Gov Sovereigns/Treasurys

Highlights Monetary Policy: It’s all but certain that tapering will begin next month and conclude by the middle of next year, but the FOMC is currently split right down the middle on whether it will be appropriate to lift rates in H2 2022. We present five factors to track to decide when the Fed will hike rates. Yield Curve: A bear-flattening of the nominal yield curve remains the most likely scenario for the next 6-12 months. Maintain a position short the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Investors should enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. The 2-year real yield, in particular, has a lot of upside during the next 6-12 months. EM Bonds: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling. Feature This past week was quite eventful for US bond investors. First, the Fed presented its September update on Wednesday, offering some hints about the timing and pace of asset purchase tapering alongside its updated economic and interest rate forecasts. Then, bonds sold off sharply on Thursday, Friday and Monday with the 10-year Treasury yield rising all the way to 1.49%. The first section of this week’s report looks at what we learned from last week’s FOMC meeting and opines on some monetary policy questions that remain unanswered. The second section updates our views on portfolio duration, the yield curve and TIPS in light of last week’s large market moves. Finally, we conclude with an update on the outlook for USD-denominated Emerging Market bonds. Powell Answers Some Small Questions, Avoids The Big One The Small Questions The start date for asset purchase tapering is the first small question that the Fed answered last week. A new sentence was added to the post-meeting statement saying that “a moderation in the pace of asset purchases may soon be warranted” and, in his press conference, Chair Powell clarified that the purpose of the new language is “to put notice out there that [tapering] could come as soon as the next meeting”. After this statement from the Fed, we expect asset purchase tapering to be announced at the next FOMC meeting on November 3rd. A delay until December is possible if September’s employment report is a massive disappointment, but the bar for delaying tapering beyond November appears high. Chair Powell also shed some light on a second small question related to the Fed’s balance sheet. Specifically, the pace of asset purchase tapering. In his press conference the Chair said that “participants generally view that, so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.” The information about the pace of tapering is slightly more interesting than the start date, if only because Fed policymakers have expressed a desire for net purchases to reach zero before the first interest rate increase. The fact that the Fed is planning to reach net zero purchases by the middle of next year suggests that it wants to leave the door open for a possible rate hike in the second half of 2022. This message was confirmed by the Fed’s updated interest rate projections (Chart 1). The projections revealed an even split (9 vs. 9) on the Committee between those that expect at least one 25 basis point rate increase before the end of 2022 and those that do not expect to lift rates next year. It’s also notable that, out of the 9 participants that don’t expect a rate hike in 2022, 8 anticipate lifting rates in 2023. Chart 1Rate Expectations Rate Expectations Rate Expectations Of course, as Chair Powell often points out, the Fed’s interest rate projections are contingent on the future state of the economy and will almost certainly be revised as the outlook evolves. What’s more important from a forecasting perspective is knowing how the Fed will react to different economic conditions. The Big Question With that in mind, we know that the Fed has promised not to lift rates until the labor market reaches “maximum employment”. However, as we noted in a recent report, the Fed hasn’t provided much detail on what “maximum employment” actually means.1 Powell’s comments last week didn’t add much clarity, but we can hunt for clues in the Summary of Economic Projections (SEP). In the SEP, we first notice that 13 FOMC participants expect the unemployment rate to be 3.8% - 3.9% or lower by the end of 2022 (Chart 2A). It is logical to assume that this group includes the 9 participants who expect to lift rates in 2022 and 4 additional ones. We also observe that 17 out of 18 participants anticipate an unemployment rate of 3.8% - 3.9% or lower by the end of 2023 (Chart 2B), exactly matching the number of participants who expect to lift rates by then. We can therefore infer that the Fed views an unemployment rate of roughly 3.8% as consistent with “maximum employment”. That is, FOMC participants tend to have rate hikes penciled into their forecasts once the unemployment rate is below 3.8%. Chart 2AFOMC 2022 Unemployment Rate Projection Distribution Damage Assessment Damage Assessment Chart 2BFOMC 2023 Unemployment Rate Projection Distribution Damage Assessment Damage Assessment The SEP’s inflation forecasts are less illuminating than the unemployment ones. All but 4 participants expect core PCE inflation to be above the Fed’s 2% target at the end of 2022 (Chart 3A) and no FOMC participant is forecasting below-2% core PCE at the end of 2023 (Chart 3B).2 The most we can take away from these forecasts is that 14 FOMC participants expect inflation to be above target in 2022, but five of those participants don’t see the labor market as being tight enough to lift rates by then. Chart 3AFOMC 2022 Core PCE Inflation Rate Projection Distribution Damage Assessment Damage Assessment Chart 3BFOMC 2023 Core PCE Inflation Rate Projection Distribution Damage Assessment Damage Assessment The revelation that FOMC participants view a 3.8% unemployment rate as consistent with “maximum employment” is illuminating, but it doesn’t tell the entire story. We don’t know, for example, what assumptions about labor force participation the different Fed officials are using. Our sense is that the following five criteria will ultimately determine when the Fed starts to lift interest rates: An unemployment rate in the neighborhood of 3.8%. Prime-age (25-54) labor force participation close to its pre-pandemic level (Chart 4, top panel). Accelerating wage growth (Chart 4, bottom 2 panels). Long-dated inflation expectations at or above target levels (Chart 5, top 2 panels). Non-transitory inflation at or above target levels (Chart 5, bottom panel). Bottom Line: The FOMC is currently split right down the middle on whether it will be appropriate to lift rates in 2022, but these forecasts aren’t set in stone and next year’s economic data – particularly the five factors listed above – will determine which group is correct. Chart 4Part Rate & Wage Growth Part Rate & Wage Growth Part Rate & Wage Growth Chart 5Inflation & Inflation Expectations Inflation & Inflation Expectations Inflation & Inflation Expectations Our own view is that the labor market will be