknown about the dangers of the Omicron variant. The admittedly very early data out of South Africa, however, indicates that there has not been a major surge in hospitalizations related to Omicron cases. A new COVID strain that proves to be more virulent, but that does not strain health care systems, should help allay investor concerns over a major economic hit from Omicron. This presents an opportunity to put on positions that will profit from a rebound in global bond yields led by higher US Treasury yields. The Fed The Omicron threat to date has not been enough to move the Fed off its plans to rein in the monetary accommodation put in place in 2020 to fight the pandemic. If Omicron is to have any impact on the US economy, it will do so at a time when the economy continues to grow well above trend. The November reading on the ISM Manufacturing survey showed strength in the overall index, with a stabilization of the New Orders/Inventory ratio that leads overall growth, and only a very modest reduction in the still-elevated Prices Paid and Supplier Deliveries indices (Chart 4). The Atlanta Fed’s GDPNow model is suggesting that US real GDP growth could come in at a whopping 9.7% in Q4. As further evidence that the US economy is growing at a pace well above trend, just look to labor market data. New US jobless claims are at the lowest level since 1969. The November US Payrolls report showed that the headline unemployment rate fell 0.4 percentage points on the month to 4.2% - within the range of full employment estimates of the FOMC - even with actual job growth falling short of consensus forecasts (Chart 5, top panel). Chart 4Nothing Bond-Bullish In US Manufacturing Nothing Bond-Bullish In US Manufacturing Nothing Bond-Bullish In US Manufacturing The improving health of the labor market is being felt more broadly, with big declines seen in unemployment rates for minorities and less-educated Americans (second panel). That point is of critical importance to the Powell Fed that has emphasized reducing racial and educational gaps in US unemployment as part of reaching its goal of “maximum employment”. Chart 5Nothing Bond-Bullish In US Labor Markets Nothing Bond-Bullish In US Labor Markets Nothing Bond-Bullish In US Labor Markets Tightening labor markets are also evident in accelerating wage momentum. Excluding the 2020 spike driven by labor force compositional effects related to COVID lockdowns, the year-over-year growth in average hourly earnings reached a 39-year high of 5.9% in November (third panel). The Fed now seems willing to finally confront high US inflation and strong economic growth with some tightening of monetary policy. Chart 6A Near-Term Break From Supply-Fueled Inflation? A Near-Term Break From Supply-Fueled Inflation? A Near-Term Break From Supply-Fueled Inflation? Powell caused some investor agita last week when he indicated that the taper could end before mid-2022, the previous FOMC guidance, which would open the door for rate hikes. We see Powell’s comments as less about signaling an intensifying hawkishness and more about giving the Fed optionality on when to start lifting rates next year in the event the US economy continues to overheat. The Fed strongly believes that tapering must end before rate hikes can begin, so a more accelerated taper allows for an earlier liftoff date, if necessary. To that end, the supply fueled surge in inflation this year, which has lingered for far longer than the Fed anticipated, may be showing some signs of easing. Several indices of global shipping container prices are off the highs, while there is a reduced backlog of container ships off key US ports like Los Angeles. Overall commodity price momentum has peaked, in line with slower, but still strong, global industrial activity (Chart 6). An easing of supply-driven price pressures would be welcome by the FOMC. It would allow time to evaluate both the Omicron threat and evolving US labor market dynamics, instead of being forced to fight a rearguard action against accelerating inflation. However, a shift away from goods/commodity inflation to more domestically driven inflation would not lessen the need for the Fed to begin lifting rates next year – in fact, it could even strengthen the case for the Fed to hike rates faster, and by more, than currently discounted in markets. Importantly, forward looking indicators are still pointing to solid US growth next year (Chart 7): The Conference Board’s leading economic indicator continues to grow at a pace signaling above-trend growth US financial conditions remain highly accommodative even with the recent market turbulence The New York Fed’s yield curve based recession probability model is indicating that the spread between the 10-year US Treasury yield and the 3-month US Treasury bill rate, currently 138bps, is consistent with only a 9% chance of a US recession over the next year (bottom panel) We continue to recommend a below-benchmark duration stance within US fixed income portfolios, with a yield target on the 10-year benchmark US Treasury yield of 2-2.25% to be reached by the end of 2022. We also continue to recommend positioning in Treasury curve steepening trades. This is admittedly a counter-intuitive suggestion given that the Fed is moving towards a rate hiking cycle, but we see too much flattening priced into the Treasury forward curve over the next year (Chart 8). Chart 7A Positive Message From US Leading Growth Indicators A Positive Message From US Leading Growth Indicators A Positive Message From US Leading Growth Indicators   Chart 8Our Favorite Bearish US Rates Trades Our Favorite Bearish US Rates Trades Our Favorite Bearish US Rates Trades For global bond investors, our favorite trade that will benefit from higher US bond yields next year is to position for a wider 10-year US Treasury-German Bund spread (bottom panel). We expect the ECB to avoid any rate increases until at least mid-2023, well after the Fed has begun to tighten. Forward curves in the US and Germany currently discount a relatively stable Treasury-Bund spread in 2022, thus there is no negative carry incurred by positioning for a wider spread. Bottom Line: Omicron has thrown a growth scare into markets, but the bigger concern is that the Fed is belated starting to play catch up to high inflation and low unemployment. Fade the Omicron bond rally, and position for higher US Treasury yields over the next year. New Zealand: How Much Further Can The Bond Selloff Go? Chart 9NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness NZ Sovereign Underperformance Has Been Driven By RBNZ Hawkishness Over the past year, New Zealand bonds have sold off much faster than developed market peers (Chart 9). Markets correctly recognized the Reserve Bank Of New Zealand (RBNZ) as a central bank that would move more aggressively to tamp down on inflation and manage the financial stability and political risks arising from soaring house prices. The RBNZ has already delivered back-to-back hikes at its October and November meetings, after its plans to hike at the August meeting were thrown off by the Delta variant. Markets are now pricing in a further 172bps of tightening over the coming year, having largely faded any downside growth risk from the Omicron variant. Expectations of continued tightening have been buoyed by the response of New Zealand policymakers, who are largely looking past the Omicron variant. Restrictions have already begun to ease, with the country having entered its “Traffic Light” COVID-19 Protection Framework. The new variant is also unlikely to affect the RBNZ’s tightening path, with Chief Economist Yuong Ha stating that, given the lifting of restrictions, the RBNZ would have raised rates even if Omicron had become known before its November 24 meeting. Given the bond-bearish backdrop, New Zealand government bonds have underperformed substantially this year. On a relative hedged and duration-matched basis, New Zealand sovereigns have underperformed by -6.6% year-to-date with -4.0 percentage points of that underperformance coming after July 21 when we formally moved to an underweight stance on New Zealand debt within global government bond portfolios (Chart 9, bottom panel). However, with monetary policy entering a new phase, led by an increasingly hawkish Fed, we believe it is appropriate to re-assess our New Zealand call and judge whether this underperformance can continue into 2022. The growth picture is broadly supportive of the RBNZ’s stated policy path. Real GDP as of Q2 was above its pre-Covid trend and 2.6% over the RBNZ’s own estimate of potential GDP, supported by an easing of travel restrictions and strong consumer spending (Chart 10). On a forward-looking basis, however, the risk is now that the economy is running too hot, jeopardizing future growth. Consumer and business sentiment has been worsening as inflation expectations soar, with consumers fearing a hit to purchasing power and businesses concerned about the impact of rising input costs on profit margins. Household and business inflation fears also have a strong basis in the realized inflation data, which has soared to a 10-year high of 4.9% (Chart 11). More troublingly, underlying inflation measures such as the trimmed mean and core (excluding food and energy) are now at series highs of 4.8% and 4%, respectively, indicating that higher inflation could prove to be sticky. The RBNZ now sees headline inflation peaking at 5.7% in Q1/2022 before settling to 2% by the end of its forecast horizon in 2024. Chart 10The NZ Economy Is Overheating The NZ Economy Is Overheating The NZ Economy Is Overheating Chart 11The RBNZ Will Welcome A Slight Growth Slowdown The RBNZ Will Welcome A Slight Growth Slowdown The RBNZ Will Welcome A Slight Growth Slowdown ​​​​​​ The RBNZ clearly attributes higher inflation to an economy running above longer-term capacity rather than short-term supply factors. The Bank’s measure of the output gap is now at the most positive level since 2007, and survey measures of capacity utilization remain elevated. In contrast to the Fed, which is still nominally focused on maximum employment, the RBNZ actually believes that employment is above its maximum sustainable level, and sees a rising unemployment rate as necessary to ease capacity constraints. Given that the RBNZ is clearly comfortable with, and will likely welcome, a gradual rise in unemployment, it will take much more than a slight growth shock to deter the RBNZ from its tightening path. Chart 12Higher Rates Necessary To Stabilize The NZ Housing Market Higher Rates Necessary To Stabilize The NZ Housing Market Higher Rates Necessary To Stabilize The NZ Housing Market The newest, and most politically potent, part of the RBNZ’s remit—house prices – has further supported a bias to tighten monetary policy. However, while still dramatically elevated, house price growth looks to have peaked (Chart 12). The central bank’s hawkish shift earlier in the year has made a clear impact, with house price growth peaking shortly after mortgage rates started picking up in April of this year. Overall household mortgage credit has also begun to decelerate, indicating that the passthrough from monetary policy to credit demand and housing via the mortgage rate is working as intended. However, there is likely further to go. The last time house price growth was somewhat stable around 6.6% in the 2012-2019 period, benchmark 5-year mortgage rates averaged 6.1%. Assuming the spread between the 5-year mortgage and policy rates remains around 4%, history indicates that we would need to see the policy rate rise to at least 2% to cool down the housing market. That 2% level is also the RBNZ’s mean estimate of a “neutral” cash rate—a level at which policy would be neither accommodative nor restrictive (Chart 13). Current market pricing is quite consistent with the RBNZ’s own projected path of rates as of the November meeting—both of which are set to exceed the neutral rate by the end of 2022. Historical experience from the pre-crisis period indicates that this is not uncommon, and that a bout of restrictive policy might be needed to cool down an overheating economy. Chart 13 Indeed, if the RBNZ’s historical reaction to inflation is any guide, it seems likely that policymakers will want to push rates above inflation. The top two panels of Chart 14 show how anomalous deeply negative real policy rates are in New Zealand. Even if we make the case that developed market real rates are in a structural downtrend, as realized real rates have peaked out at successively lower levels with each tightening cycle, the current gap between the cash rate and core inflation seems obviously unsustainable and requires a tightening of policy. Chart 14NZ Real Rates Are Too Low NZ Real Rates Are Too Low NZ Real Rates Are Too Low ​​​​​​ Chart 15Go Long The 10-Year NZ Government Bond/US Treasury Spread Go Long The 10-Year NZ Government Bond/US Treasury Spread Go Long The 10-Year NZ Government Bond/US Treasury Spread ​​​​​​ Another way to think about where policy rates are in relation to a “neutral” level is to look at the yield curve (Chart 14, bottom panel). Typically, the yield curve inverts when markets judge that monetary policy is too restrictive and that short rates are too high relative to a long-run average. However, the New Zealand government bond curve has historically remained inverted for extended periods of time, troughing at around -100bps. This again indicates that the RBNZ is comfortable raising rates above neutral and keeping policy restrictive when needed. Putting together the four factors we have looked at—growth, inflation, asset prices, and the RBNZ’s reaction function—it looks likely that the RBNZ will continue along the tightening path it has set out and chances of any dovish surprise seem slim. At the same time, markets are priced to perfection in terms of the pace and amount of tightening discounted. For New Zealand sovereigns to continue underperforming, however, we will need to see markets price in, on the margin, even more tightening from the RBNZ relative to its peers. With the Fed and other central banks having become more focused on responding to US inflation dynamics, bond-bearish upside shocks to market rate expectations will increasingly come from outside New Zealand. At the same time, in the event of a negative global growth shock, perhaps relating to COVID-19, there is relatively more room for hikes to be priced out in New Zealand. Given our view that bond and rates markets have appropriately priced in the extent of the RBNZ’s likely tightening cycle, we are upgrading New Zealand sovereign debt to neutral, taking profits on our current underweight stance. While we do not include New Zealand debt in our model bond portfolio, we are expressing our view via a new tactical cross-country spread trade: long New Zealand 10-Year government bonds vs. US 10-Year Treasuries (Chart 15). Forwards are currently pricing in a flat spread between the two countries, meaning that any future spread tightening will put our trade in the black. Given that there is more space for markets to price in increased hawkishness from the Fed, we believe that spread compression is likely. We are implementing this trade by going long New Zealand cash bonds and shorting 10-year US Treasury futures. Details can be found on Page 18. Bottom Line: Underlying growth and inflation fundamentals, soaring house prices, and the central bank’s historical reaction function indicate that the Reserve Bank of New Zealand will lift the cash rate to 2% by the end of 2022. However, markets are already priced for this, leaving little room for New Zealand debt to continue underperforming on a relative basis. We are upgrading New Zealand sovereigns to neutral and initiating a long NZ/short US 10-year spread trade.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com 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 Chart 1Curve Flattening Is Overdone Curve Flattening Is Overdone Curve Flattening Is Overdone Fed Chair Jay Powell made big news last month. During Senate testimony, Powell not only signaled that the Fed is likely to accelerate the pace of asset purchase tapering when it meets in December, he also suggested that the Fed won’t necessarily wait until “maximum employment” is achieved before lifting rates. Powell’s comments suggest that the first Fed rate hike could come as early as June 2022 and as late as December 2022, and the exact timing will depend on how inflation and inflation expectations move during the next few months. The front-end of the Treasury curve is fairly priced for either scenario. The 2-year Treasury yield is currently 0.60%. If we assume that the Fed eventually lifts rates at a pace of 100 bps per year until reaching a 2.08% terminal rate, we calculate a fair value range for the 2-year yield of 0.39% to 0.74%, depending on whether Fed liftoff occurs in June or December. In contrast, the same assumptions give us a fair value range of 1.69% to 1.79% for the 10-year Treasury yield, well above its current level of 1.40% (Chart 1). The investment implications are clear. Investors should maintain below-benchmark portfolio duration and put on Treasury curve steepeners, overweight the 2-year note and underweight the 10-year. Feature Table 1Recommended Portfolio Specification Powell’s Pivot Powell’s Pivot Table 2Fixed Income Sector Performance Powell’s Pivot Powell’s Pivot Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 89 basis points in November, dragging year-to-date excess returns down to +102 bps. The index option-adjusted spread widened 12 bps on the month and our quality-adjusted 12-month breakeven spread is now at its 7th percentile since 1995. This indicates that valuations remain stretched even after the recent widening (Chart 2). The back-up in spreads was driven by the combination of the Fed’s shift toward a more hawkish policy stance and concerns about the new omicron COVID variant. This led to a large flattening of the yield curve in addition to wider corporate bond spreads. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable owning corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 – 50 bps.1  The 3-year/10-year Treasury slope currently sits at 49 bps, just below our 50 bps threshold. However, our range of fair value estimates suggests that the 3/10 slope should be between 63 bps and 86 bps today, and that it should only break below 50 bps between March and September of next year (bottom panel). All in all, we expect the pace of Treasury curve flattening to abate during the next couple of months and this will allow spreads to tighten back to their recent lows. We will turn more cyclically defensive on corporate bonds next year when the break below 50 bps in the 3/10 slope is confirmed by our fair value readings. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Powell’s Pivot Powell’s Pivot Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 121 basis points in November, dragging year-to-date excess returns down to +444 bps. The index option-adjusted spread widened 50 bps on the month, leading to a significant rise in the spread-implied default rate. The spread-implied default rate is the 12-month default rate that is priced into the junk index, assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps. At present, the spread-implied default rate sits at 3.8% (Chart 3). For context, defaults have come in at an annualized rate of 1.6% so far this year and we showed in a recent report that corporate balance sheets are in excellent shape.2  Specifically, the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We conclude that the default rate will be comfortably below 3.8% during the next 12 months, allowing high-yield bonds to outperform duration-matched Treasuries. We recommend that investors favor high-yield over investment grade corporate bonds, and we expect that last month’s spread widening will reverse in relatively short order. However, as noted on page 3, we will turn more defensive on credit risk (including high-yield bonds) next year once we are confident that the 3/10 Treasury curve has sustainably moved into a flatter regime (0 – 50 bps). MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 46 basis points in November, dragging year-to-date excess returns down to -90 bps. The zero-volatility spread for conventional 30-year agency MBS widened 13 bps on the month, driven by an 11 bps widening of the option-adjusted spread and a 2 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in last week’s report that MBS’ recent poor performance is attributable to an option cost that is too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index has been slow to fall this year despite the back-up in yields.3 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refi activity will remain sticky going forward. This will put upward pressure on MBS spreads. We recommend adopting an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel).  Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-neutral Treasury index by 35 basis points in November, dragging year-to-date excess returns down to +33 bps. Sovereign debt underperformed duration-equivalent Treasuries by 157 basis points in November, dragging year-to-date excess returns down to -220 bps. Foreign Agencies underperformed the Treasury benchmark by 9 bps on the month, dragging year-to-date excess returns down to +36 bps. Local Authority bonds underperformed by 16 bps in November, dragging year-to-date excess returns down to +406 bps. Supranationals outperformed by 2 bps, bringing year-to-date excess returns up to +18 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 42 bps in November. The Emerging Market Corporate & Quasi-Sovereign index underperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.4 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in November, bringing year-to-date excess returns up to +371 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.5 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue Munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 22% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve flattened dramatically in November. Increasingly hawkish rhetoric from the Fed pushed front-end yields higher as news about the omicron COVID strain pressured long-dated yields lower. The 2-year/10-year Treasury slope flattened 16 bps on the month, it currently sits at 75 bps. The 5-year/30-year Treasury slope flattened 11 bps on the month, it currently sits at 56 bps. As noted on the front page, long-dated Treasury yields have fallen to well below levels consistent with a reasonable Fed rate hike cycle. This drop in long-maturity yields has pushed the 2/5/10 butterfly spread to extremely high levels, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that 2/10 yield curve steepeners are incredibly cheap. Indeed, we observe that the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4). A trade long the 5-year bullet and short a duration-matched 2/10 barbell does indeed look attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen during the next 6-12 months, and we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. This leads us to recommend a position long the 2-year note and short a duration-matched barbell consisting of cash and the 10-year note. We also advise investors to own a position long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This latter position offers a very attractive duration-neutral yield advantage of 24 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in November, leaving year-to-date excess returns unchanged at +739 bps. The 10-year TIPS breakeven inflation rate fell 8 bps on the month while the 2-year TIPS breakeven inflation rate rose 17 bps. The 10-year and 2-year rates currently sit at 2.44% and 3.24%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 8 bps on the month. It currently sits at 2.16%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve, where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long-end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect it will. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 9 basis points in November, dragging year-to-date excess returns down to +26 bps. Aaa-rated ABS underperformed by 11 bps on the month, dragging year-to-date excess returns down to +13 bps. Non-Aaa ABS performed in line with Treasuries in November, keeping year-to-date excess returns steady at +93 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). The result is that the collateral quality backing consumer ABS is exceptionally high. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in November, dragging year-to-date excess returns down to +155 bps. Aaa Non-Agency CMBS underperformed Treasuries by 30 bps in November, dragging year-to-date excess returns down to +63 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 70 bps, dragging year-to-date excess returns down to +469 bps (Chart 10). Though returns have been strong this year and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 47 basis points in November, dragging year-to-date excess returns down to +58 bps. The average index option-adjusted spread widened 9 bps on the month. It currently sits at 40 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.     Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -62 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 62 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 30th, 2021) Powell’s Pivot Powell’s Pivot Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 30th, 2021) Powell’s Pivot Powell’s Pivot Table 6Discounted Slope Change During Next 6 Months (BPs) Powell’s Pivot Powell’s Pivot Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11 Footnotes 1   Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 5  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.

Highlights Fed: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. Treasuries: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporates: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. MBS: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios. Feature Chart 1Curve Flattening Is Overdone Curve Flattening Is Overdone Curve Flattening Is Overdone Up until Friday, the bear-flattening of the Treasury curve was a well-established trend, one that even accelerated early last week before revelations about the new omicron COVID variant sent yields sharply lower (Chart 1). Large swings in expectations about the timing of Fed liftoff have been responsible for the recent volatility in Treasury yields. Back in September, the market was priced for no rate hikes at all until 2023. Just two months later we find the fed fund futures market pricing Fed liftoff in July 2022 with 75% odds of three rate hikes before the end of next year (Chart 2A). At one point early last week the market was priced for Fed liftoff in June 2022, with 32% chance of liftoff in March 2022 (Chart 2B). Chart 2ALiftoff Expectations: H2 2022 Liftoff Expectations: H2 2022 Liftoff Expectations: H2 2022 Chart 2BLiftoff Expectations: H1 2022 Liftoff Expectations: H1 2022 Liftoff Expectations: H1 2022   Pre-Omicron Market Moves June and March liftoff dates came into play early last week because of mounting evidence that the Fed is considering accelerating the pace of its asset purchase tapering. As it stands now, the current pace of tapering gets net asset purchases to zero by June of next year. Given the Fed’s stated preference for lifting rates only after tapering is finished, the current pace means that Fed liftoff is only possible in H2 2022 or later. However, if the pace of tapering is increased it would make earlier liftoff dates possible. It was speculation about an announcement of accelerated tapering at the December FOMC meeting that caused the market to bring June and March 2022 liftoff dates into play last week. Speculation about an accelerated taper really got going after an interview by San Francisco Fed President Mary Daly. Daly is widely regarded as one of the most dovish members of the FOMC, and indeed in last week’s report we highlighted her November 16th speech that called for patience in the face of high inflation.1 But last week, Daly said in an interview that “if things continue to do what they’ve been doing, then I would completely support an accelerated pace of tapering.”2 With one of the most dovish FOMC members seemingly on board, we see a good chance that the committee will announce an accelerated taper at the next meeting. As of today, we’d put the odds of an accelerated taper announcement in December at 50%, with still one more CPI report and one more employment report that will tip the scales in one direction or the other before the Fed meets. An accelerated taper doesn’t necessarily mean that the Fed will move toward earlier rate hikes, it simply gives the committee the option to hike sooner if inflation remains stubbornly high. In fact, we’ve been expecting a later liftoff date (December 2022) on the view that inflationary pressures will wane between now and the middle of next year. We continue to think that a September 2022 or December 2022 liftoff date is the most likely outcome, as we expect that falling inflation during the next six months will allow the Fed to focus more on the employment side of its mandate. However, if inflation doesn’t fall as we expect, then the Fed may move more quickly. The Impact Of The Omicron Variant Chart 3Households Have Ample Savings Households Have Ample Savings Households Have Ample Savings Friday’s revelation that a new COVID variant (the omicron variant) has been identified sent yields lower and caused the market to push out its liftoff expectations. As of today, available evidence suggests that the omicron variant will out-compete the delta variant and quickly become the world’s dominant COVID strain. There is some evidence to suggest that current vaccines will offer less protection against omicron. However, it is still unknown whether the omicron variant causes more (or less) severe illness than prior strains. Even in a severe scenario where the new strain leads to the re-imposition of lockdown measures, we are puzzled by Friday’s bond market moves. The market seems to be saying that a prolonged pandemic will be deflationary and lead to a later Fed liftoff date. We aren’t so sure that’s the case. US households continue to enjoy a large buffer of accumulated savings compared to the pre-COVID trend (Chart 3) and they have ample room to increase consumer debt (Chart 3, bottom panel). This suggests that aggregate demand will stay well supported next year, even in the face of greater pandemic concerns. The re-imposition of lockdown measures, however, will hamper the supply side of the economy and prolong the economy’s issues with supply chain bottlenecks and labor shortages. It will also prevent consumers from shifting demand away from over-heating goods sectors and towards services. All of this will only keep inflation higher for longer, a development that could actually encourage the Fed to act more quickly. Bottom Line: Until more is learned about the omicron variant, our base case view remains that the Fed will lift rates later than what is currently priced in the market. We think a September or December 2022 liftoff date is reasonable. However, if inflation refuses to fall during the next 3-6 months there is a risk that the Fed will be tempted to move earlier. The Treasury Market Implications Of Earlier Liftoff Tables 1A – 1C show expected 12-month returns for different Treasury maturities. Each table assumes that the market moves to fully price-in a specific expected path for the fed funds rate during the 12-month investment horizon. Chart Chart Chart The scenario presented in Table 1A assumes that the Fed starts to lift rates in June 2022. It then proceeds with rate increases at a pace of 100 bps per year before the fed funds rate levels-off at 2.08%, 8 bps above the lower-end of a 2.0% - 2.25% target range.3 The scenarios presented in Tables 1B and 1C use the same rate hike pace and terminal rate as in Table 1A. However, we vary the expected liftoff dates. Table 1B assumes that liftoff occurs at the September 2022 FOMC meeting and Table 1C assumes that liftoff occurs at the December 2022 FOMC meeting. The first big conclusion we draw is that expected Treasury returns are negative for most maturities in all three scenarios. This justifies sticking with below-benchmark portfolio duration. Second, expected returns are better at the short-end of the curve (2yr) than at the long-end (10yr) in all three scenarios. This justifies sticking with our recommended 2/10 yield curve steepener. Specifically, we advise clients to buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Finally, the 20-year bond continues to offer greater expected returns than the 10-year and 30-year maturities. We view this as an attractive carry trade opportunity and advise clients to buy the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. Bottom Line: Our main Treasury curve investment recommendations: below-benchmark portfolio duration and 2/10 curve steepeners, are not that sensitive to the timing of Fed liftoff. Both positions should be profitable whether the first rate hike occurs in June 2022 or December 2022. Corporate Spreads: Just A Tremor, Not The Big One Chart 4IG Spreads Troughed In September IG Spreads Troughed In September IG Spreads Troughed In September Corporate bond spreads had already been widening before Friday’s news sent them even higher (Chart 4). Prior to Friday, the most likely reason for spread widening was a concern about a quicker pace of Fed tightening. As we highlighted in last week’s report, corporate balance sheet health is sublime and all signs point to default risk remaining low for some time.4 In fact, up until Friday, investment grade corporates were performing worse than high-yield as spreads widened. This suggests that the widening had more to do with perceptions of monetary accommodation than with perceptions of default risk. Then, on Friday, spreads widened sharply and high-yield underperformed investment grade. This is consistent with the market pricing-in an increase in expected default risk due to the emergence of the omicron variant. Our view is that the recent bout of spread widening will reverse in the near-term. Spreads will tighten back down to their recent lows giving investors an opportunity to reduce exposure sometime next year. We posit three possible scenarios: In the first scenario, the omicron COVID variant turns out to be less economically impactful than the recent delta strain. In this case, the recent spike in default expectations will reverse and inflation will moderate during the next six months as pandemic fears recede. In this scenario, the Fed will be able to wait until September or December 2022 – when its “maximum employment” target will be met – before lifting rates. Spreads will tighten on expectations of more accommodative monetary policy. Chart 5Pace Of Curve Flattening Will Moderate Pace Of Curve Flattening Will Moderate Pace Of Curve Flattening Will Moderate In the second scenario, the omicron COVID variant turns out to be inflationary. US consumer demand is not curbed significantly, but supply chains remain under pressure and labor shortages persist. This will encourage the Fed to move more quickly, possibly lifting rates as early as June. However, even this scenario would only see the 3-year/10-year Treasury slope dip below 50 bps in March of next year (Chart 5). Our prior research has shown that excess corporate bond returns tend to be strong when the 3-year/10-year Treasury slope is above 50 bps, as this suggests a highly accommodative monetary environment.5 We would likely see another period of spread tightening between now and March, even in this worst-case scenario for corporate spreads. The final possible scenario is one where the omicron COVID variant turns out to be deflationary. Growth and inflation both slow and the Fed significantly delays tightening, possibly into 2023. Given the robust health of corporate balance sheets, this scenario would be excellent for corporate bond returns. The deflationary shock would have to be very severe, much worse than the delta wave, to push the default rate meaningfully higher. Further, a shift toward more accommodative Fed policy would lengthen the runway for strong corporate bond returns. That is, it would be some time before the 3-year/10-year slope dips below 50 bps. Bottom Line: Investors should remain overweight spread product versus Treasuries in US bond portfolios, maintaining a preference for high-yield corporates over investment grade. The recent bout of spread widening caused by expectations of more restrictive monetary policy and news about the omicron variant will reverse in the coming months. Investors will be able to reduce cyclical corporate bond exposure at more attractive levels sometime next year. Stay Negative On Agency MBS We have been recommending an underweight allocation to Agency MBS in US bond portfolios for quite some time, and that is not likely to change anytime soon. Since the March 23rd 2020 peak in credit spreads, conventional 30-year Agency MBS have outperformed a duration-matched position in Treasuries by 0.59% while Aaa and Aa-rated corporate bonds have outperformed by 16% and 15%, respectively (Chart 6). MBS performance has been particularly poor since the spring. A big reason why is that MBS spreads did not adequately compensate investors for the magnitude of mortgage refinancings. Chart 7 shows that the compensation for prepayment risk embedded in MBS spreads (the option cost) plunged in mid-2020 as interest rates were cut to zero and mortgage refis spiked. In fact, the option cost embedded in MBS spreads was the lowest it had been in several years (Chart 7, panel 2), signaling that the market was priced for a big drop in refi activity. However, that big drop in refi activity never materialized. The MBA Refinance Index has remained elevated in 2021 (Chart 7, bottom panel), despite the back-up in bond yields. Chart 6MBS Returns Have Lagged Corporates MBS Returns Have Lagged Corporates MBS Returns Have Lagged Corporates Chart 7Option Cost Must Rise Option Cost Must Rise Option Cost Must Rise An increase in cash-out refinancings is a big reason for the stickiness in refi activity this year. Home prices have been on a tear and households have an increasing incentive to tap the equity in their homes (Chart 8). Freddie Mac recently noted an increase in both the share of refinancings that are for “cash-out” and the aggregate dollars of equity that borrowers are extracting from their homes.6 They also noted, however, that the amount of equity extraction as a percent of property values has trended down. This suggests that this trend toward cash-out refinancings is not yet exhausted. In fact, we expect refi activity will remain elevated during the next 6-12 months, even as bond yields move modestly higher. Chart 8Households Can Tap Their Home Equity Households Can Tap Their Home Equity Households Can Tap Their Home Equity Against this back-drop, our sense is that the compensation for prepayment risk embedded in MBS spreads remains too low. But, even if we assume that the MBS option cost is exactly right, it still wouldn’t make Agency MBS look attractive compared to alternative investments. The option-adjusted spread (OAS) offered by conventional 30-year Agency MBS is below the OAS offered by Aaa and Aa-rated corporate bonds (Chart 9). It is only slightly above the OAS offered by Agency CMBS and Aaa-rated consumer ABS. Chart 9OAS Differentials OAS Differentials OAS Differentials Bottom Line: Agency MBS are unattractive relative to other US spread products, and current MBS valuations may understate the future pace of mortgage refi activity. Remain underweight Agency MBS within US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 2 https://news.yahoo.com/san-francisco-fed-mary-daly-certainly-see-a-case-for-speeding-up-taper-142328227.html 3 The effective fed funds rate currently trades 8 bps above the lower-end of its target range, and we assume that this will continue to be the case. 4 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 5 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 6 http://www.freddiemac.com/research/insight/20211029_refinance_trends.page Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Feature Over the past months, we have seen a potent bout of volatility in developed government bond markets, as investors have tried to assess the “lift-off” dates for central bank hiking cycles and the speed and cumulative degree of eventual monetary tightening. Record inflation prints have also created a communication challenge for central banks, with investors demanding more certainty in relation to the preconditions that need to be met in the data for central banks to raise rates. Adding to the uncertainty are the new frameworks adopted by the US Federal Reserve and the European Central Bank (ECB) that allow for overshoots of the 2% inflation target to make up for historical undershoots. However, it remains to be seen how committed policymakers will be to these new frameworks. Even the historically dovish European Central Bank has been forced to talk down market pricing, with overnight swap markets eyeing a rate hike as early as next year. Across the English Channel, the Bank Of England, which initially baffled investors by failing to deliver a rate hike during its November meeting, now appears to have embarked on a new path, with Governor Andrew Bailey calling into question the very efficacy of forward guidance itself and possibly returning to making decisions on a meeting-by-meeting basis. Chief Economist Huw Pill has recently talked about “training” people to “think the right way about monetary policy,” but it remains to be seen if market participants will be receptive students. In any case, it is clear that the uniformly dovish period of extraordinary monetary accommodation induced by the pandemic is at an end. To navigate the uncertainty as central banks shift gears toward tighter policy on the margin, we are introducing revised versions of our BCA European Central Bank monitors this week. These indicators use economic and financial market data to gauge whether the current stance of monetary policy lines up with current conditions. Our revisions focus on making the monitors more dynamic and responsive to shifts in central bank reaction functions. Overall, the message from our new monitors is clear—rebounding growth and inflation data mean that all our indicators are moving in a direction more consistent with tighter policy even after Friday's market action (Chart 1). In the following sections of this report, we cover in greater detail the methodological changes to our indicators, followed by region-level assessments of the five new monitors introduced in this report for the Euro Area, UK, Sweden, Norway, and Switzerland. Chart 1The New BCA European Central Bank Monitors The New BCA European Central Bank Monitors The New BCA European Central Bank Monitors What’s New? We have made three major improvements to our central bank monitors: First, the sub-components—economic growth, inflation, and financial conditions—are no longer calculated as a simple average of their constituent data series. Instead, each data series is now weighted according to the degree that it moves in conjunction with other data series over a 60-month rolling window. In other words, data series that are highly correlated with other series receive a greater weight. There are two benefits to this approach: (i) it makes the monitors more dynamic and (ii) it adjusts for changes in correlations over time. Second, the weights of each of the three sub-components in the overall monitor are now determined so as to minimize the sum of squared residuals (SSR) of a regression of the 12-month change in policy rate (the dependent variable) with the readings from our monitors (the independent variable). We have imposed two constraints: each sub-component must have a minimum weight of 15% and may not weigh more than 70%. More importantly, the weights are now re-calculated every 60 months. In doing so, there is no assumption that central bankers’ reaction function is constant over time, and it avoids look-ahead bias. There is also the natural question of how to optimize the weights of our sub-components when policy rates remain flat for extended periods at, or near, the Zero Lower Bound (ZLB). While we did consider calculating a different set of weights targeting the annual change in assets held by the Central Bank during ZLB periods, we eschewed this approach for two reasons: these periods are neither frequent nor sufficiently prolonged to provide an appropriate sample. As a result, the weights currently applied to the monitors are based on the 60 months preceding policy rates reaching the Zero Lower Bound. Table 1 shows the weights currently being used for each monitor. Table 1European Central Bank Monitors' Weights A Tour Of The New BCA European Central Bank Monitors A Tour Of The New BCA European Central Bank Monitors Third, all of the data series included in our monitors are now standardized over 60-month rolling time horizons. Like the changes made to the weight calculation above, it ensures the monitor does not rely too heavily on either past or future data. Although central banks’ mandates do not change often—if at all—their reaction functions do. Take inflation, for instance. Our monitors should not factor in the level of price changes experienced in the 1970s as a benchmark to determine whether a central bank should be more or less accommodative based on what inflation is today. We also took this opportunity to make changes to the data series included in the monitors, with a focus on including higher-frequency series to improve the timeliness of the indicator. All in all, clients should note that these improvements do not change the interpretation of the monitors. A rising trend is still consistent with fundamentals that would have caused central banks to tighten in the past and vice versa. ECB Monitor: Stay Put Chart 2Euro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Our European Central Bank (ECB) Monitor is currently in positive territory, suggesting that the ECB should be removing accommodation (Chart 2). However, the ECB did not sound any more hawkish at the close of its last meeting held at the beginning of the month. The latest surge of COVID-19 cases in Europe and subsequent governments’ responses will weigh on economic growth and give reason to the ECB not to rush into a new tightening cycle. It will also be interesting to see how the renewed energy crisis affects President Christine Lagarde's stance on the transitory aspects of inflation. The components of our ECB Monitor are consistent with these two forces (Chart 2, panel 2). Strong economic data prints have been losing steam this year, which weighed on the economic growth component. Nonetheless, this indicator now tries to move back up. Meanwhile, the inflation component is surging, driven by both the rapid acceleration in European realized inflation and CPI swaps. We have argued that energy, taxes, and base effects account for the bulk of the price increases in the Euro Area, and that, as such, the ECB was correct in looking past them. Market participants do not agree with the ECB. The Euro Overnight Index Average (EONIA) curve is now pricing 15bps of tightening by the end of 2022 (Chart 2, bottom panel), which is unlikely to happen considering the ECB’s dovish communication and its adoption of AIT. In this context, we lean against the EONIA pricing and expect the ECB to increase rates in 2024, at the earliest. We also continue to recommend an overweight stance on European government bonds within global fixed income portfolios. BoE Monitor: Tightening On The Way Chart 3UK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Our Bank of England (BoE) monitor has continued its sharp rebound into positive territory since its trough in 2020 (Chart 3). While the BoE’s communication has been questionable, the Bank has done nothing to reverse its recent hawkish turn. This makes sense given economic data that is showing signs of an overheating economy. Consumer price inflation came in at 4.2% year-over-year in October, a ten-year high. And as we discussed in a recent BCA Research Global Fixed Income Strategy report, there are signs that rising inflation is having a dampening effect on consumer confidence, imperiling growth in 2022. Turning to the individual components of our BoE monitor, we see broad-based pressure to tighten policy, with all three components in solidly positive territory and rising quickly (Chart 3, middle panel). Inflationary pressures are being driven not only by strong CPI prints, but also by rising input prices and inflation expectations that are becoming unmoored from the BoE’s target. Meanwhile, capacity utilization scores from the BoE’s Agents’ Summary are at the highest level since 2007, creating scope for further inflation down the road. Growth is ebullient as well, with both manufacturing and services PMIs significantly above the 50 advance/decline line. Rising house prices and consumer lending are creating stability risks captured in the financial subcomponent of the monitor. Market anticipations for tightening over the next year have continued to increase, notwithstanding the muddled messaging from the BoE, with 111bps of tightening expected over the coming year (Chart 3, bottom panel). With the BoE set to be one of the more hawkish developed market central banks in 2022, we are comfortable maintaining an underweight stance on Gilts within global government bond portfolios. Riksbank Monitor: On Hold, But Not For Long Chart 4Sweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Our Riksbank Monitor is now close to neutral, after reaching all-time highs earlier this year (Chart 4). For now, the Riksbank seems content to continue to hold the repo rate at 0%, while expanding the size of its balance sheet. Taking a closer look at the breakdown in the Riksbank Monitor, we can see that the earlier surge was mostly driven by the financial conditions component, which is still solidly in positive territory (Chart 4, panel 2). The inflation component confirms that inflation is still not a concern for the Riksbank. In fact, core CPI stands at 1.82% annually, below the 2% target and far from what other developed economies are currently experiencing. We expect the ongoing robust economic recovery to continue lifting the economic growth component, which, at some point in the future, should place more pressure on the Riksbank to remove accommodation. Market participants have only started pricing in some rate hikes from the Riksbank recently (Chart 4, bottom panel). Still, we view this 35bps of expected tightening as too modest relative to the actual pressure on the Riksbank to tighten policy. The positive outlook for the Swedish economy,1 as well as rising house prices and household indebtedness, will force the Riksbank to tighten policy before the ECB—all of which may happen sooner if inflation starts to accelerate. Consequently, Swedish sovereign debt does not appear as an attractive underweight candidate in global government bond portfolios. Norges Bank Monitor: More Hikes To Come Chart 5Norway: Norges Bank Monitor Norway: Norges Bank Monitor Norway: Norges Bank Monitor Our Norges Bank Monitor is well into positive territory and continues to increase, signaling pressure for tighter policy (Chart 5). In September, the Norges Bank became the first of the G10 central banks to deliver a rate hike, which it paired with forward guidance suggesting hikes at its coming December, January, and March meetings. We believe such an outcome is supported by the data, which show pressure to tighten on a growth and inflation basis (Chart 5, middle panel). The growth subcomponent of our indicator has been driven by rebounding business and consumer sentiment. Meanwhile, inflationary pressures have been driven by rising capacity utilization and producer prices, which grew at an unbelievable 60.8% year-over-year in October, the highest annual growth rate that has ever been recorded for the series. The reading from the financial subcomponent is more neutral, hovering above the zero level. This slight decline this year may largely be explained by slowing house price growth and falling debt service ratios. However, the NOK remains undervalued on a PPP-basis, which, at the margin, creates pressure on the Norges Bank to tighten. Overnight index swap curves are currently discounting 136bps of tightening in Norway over the coming year. We believe this is a realistic outcome, given the Norges Bank’s uniquely hawkish reaction function and pressures to tighten, which are not likely to dissipate any time soon. We remain bearish on Norwegian government debt. SNB Monitor: Still About The Swiss Franc Chart 6Switzerland: SNB Monitor Switzerland: SNB Monitor Switzerland: SNB Monitor Our Swiss National Bank (SNB) Monitor has decreased somewhat after peaking earlier this year, but remains solidly in positive territory, which suggests that the SNB should remove accommodation (Chart 6). This is unlikely to happen anytime soon. At the Central Bank leadership’s annual meeting with the Swiss government last month, the SNB emphasized the need to maintain accommodative monetary policy. In so doing, it kept policy rate and interest on sight deposits at the SNB at −0.75%, while remaining willing to intervene in the foreign exchange market as necessary, in order to counter upward pressure on the Swiss franc. After all, the currency remains the main determinant of Swiss monetary conditions. Therefore, the SNB will continue to try to cap the upside in the CHF vis-à-vis the EUR, because it considers the Swiss franc "highly valued". Meanwhile, inflation does not seem to be an imminent concern for the SNB. Headline inflation and core inflation stand at 1.25% and 0.58%, respectively. All three components of our SNB Monitor appear to send the same message at the moment (Chart 6, panel 2). Markets largely seem to believe the SNB’s unwillingness to tighten monetary policy (Chart 6, bottom panel). Only 16 bps of tightening are priced over the next 12 months, and 54bps over the next 24 months. We maintain our neutral stance on Swiss bonds within global portfolios, given low liquidity. Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com   Footnotes 1      Please see BCA Research European Income Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcareseach.com.

Highlights There are a few consistencies with the dollar breakout. Global growth is peaking and the risk of a significant slowdown early next year has risen. As a momentum currency, further gains in the DXY remain very high in the near term. We are shifting our near-term target to 98 (previously 95). That said, the dollar is now close to pricing a global recession, which seems improbable given easy monetary settings and ample fiscal stimulus. High inflation is not a US-centric phenomenon but a global problem. This means that monetary policy in the US cannot sustainably diverge from other central banks. Correspondingly, low US TIPS yields do not confirm the breakout in the dollar. Even if the US 10-year Treasury yield rises towards 2.5%, real interest rates will remain very low compared to history and other G10 economies. While global growth will slow next year, we expect that it will remain robust. And if it rotates from the US to other countries, the dollar will have a very sharp reversal. Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Feature Chart I-1The Dollar Diverges From Real Rates The Dollar Diverges From Real Rates The Dollar Diverges From Real Rates After spending most of this year range bound between 89 and 94, the DXY index has broken out. The narrative has been centered around rising US inflation, which will trigger much faster interest rate increases from the Fed. This is consistent with recent economic data, where US inflation has indeed blown out, and is also rising at the fastest pace among G10 countries. What has been inconsistent is that US TIPS yields remain very low, and have diverged from the broad dollar trend (Chart I-1). One of the key structural drivers of currencies is real interest rate differentials. If the Fed does move ahead of the inflation curve and aggressively hikes interest rates, then US TIPS yields will rise and catch up with the dollar. Otherwise, the recent rise in the greenback could represent a capitulation phase that will quickly reverse should the inflationary mania subside. Consistencies With The Dollar Rise 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 (Chart I-2). 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). The market suggests that compared to earlier this year, a 63bps spread difference is now warranted between US and European interest rates, while an 80bps difference is appropriate vis-à-vis Japanese rates. This shift perfectly explains the move in the dollar over the last few weeks (Chart I-3). Chart I-2Markets Now Expect A More Hawkish Fed Markets Now Expect A More Hawkish Fed Markets Now Expect A More Hawkish Fed Chart I-3A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally A Key Driver Of The Dollar Rally These market moves have been consistent with economic developments. Upside economic surprises in the US have dominated other G10 economies and supported the dollar (Chart I-4). The slowdown in China has been another hiccup in the global growth story. While global export growth has remained relatively resilient, the narrative is that the slowdown in Chinese demand is metastasizing into a genuine slump that will impact commodity import demand and hurt procyclical currencies liked the AUD (Chart I-5). Chart I-4Positive Economic Surprises Have Supported A Strong USD Positive Economic Surprises Have Supported A Strong USD Positive Economic Surprises Have Supported A Strong USD Chart I-5A Slowing China Has Hurt Currencies Like The AUD A Slowing China Has Hurt Currencies Like The AUD A Slowing China Has Hurt Currencies Like The AUD The slowdown is not unique to China. With new Covid-19 infections surging in various European countries, ex-US economic data is likely to remain underwhelming early next year. Within this context, the US economy remains relatively immune. Exports explain only 10% of US GDP. The IMF projects that the US is one of the first countries to close its output gap (Chart I-6). This will support a tighter monetary stance in the US, compared to other G10 countries. Chart I-6 Contradictions With The Dollar Rally There are a few contradictions with the dollar rally. First, the Fed is already lagging the US inflation curve. Various DM and EM central banks have calibrated monetary policy higher in response to rising inflation (Chart I-7). While the Fed might accelerate the pace of tapering asset purchases, other central banks in developed economies have already ended QE and are raising rates. At some point, relative monetary policies would matter for currencies, as has historically been the case. Since the start of the year, market pricing for higher rates according to the OIS curve has been lifted for most G10 countries (Table 1). Yet the dollar has rallied, while other currencies have collapsed (Chart I-8). Chart I-7Many Central Banks Are Already Hiking Interest Rates Many Central Banks Are Already Hiking Interest Rates Many Central Banks Are Already Hiking Interest Rates Chart I- Chart I-8Will The Fed Hike As Much As Is Priced By The Dollar? Will The Fed Hike As Much As Is Priced By The Dollar? Will The Fed Hike As Much As Is Priced By The Dollar? Second, part of that rally has been driven by speculative inflows, and not by underlying economic fundamentals. Net speculative positions in the US dollar are near levels that have usually signaled that the trade is becoming much crowded (Chart I-9). As we highlighted in Chart 1, this has occurred amidst very low nominal and real interest rates. But more importantly, as a reserve currency, the dollar enjoys the priviledge of being the safe-haven asset of choice. It is quite plausible that one of the key drivers of the rally has also been hedging by fund managers for an equity market correction (Chart I-10). Chart I-9Speculators Are Nearing Exhaustion ##br##Levels Speculators Are Nearing Exhaustion Levels Speculators Are Nearing Exhaustion Levels Chart I-10Long Dollar Is Being Used To Hedge Bullish Equity Bets Long Dollar Is Being Used To Hedge Bullish Equity Bets Long Dollar Is Being Used To Hedge Bullish Equity Bets Third, inflation could indeed prove to be transitory. Our sister publication, the Commodity & Energy Strategy, suggests that metals and oil prices will remain well bid in the near term. Inflation however is about rates of change. Natural gas prices rose 100% this year while oil prices rose 60%. Market expectations are that these prices will roll over (Chart I-11). The Baltic Dry Index, a proxy for shipping costs and supply bottlenecks, initially rose 300% and is now down 53% from its peak. A middle ground where prices remain well bid but do not generate the same inflationary impulse next year seems most plausible. This will ease all market expectations for central bank hawkishness, but could sound the death knell for the dollar that has quickly moved to price in the current market narrative. Chart I-11Some' Inflation Will Be Transitory Some' Inflation Will Be Transitory Some' Inflation Will Be Transitory Fourth, a strong US dollar hurts US growth. According to the Fed’s own estimates, a 10% rise in the dollar reduces US growth by 0.5% in the subsequent four quarters and 1.2% over two years. Meanwhile, a strong US dollar will certainly alleviate pressure on the Fed to fight inflation. A Counterpoint View To The Market Narrative Covid-19 will be with us for a while. As such, the volatility of growth forecasts around infection waves will subside. The remarkable thing is that despite fears of a global growth slowdown, there is a pretty robust expectation that the US will fare poorly relative to other developed markets in terms of growth next year. Countries such as Canada, New Zealand, the UK, and Japan are seeing a bottoming in growth momentum relative to the US (Chart I-12). For some, this is occurring at the same time as their local central banks are becoming more orthodox about monetary policy. As we have argued earlier, this is clear real-time evidence that the Fed will lag the inflation curve. Chart I-12AA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US Chart I-12BA Global Growth Rebound Outside The US A Global Growth Rebound Outside The US A Global Growth Rebound Outside The US One key signpost is China. It has tightened policy amidst very low inflation, and the traditional relationship between real rates and the RMB is working like a charm as the currency appreciates in trade-weighted terms. In a nutshell, currency markets tend to reconverge with real interest rate differentials over time. This will eventually be the case with the dollar (Chart I-13). Chart I-13Real Interest Rates Eventually Matter For Currencies Real Interest Rates Eventually Matter For Currencies Real Interest Rates Eventually Matter For Currencies Finally, China might marginally ease policy to sustain growth. In our view, China could stand pat since nominal bond yields are falling and exports are robust suggesting overall financing conditions are not a problem. But if this is a primate cause for fuelling long dollar bets, that will eventually hurt EM demand, China could also shift. This will be bullish for the dollar in the near term (it will require a riot point for China to shift), but bearish the dollar over a cyclical investment horizon, as commodity economies bottom. Investment Strategy Chart I-14Current Dollar Strength Is Pricing In A Manufacturing Recession Current Dollar Strength Is Pricing In A Manufacturing Recession Current Dollar Strength Is Pricing In A Manufacturing Recession In the current environment, the DXY could hit 98. This will be consistent with a blowout in our capitulation index, as well an exhaustion of dollar bulls. That said, the dollar is now close to pricing a global manufacturing recession, which seems improbable given easy monetary settings and ample fiscal stimulus in most DM economies (Chart I-14). Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Finally, our agnostic trading model continues to suggest short dollar positions (Chart I-15). Admittedly, it is the valuation component driving the calibration, rather than sentiment or appreciation for the investment shift in the macro narrative. In our portfolio, we will sit on the sidelines until most of our intermediate-term indicators stage a reversal. Chart I-15AOur Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Chart I-15BOur Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now Our Model Is Short The Dollar, But Stand Aside For Now 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

Highlights Fed: The Fed is embroiled in a debate about whether to move more quickly toward rate hikes. Our expectation is that the Fed will remain relatively dovish unless 5-year/5-year forward inflation expectations show signs of breaking out. We continue to expect liftoff in December 2022. TIPS: We recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Investors should short 2-year TIPS outright, enter 2/10 inflation curve steepeners and 2/10 real (TIPS) curve flatteners. Corporate Bonds: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Should The Fed Take Out Some Insurance? Inflation has arrived much earlier in the cycle than usual and it has put the Fed in a tough spot. The so-called Misery Index – the sum of the unemployment and inflation rates – has moved in the wrong direction this year (Chart 1), and there is increasing disagreement about how the Fed should respond. Chart 1A Setback For The Fed A Setback For The Fed A Setback For The Fed The Case For Buying Insurance On the one hand, some people – both inside and outside the FOMC – are calling for the Fed to move more quickly toward tightening. One notable external voice is the former Chair of the Council of Economic Advisers Jason Furman who just published a report calling for the Fed to speed up the pace of tapering so that it can prepare markets for rate hikes starting in the first half of 2022.1 Such a policy shift would significantly impact bond markets, which are currently priced for Fed liftoff to occur at the July 2022 FOMC meeting and for 69 bps of rate hikes in total by the end of 2022 (Chart 2). This equates to 100% odds of two 25 basis point rate hikes in 2022, with a 92% chance of a third. Chart 22022 Rate Expectations 2022 Rate Expectations 2022 Rate Expectations Furman makes the point that the Fed has already achieved its new Flexible Average Inflation Target (FAIT). The PCE deflator has averaged more than 2% annual growth since the target was adopted in August 2020 and even since just before the pandemic (Chart 3). Inflation has still averaged only 1.7% annual growth during the post-Great Financial Crisis period, but FOMC participants have generally focused on shorter look-back periods when discussing the FAIT framework. Chart 3The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action The Fed's Flexible Average Inflation Target In Action In addition to its FAIT framework, the Fed has articulated a three-pronged test for when it will lift rates. The Fed has promised to only lift rates once (i) PCE inflation is above 2%, (ii) PCE inflation is expected to remain above 2% for some time and (iii) labor market conditions have reached levels consistent with “maximum employment”. Furman argues that the Fed should abandon this three-pronged liftoff test on the grounds that it leaves no room for assessing how far inflation is from its goal. For example, Furman says that if we take the Fed’s guidance literally then “it would not lift rates in the face of a 10 percent inflation rate if the unemployment rate was even 0.2 percentage points above its full employment level.” Chart 4Short-term Inflation Expectations Short-term Inflation Expectations Short-term Inflation Expectations Effectively, Furman is arguing for the Fed to take out some insurance against the risk of long-lasting inflationary pressures. Inflation is high right now. It may come back down naturally, but it may not. Furman argues that it makes sense for the Fed to marginally tighten policy in the meantime to lessen the risk of falling behind the curve and having to play catch-up. Fed Governor Christopher Waller seems to agree with most of Furman’s arguments. Waller also argued for speeding up the pace of tapering in a recent speech, and while he didn’t go so far as to say that the Fed should abandon its maximum employment test for liftoff, he implied that his personal definition of “maximum employment” could be achieved very soon.2 Waller said that after “adjusting for early retirements, we are only 2 million jobs short of where we were in February 2020”. This would suggest that just four more months of +500k employment gains, like we saw in October, would be enough for Waller to argue for rate increases. In his speech, Waller also mentioned the risk he sees from rising inflation expectations. He specifically pointed to elevated readings from the 5-year TIPS breakeven inflation rate, the New York Fed Survey of Consumers’ 3-year expectation, and the University of Michigan Survey’s 1-year expectation (Chart 4). Waller cautioned that: [I]f these measures were to continue moving upward, I would become concerned that expectations would lead households to demand higher wages to compensate for expected inflation, which could raise inflation in the near term and keep it elevated for some time. This possibility is a risk to the inflation outlook that I’m watching carefully. The Case Against Insurance    San Francisco Fed President Mary Daly sits on the other side of the argument. She argued against the Fed taking preemptive action to tame inflation in a recent speech.3  Her main argument is that rate hikes would do little to lower inflation in the near-term and may end up harming the economy down the road: Chart 5Long-term Inflation Expectations Long-term Inflation Expectations Long-term Inflation Expectations Monetary policy is a blunt tool that acts with a considerable lag. So, raising rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers. Like Waller, Daly also pointed to possible risks from rising inflation expectations. If the high readings on inflation last long enough, they could seep into our psychology and change our expectations about future inflation. Households would then expect prices to keep rising and ask for higher wages to offset that. Businesses, of course, would pass those increases on to consumers in the form of higher prices, causing workers to ask for even higher wages. And on it would go, in a vicious wage-price spiral that would end well for no one. However, unlike Waller, Daly said that “there is little evidence” that such an expectations-driven spiral is starting to take hold. To make her point, Daly stressed that long-term inflation expectations remain well-anchored near levels consistent with the Fed’s target. This is certainly true. Five-to-ten year ahead inflation expectations, whether from survey responses or derived from TIPS prices, have been remarkably stable during inflation’s recent surge (Chart 5). This would seem to suggest that people generally believe that current high inflation will fade over time, and that the Fed’s medium-term inflation target is not at risk. The BCA View Our sense is that there are a number of FOMC participants in both the hawkish and dovish camps. But for the time being, the fact that 5-year/5-year forward inflation expectations remain well-anchored tips the scale in favor of the doves. As a result, the Fed will watch the incoming data as it tapers asset purchases between now and June. If 5-year/5-year forward inflation expectations remain stable during that period, the Fed will wait until its “maximum employment” goal is met before lifting rates. However, if the 5-year/5-year forward TIPS breakeven inflation rate rises above 2.5%, the doves will capitulate and abandon the “maximum employment” liftoff target. The committee will move quickly toward tightening to stave off the sort of wage/price spiral described by both Waller and Daly. Our own view is that realized inflation will trend lower between now and next June. This will prevent 5-year/5-year forward inflation expectations from rising and will push down shorter-dated inflation expectations. As a result, the Fed will wait until its “maximum employment” target is met before lifting rates. We continue to think the first rate hike is most likely to occur at the December 2022 FOMC meeting, slightly later than what is currently priced in the market. On Inflation And TIPS Valuation We continue to recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries. While there is a risk that a lengthy period of high inflation will eventually lead to a break-out in long-maturity TIPS breakeven inflation rates, that risk must be weighed against the fact that our TIPS Breakeven Valuation Indicator shows that the 10-year TIPS breakeven inflation rate is too high relative to different measures of underlying inflation (Chart 6). Chart 6TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals TIPS Are Expensive Relative To Nominals Our TIPS Breakeven Valuation Indicator has a strong track record, with readings between -1 and -0.5 usually coinciding with a subsequent drop in the 10-year TIPS breakeven inflation rate (Table 1). Table 1TIPS Valuation Indicator Track Record The Fed’s Inflation Problem The Fed’s Inflation Problem Moreover, we continue to think that inflation is very likely to trend down during the next 6-12 months. The most important driver of today’s high inflation rate has been a remarkable surge in core goods inflation, from near 0% prior to the pandemic to 8.5% today (Chart 7). This jump in core goods prices is explained by a shift in the composition of consumer spending away from services and toward goods (Chart 8). This shift started during the worst of the pandemic when spending on services was not an option. Households diverted their spending toward goods at a time when COVID prevented factories from running at full capacity. Chart 7Goods Inflation Goods Inflation Goods Inflation Chart 8Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Consumer Spending: Goods v. Services Our sense is that as the impact of the pandemic fades, we will see the composition of spending shift back toward services and firms will also be able to increase capacity. The result will be a drop in core goods inflation during the next 6-12 months, one that is significant enough to send the overall inflation rate lower. In fact, there are already signs that inflation is close to peaking. The Baltic Dry Index – an index that measures the cost of transporting raw materials – has plunged (Chart 9), and other measures of the price of shipping containers are starting to top out (Chart 9, bottom 2 panels). All of these indicators tracked inflation’s recent rise and are now signaling an easing of bottlenecks in the goods supply chain. The upshot from an investment perspective is that falling inflation will keep a lid on long-maturity TIPS breakeven inflation rates during the next 6-12 months. It will also send short-maturity TIPS breakeven inflation rates lower, and we recommend an underweight allocation to TIPS versus nominal Treasuries at the front-end of the curve. The top panel of Chart 10 shows that the 2-year TIPS breakeven inflation rate has greatly exceeded the Fed’s target range. In contrast, the 10-year TIPS breakeven inflation rate is only slightly above target. If we assume a base case scenario where both rates trend toward the middle of the Fed’s target range during the next 12 months, and a base case scenario for nominal yields consistent with the Fed lifting rates in December 2022 and then hiking at a pace of 100 bps per year until reaching a 2.08% terminal rate (Chart 10, bottom panel), we see that the 2-year real yield has a lot of upside during the next 12 months (Chart 10, panel 2). This is true both in absolute terms and relative to the 10-year real yield. Chart 9Peak Shipping Costs Peak Shipping Costs Peak Shipping Costs Chart 10The Upside In Real Yields The Upside In Real Yields The Upside In Real Yields As a result, our view that inflationary pressures will ease during the next 6-12 months leads to the following investment recommendations: Short 2-year TIPS outright Enter 2/10 TIPS breakeven inflation curve steepeners Enter 2/10 real (TIPS) yield curve flatteners Corporate Balance Sheets Are In Great Shape Gross corporate leverage – the ratio of total corporate debt to pre-tax profits – has plunged during the past few quarters. This indicator is the backbone of our macro default rate model and, as such, its drop explains why there have been so few corporate defaults this year.4 Digging beneath the surface, we see that a great deal of leverage’s decline is explained by soaring profit growth, but a sharp drop in debt growth is also partly to blame (Chart 11). If we broaden our scope of corporate balance sheet indicators, the evidence further points to the fact that balance sheets are in great shape. Our Corporate Health Monitor – a composite indicator consisting of six different balance sheet metrics – is deep in “improving health” territory, aided by extremely high readings from the Free Cash Flow-to-Total Debt and Interest Coverage ratios (Chart 12). Chart 11Gross Leverage Is Falling Gross Leverage Is Falling Gross Leverage Is Falling Chart 12Corporate Health Monitor Corporate Health Monitor Corporate Health Monitor One thing that seems certain is that corporate profits will not continue to grow by more than 50%, as they did during the past four quarters. As such, we hesitate to make too big a deal out of balance sheet ratios that are directly tied to profit growth. However, even if we look at different measures of the amount of debt versus equity on corporate balance sheets, we arrive at the same conclusion that balance sheets are extremely healthy. The top panel of Chart 13 shows the ratio between total corporate debt and the market value of equity. This ratio is at its all-time low, but one could argue that it is being inappropriately flattered by elevated stock valuations. If we look at the ratio of total debt-to-net worth, where net worth is the difference between assets and liabilities with real estate assets valued at market value and non-real estate assets valued at replacement value, we also see a significant improvement and the lowest ratio since 2010 (Chart 13, panel 2). Finally, we also find the lowest ratio of debt-to-net worth since 2013 even if we value all non-financial corporate assets at historical cost (Chart 13, bottom panel). In other words, the message is clear. Corporate balance sheets have repaired themselves considerably since the pandemic and leverage ratios are the lowest they’ve been in years. This fact has not gone unnoticed by ratings agencies who’ve announced far more upgrades than downgrades so far this year (Chart 14). Chart 13Leverage Ratios Leverage Ratios Leverage Ratios Chart 14Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades Upgrades Much Higher Than Downgrades What about the path forward for balance sheets? Our view is that balance sheet health will stop improving at the margin, but that it still has a long way to go before it poses a risk for defaults or corporate bond spreads. The recent spike in profit growth will recede in the coming quarters. This sort of large jump in profits following a recession is fairly typical, but it also tends to be short-lived (Chart 11, panel 2). Further, while corporate debt growth probably won’t surge next year it is likely that it will start to increase. At present, slow corporate debt growth is explained by the fact that company earnings have far outpaced capital investment requirements (Chart 15). This is partly because earnings have been strong and partly because capex requirements have been low. This is about to change. Inventory-to-sales ratios are near record lows and we have already seen a jump in core durable goods orders. All of this points to a capex resurgence in 2022 that will be partially financed by rising corporate debt. Chart 15Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Debt Growth Will Rise In 2022 Bottom Line: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.piie.com/sites/default/files/documents/furman-2021-11-17.pdf 2 https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm 3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2021/november/policymaking-in-a-time-of-uncertainty/ 4 For more details on our Default Rate Model please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Expectations for monetary policy in Australia have turned aggressively hawkish over the past month, with markets now discounting multiple rate hikes next year. This pricing defies guidance from the Reserve Bank of Australia (RBA), which calls for no rate hikes until 2024. An update of our RBA Checklist shows that while there is a growing case for the RBA to tighten, there are still enough lingering uncertainties about the trajectory for growth (specifically, Chinese import demand) and inflation (specifically, wage growth) for the RBA to credibly remain on the sidelines next year. Fade the aggressive 2022 rate hike profile discounted in Australian interest rate markets by staying overweight Australian government bonds in global bond portfolios. Also position for a steeper yield curve (that should also benefit Australian bank stocks) and wider breakevens on Australian inflation-linked bonds. The Australian dollar offers compelling medium-term value, but play that through positions on the crosses (long AUD/NZD & AUD/CHF) with the RBA/Fed policy gap keeping a lid on AUD/USD in the near term. Feature With inflation surging across the world, investors have become hyper-sensitive to any potentially hawkish turn by central banks that have used ultra-accommodative monetary policy to fight the economic shock of the COVID-19 pandemic. Rapidly shifting interest rate expectations have triggered bouts of bond and currency volatility in countries like the UK, Canada and New Zealand over the past several months – with perhaps the biggest shock seen in Australia. Australian government bonds had enjoyed an impressive period of outperformance versus developed market peers between March and September of 2021. All that changed in late October (Chart 1), when the RBA effectively abandoned its yield curve control policy that anchored shorter-maturity bond yields with asset purchases, triggering a spike in Australian yields (the yield on the April 2024 government bond that was targeted by the RBA jumped +80bps in a single week). Interest rate expectations have rapidly been repriced higher to the point where there are now nearly four rate hikes in 2022 discounted in the Australian overnight index swap (OIS) curve – even with the RBA still formally saying that it does not expect to lift rates until 2024 (Chart 2). Chart 1The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations The RBA Will Likely Disappoint Market Expectations Chart 2A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates A Very Aggressive Term Structure For Aussie Interest Rates   In this Special Report, we revisit our RBA Checklist, originally introduced in January of this year, to determine if the time is indeed right to expect tighter monetary policy in Australia next year, which has implications for not only the Australian bond market but also the Australian dollar. While much of the checklist is flashing a need for the RBA to begin lifting rates, there are still enough lingering uncertainties on the outlook for inflation, the labor market and export demand to keep the central bank on hold in 2022. Checking In On Our RBA Checklist Chart 3Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Tentative Signs Of A Rebound In Aussie Economic Activity Before the recent Australian bond market turbulence, the potent policy mix from the RBA since the start of the pandemic – cutting the Cash Rate to 0.1%, with aggressive quantitative easing (QE) and yield curve control, all reinforced with very dovish forward guidance – helped cap market pricing for interest rate hikes. A sharp outbreak of the Delta Variant earlier this year, leading to severe economic restrictions in Australia’s major cities, also helped anchor bond yields Down Under on a relative basis compared with other countries. As RBA Governor Philip Lowe noted in his speech following the November 2 RBA policy meeting, “At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight. As [pandemic] restrictions are eased, spending is expected to pick up relatively quickly as people seek a return to a more normal way of life.” At the same time, Lowe stated that “the latest data and forecasts do not warrant an increase in the Cash Rate in 2022.” Thus, any attempt to begin unwinding RBA policy accommodation would require clear evidence that the impacts of the pandemic on economic growth, and also on inflation and financial stability, were evolving such that emergency policy settings were no longer required. On the growth front, there are already signs of recovery looking at reliable cyclical indicators like the manufacturing and services PMIs, which have rebounded by 6.2 points and 8.9 points, respectively, from the August lows (Chart 3). Yet while inflation expectations have remained fairly stable – the 5-year/5-year Australia CPI swap rate has stayed in a 2.2-2.5% range throughout 2021, despite the Delta outbreak – our RBA Monitor has rolled over, led by the economic growth components. This suggests there may be some diminished pressure for tighter monetary policy in Australia. To get a clearer picture on the outlook for Australian monetary policy over the next year, it is a good time to revisit our RBA Checklist - the most important things to monitor to determine when the RBA could be expected to turn more hawkish. We compiled the Checklist back in January, and the elements are still relevant today. 1.  The COVID-19 vaccination process goes quickly and smoothly (✓) We are placing a checkmark next to this part of our RBA Checklist. After a very slow start earlier in 2021, Australia has executed a successful vaccination campaign with 71% of the population now fully vaccinated (Chart 4). More importantly, the number of daily new infections is rolling over rapidly, and hospitalization rates remain low. This is allowing economic restrictions to be lifted quickly. Chart 4The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis The Beginning Of The End Of Australia's 2021 COVID Crisis 2.  Private sector demand accelerates as the impulse from COVID fiscal stimulus fades (✓?) We are tentatively giving a checkmark for this component of the Checklist, but with a question mark given some of the cross-currents visible on the consumer spending side. Real consumer spending rebounded sharply in the first half of 2021 (Chart 5). However,  the Delta lockdowns weighed on consumer confidence and demand in Q3, with retail sales contracting on a year-over-year basis (both in nominal and inflation-adjusted terms). Furthermore, much of the spending boom was fueled by Australian households running down the high savings accumulated during the 2020 COVID lockdowns. The household savings rate fell from a peak of 22% in Q2 2020 to 10% in Q2 2021, the last data point available, while real disposable income growth actually fell by -2.6% on a year-over-year basis in Q2. We expect the next few consumer confidence prints to improve sharply as economic restrictions are lifted, with consumer spending following suit. This would lead us to remove the question mark next to this item of the RBA Checklist. Already, business confidence is rebounding with the NAB survey bouncing 6 points in October (Chart 6), which should translate into increased capital spending and hiring activity by Australian companies that have maintained profitability during the pandemic (top panel). Chart 5Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Australia's Economy Holding Up Well Despite COVID Wave Chart 6Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment Resilient Business Confidence Will Support Employment   3. Inflation, both realized and expected, returns to the RBA’s 2-3% target (✓?) Chart 7 We are giving another tentative checkmark with a question mark for this entry in the RBA Checklist, given that wage growth remains modest despite high realized inflation. Australian headline CPI inflation, on a year-over-year basis, was 3.8% in Q2/2021 and 3.0% in Q3/2021, above the top of the 2-3% RBA target. Much of that inflation has come from the Transport sector, which includes the prices of both car fuel and new car prices, which contributed 1.1% to inflation in Q3 (Chart 7). The former is impacted by high oil prices and the latter is influenced by the global supply chain disruption and shortage of semiconductors used in cars. Beyond those sectors, there was a modest pickup in inflation across much of the consumption basket. Underlying inflation was more subdued but did pick up over the same Q2/Q3 period. Annual growth in the trimmed mean CPI accelerated from 1.6% in Q2 to 2.1% in Q3 - returning to the bottom half of the RBA’s target range for the first time since Q4/2015 (Chart 8). The latest RBA projections call for underlying inflation to stay in the lower half of the inflation target range in 2022 (2.25%) and 2023 (2.5%), although this is conditional on a steady tightening of the Australian labor market. The RBA is forecasting the unemployment rate, which was at 5.2% in October, to fall to 4.25% by the end of 2022 and 4% by the end of 2023. The RBA expects a tighter labor market to eventually boost wage growth to a pace consistent with underlying inflation staying within the RBA target band – which would then augur for tighter monetary policy. The central bank has repeatedly stated that annual growth in the Wage Cost Index, its most preferred measure of Australian wages, has historically been in the 3-4% range when underlying inflation was consistently between 2-3%. The Wage Cost Index grew by only 2.2% on a year-over-year basis in Q3, so still well below the pace that would convince the RBA that underlying inflation would stay within the target. This argues for a wait-and-see approach. Chart 8Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Wage Uncertainty Preventing A Hawkish RBA Turn Chart 9A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market A Rising Participation Rate Will Cushion Tightening In The Labor Market RBA Governor Lowe has noted that there is still ample spare capacity in labor markets that opened up because of COVID lockdowns, which will prevent a more rapid decline in the unemployment rate even with labor demand still quite strong. On that note – the Australian labor force participation rate fell from a 2021 high of 66.3% in March of this year to 64.7% in October, a 1.6 percentage point decline that provides a buffer to absorb the strong labor demand in Australia (Chart 9). Given that Australian inflation and wages are reported less frequently (quarterly) than employment data (monthly), it is a challenge for the RBA to quickly assess to true state of inflationary pressure in the Australian economy. We see the inflation data as being far more important than labor market developments in assessing the RBA’s next move. The RBA will likely want to a few more Wage Cost Index and CPI prints before signaling any move to hike rates sooner than currently projected. The RBA will not have a complete reading on wages for the first half of 2022 until August, when the Q2/2022 Wage Cost Index is released. Thus, it would not be until well into the latter half of 2022 before any shift in hawkish messaging could plausibly occur, at the earliest, even if CPI inflation were to surprise to the upside over the same period. The RBA will need to see price inflation confirmed by wage inflation before changing its stance. In a nutshell, robust inflation prints out of Australia will need to be reinforced by strong wage data, for the RBA to move the dial closer to market expectations for interest rate hikes. 4. House price inflation is accelerating (✓) We are placing a checkmark next to this piece of our Checklist. Given Australia’s past history with periods of surging home values, signs that housing markets are overheating could prompt the RBA to consider tightening monetary policy sooner than expected. On that front, there is plenty of evidence to give the RBA anxiety. Median house prices grew at a 16.8% year-over-year rate in Q2, the fastest pace since 2003, and now appear very expensive relative to median incomes (Chart 10). Chart 10House Price Appreciation Could Moderate House Price Appreciation Could Moderate House Price Appreciation Could Moderate High prices may eventually begin to turn away buyers, as the “good time to buy a home” component of the Melbourne/Westpac consumer confidence survey has fallen sharply (bottom panel). Some of that decline may also be due to the Delta wave, as the growth rate of new building approvals has also slowed alongside rising COVID cases (top panel). The RBA will likely want to see a few post-Delta prints on Australian house prices and housing demand to determine the true underlying trends. But given the extreme readings on overall house prices, the housing market is a legitimate reason for the RBA to turn more hawkish. 5. Export demand, particularly from China, is strong (x) We are NOT placing a checkmark next to this item of our RBA Checklist. A booming external environment could lead the RBA to feel more comfortable signaling rate hikes. So far, that has been the case via a rising terms of trade, which has positive implications for the valuation of the Australian dollar, as we discuss below. But on the volume front - which is critical for the growth outlook, and RBA policy decisions, given the importance of the export sector to the Australian economy - there is reason for caution. First, the Chinese economy continues to slow down. The Chinese credit impulse, one of the key gauges of momentum in domestic activity peaked in October last year and has been rolling over since. Historically, this has been a bad omen for Aussie exports in general, as well as the performance of the AUD (Chart 11). Almost 40% of Australian exports go to China. This suggests that exports of both coal and iron ore are particularly susceptible to a further slowdown in Chinese construction activity. That said, the slowdown in China has probably passed the “maximum deceleration” phase and the odds are that, going forward, both monetary and fiscal policy will be marginally eased. This will help cushion the Australian dollar and bond yields from undershooting below current levels. Chinese bond yields have already declined, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it has become a good proxy for monetary conditions. As such, the trend in Chinese bond yields has tended to lead Chinese imports. As Chinese going concerns finance working capital requirements at lower rates, this could help stabilize import volumes (Chart 12). Chart 11A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD A Slowdown In China Is A Risk For The AUD Chart 12Easing Financial Conditions In China Easing Financial Conditions In China Easing Financial Conditions In China Political tensions between Australia and China remain a key point of contention for higher Aussie terms of trade and an improving basic balance. However, many Australian exports are fungible and have been redirected to other countries. For example, despite China’s ban on Australian coal imports, Aussie export volumes and terms of trade remain robust, leading to a sharp improvement in Australia’s external accounts (Chart 13). This is because Australian exports to Japan, India, and South Korea have picked up as China has redirected imports of coal from Australia to other countries. Commodity prices remain resilient, but could face downside in the coming months. This is especially the case for Australian export prices, which have outperformed that of other commodity-producing nations, leading to the sharp improvement in the terms of trade (Chart 14). Part of the story has been a supply-side shock. But Australia is also relatively competitive in supplying the types of raw materials that China needs and wants such as higher-grade iron ore, which is more expensive, pollutes less, and is in high demand. Similarly, Australia is one of the largest exporters of liquefied natural gas, of which prices have been soaring in recent months amidst a global push to clean the planet. Chart 13An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD An Improving Basic Balance Supports The AUD Chart 14Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Australian Terms Of Trade Are Robust Historically, the terms of trade has been one of the best explanatory variables for the AUD. That said, our model suggests that even a 15%-20% decline in forward prices will still keep the AUD undervalued relative to levels implied by terms of trade (Chart 15). While Australian export prices have overtaken their 2011 highs, the AUD remains around 35% below 2011 levels. On a longer-term basis, Australia’s terms-of-trade improvement is likely to continue. First, a boom in global infrastructure spending is likely to keep the prices of the commodities Australia exports well bid. This includes both copper and iron ore. Second, China’s clean energy policy shift away from coal and towards natural gas will buffet LNG export volumes (Chart 16). Given that reducing - if not outright eliminating - pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and LNG import volumes. Chart 15A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD A Drop In Commodities Is Well Discounted By The AUD Chart 16 In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart 17). Significant investment in resource projects over the last decade are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, even in the absence of RBA rate hikes. This argues for short-term caution, but a longer-term bullish view on the Aussie. Chart 17External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings External Funding Will Face Competition From Domestic Savings Investment Implications A check of our RBA Checklist shows that the argument in favor of tighter monetary policy is becoming more compelling. However, the uncertainties over Australian wages and Chinese growth – both critical for the RBA’s next move - will not be resolved until the second half of 2022, so RBA tightening is not likely until the first half of 2023 at the earliest. There are a number of ways that investors can position for continued RBA dovishness in 2022. Fixed Income Bond investors should overweight Australian government bonds in global portfolios, as the RBA will not match the policy tightening expected in the US, Canada or the UK. Those overweights should be concentrated versus the US, given the lower yield beta of Australian government bonds versus US Treasuries (Chart 18). For dedicated Australian bond investors, maintain a below-benchmark duration stance as longer-maturity yields have more room to rise as the economy continues to recover from the Delta wave. In addition, favor inflation-linked debt over nominal bonds, as both survey-based inflation expectations and the fair value from our 10-year breakeven spread model are rising. Wider breakevens pushing up longer-term yields, and a dovish RBA capping shorter-maturity bond yields, both point to a bearish steepening of the government bond yield curve over the next 6-12 months (Chart 19). Chart 18Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Remain Overweight Aussie Bonds... Chart 19...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve ...And Position For A Steeper Yield Curve Currency A lot of pessimism is already embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. One catalyst will be a continued reversal in COVID-19 infection rates. The second is valuation. The Aussie is at fair value on a PPP basis, but remains very cheap on a terms-of-trade basis. Historically, terms of trade have had much better explanatory power for the direction of the Aussie, compared to relative real interest rates or fluctuations from purchasing power parity. Even accounting for falling commodity prices, the valuation margin of safety makes the AUD a good bet over a cyclical horizon, though in the very near-term, it is fraught with risks. We have a limit-buy on AUD/USD at 70 cents, which could be a capitulation level. On the upside, if the Aussie closes its undervaluation gap vis-à-vis terms of trade as it has done historically, this will lift AUD/USD towards 85 cents and beyond. Finally, sentiment on the Aussie is very depressed. Extreme short positioning suggests a dearth of buyers and the potential for a short covering rally (Chart 20). On the crosses, we are already long AUD/NZD, but AUD/CHF and AUD/CAD should also be winners in any Aussie short squeeze. Chart 20Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Lots Of Shorts In The Aussie Equities 37% of the MSCI Australia index is financials, while 16% is materials. Therefore, a call on the Australian equity market is a call on banks and resources. On the resource front, Australian producers will benefit from a pickup in natural gas exports and a shift away from coal. Therefore, the strategy will be to overweight Australian LNG producers in a resource portfolio. On banks, a relatively dovish RBA will keep the Australian yield curve steep. Meanwhile, banks have still underperformed the improvement in the interest rate term structure. A bottoming economy will also benefit banks, as investors start to price in the prospect for interest rate hikes beyond 2023 (Chart 21). Chart 21A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks A Steeper Yield Curve Will Benefit Banks   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@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 On a 2-3 year horizon, stay overweight the US stock market, in absolute terms and relative to the non-US stock market… …and stay overweight the US dollar. A good model for the US stock market is the 30-year T-bond price multiplied by US profits. A good model for the non-US stock market is the 2-year T-bond price multiplied by non-US profits. A major long-term risk to the US stock market comes from the blockchain, which is set to return the ownership and control of our data and digital content back to us – from Facebook, Google, and the other tech behemoths that currently control, manipulate, and monetise it… …but this risk is only likely to manifest itself on a 5-10 year horizon. Fractal analysis: The Israeli shekel is overbought. Feature Chart of the WeekThe US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Fears that inflation will stay stubbornly high have lit a fuse under short-dated bond yields. But further along the curve, longer-dated bonds have remained an oasis of relative calm. Indeed, the 30-year T-bond yield stands 50 bps lower today than it stood in March. Given that long-duration bonds underpin the valuation of long-duration stocks, the relative calm of the 30-year bond yield explains the relative calm of the stock market in the face of higher short-term bond yields. The corollary is that substantially higher 30-year yields would threaten that calm. Inflation Will Crash Back To Earth In 2022 The relative calm of the 30-year bond yield is telling central banks: go ahead and hike rates if you want. You’ll just have to slash them again and, on average, keep them lower than you would if you didn’t hike them so soon. Rate hikes work by choking aggregate demand, but aggregate demand doesn’t need choking. Aggregate demand is barely on its pre-pandemic trend in the US, and remains far below its pre-pandemic trend in other major economies, such as the UK, Germany, and France. The pre-pandemic trend is important because it is our best estimate of potential supply. On this best estimate, aggregate demand is still below potential supply (Chart I-2). Chart I-2The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile The 30-Year T-Bond Yield Sees That Aggregate Demand Is Fragile If aggregate demand is below potential supply, then what can explain the recent surge in inflation? The answer is the massive and unprecedented displacement of demand from services to goods, combined with modern manufacturing processes unable to meet even a 5 percent excess demand, let alone the 26 percent excess demand for durables recently experienced in the US (Chart I-3). Chart I-3The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall The Booming Demand For Goods Is Crashing Back To Earth While Services Remain In Shortfall Yet as we highlighted last week in The Global Demand Shortfall Of 2022, the recent booming demand for goods is crashing back to earth while the demand for some services will remain structurally below the pre-pandemic trend. Combined with a tsunami of supply that will hit the global economy with a lag, inflation is also likely to crash back to earth by late 2022. The US Stock Market = The 30-Year T-Bond Multiplied By US Profits An important characteristic of any investment is its duration. If all an investment’s cashflows were converted into one ‘lump-sum’ cashflow, then the duration of the investment quantifies how far into the future that lump-sum cashflow would be. For a bond, the duration also equals the percentage change in its price for every 1 percent change in its yield.1 Interestingly, the durations of the US stock market and the 30-year T-bond are very similar, at around 25 years. Therefore, all else being equal, the US stock market should track the 30-year T-bond price. Of course, all else is not equal. The 30-year T-bond has fixed cashflows, whereas the stock market has cashflows that track profits. Allowing for this key difference, the US stock market should track: (The 30-year T-bond price) multiplied by (US profits) multiplied by (a constant) In which the constant connects current profits to the theoretical lump-sum payment 25 years ahead, thereby quantifying the structural growth of profits. But to the extent that the constant does not change, we can ignore it. Simplistic as this model appears, it does provide an excellent explanation for the US stock market’s evolution through the past 40 years (Chart of the Week and Chart I-4) – with deviations from the ‘fair-value’ giving a good gauge of the market’s over- or under-valuation. Chart I-4The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits The US Stock Market = The 30-Year T-Bond Multiplied By US Profits Looking ahead, there are three ways in which the structural bull market could end: If the overvaluation (deviation from fair-value) became so extreme that a substantial decline in price was required to re-converge with the 30-year T-bond price multiplied by profits. If the 30-year T-bond price could no longer rise to counter a substantial decline in profits. If the constant that links current profits to future profits phase-shifted down, implying that the growth rate of US stock market profits had phase-shifted down – as happened for non-US stock market profits after the dot com bust (Chart I-5). Going through each of these, the US stock market’s current overvaluation of around 10 percent is not so extreme as to be a structural impediment. Chart I-5The Valuation Of The Non-US Stock Market Phase-Shifted Down The Valuation Of The Non-US Stock Market Phase-Shifted Down The Valuation Of The Non-US Stock Market Phase-Shifted Down Meanwhile, the 30-year T-bond yield has scope to decline by at least 150 bps, equating to a 40 percent counterweight to a decline in profits. Hence, this is not a structural impediment either, but will become one once the 30-year T-bond yield reaches 0.5 percent in the next deflationary shock. As for a phase-shift down in profit growth, this is a genuine long-term risk. The main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. The blockchain is set to return that ownership and control back to us, to the detriment of Facebook, Google, and the other behemoths of the US stock market. However, this is a long-term risk, likely to manifest itself on a 5-10 year horizon. We conclude that on a 2-3 year horizon, investors should own the US stock market. The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits We can extend the preceding analysis to the non-US stock market, with two differences. First, the non-US stock market has a much shorter duration given its much lower exposure to growing cashflows. A higher weighting to financials – which underperform when long yields are falling – further lowers the effective duration to just 2 years (empirically). Second, and obviously, the non-US stock market depends on non-US profits (Chart I-6). Chart I-6The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits The Non-US Stock Market = The 2-Year T-Bond Multiplied By Non-US Profits It follows that the non-US stock market tracks: (The 2-year T-bond price) multiplied by (non-US profits) We can now decompose the post dot com performance of the US and non-US stock markets into their underlying structural components. The US stock market has received a massive tailwind: a 60 percent increase in the 30-year T-bond price plus a 200 percent increase in profits (Chart I-7). While the non-US stock market has received a lesser tailwind: a 10 percent increase in the 2-year T-bond price plus a 60 percent increase in profits (Chart I-8).2   Chart I-7The US Stock Market Has A Powerful Tailwind... The US Stock Market Has A Powerful Tailwind... The US Stock Market Has A Powerful Tailwind... Chart I-8...The Non-US Stock Market Has A Weak Tailwind ...The Non-US Stock Market Has A Weak Tailwind ...The Non-US Stock Market Has A Weak Tailwind Therefore, over the past two decades, the non-US stock market has been hampered by its low duration and by its profits that are fossilised, both metaphorically and literally. Metaphorically fossilised, because the non-US stock market is over-exposed to industries that are in structural decline such as financials and basic resources. And literally fossilised, because it is also over-exposed to the dying fossil fuel industry. Looking ahead, there are three ways that non-US stocks could outperform US stocks: If the relative valuation (deviation from respective fair-values) became extreme in favour of non-US stocks. If the 2-year T-bond price outperformed the 30-year T-bond price – effectively meaning that the 30-year T-bond price would have to fall far given that the 2-year T-bond is like cash. If non-US profits outperformed US profits. Going through each of these: both the US and non-US stock markets appear similarly overvalued versus their respective fair-values; the 30-year T-bond is unlikely to fall far given that it would destabilise the global financial system; and fossilised non-US profits are unlikely to outperform those in the US in the next few years. We conclude that on a 2-3 year horizon, investors should stay overweight the US stock market relative to the non-US stock market. One final consideration is the US dollar. Successive deflationary shocks – the 2008 GFC, the 2015 EM recession, and the 2020 pandemic – have taken the greenback to new highs as capital flows have flooded into US T-bonds (Chart I-9). It follows that the ultimate high in the dollar will coincide with the ultimate low in the 30-year T-bond yield. Chart I-9Successive Deflationary Shocks Take The Dollar To New Highs Successive Deflationary Shocks Take The Dollar To New Highs Successive Deflationary Shocks Take The Dollar To New Highs Stay structurally overweight the US dollar. The Israeli Shekel Is Overbought In this week’s fractal analysis, we note that the strong recent rally in ILS/GBP has reached the point of maximum fragility on its 130-day fractal structure that has signalled several previous reversals (Chart I-10). Chart I-10The Israeli Shekel Is Overbought The Israeli Shekel Is Overbought The Israeli Shekel Is Overbought On this basis, a recommended trade would be short ILS/GBP, setting a profit target and symmetrical stop-loss at 4.2 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. 2 From January 1, 2005. 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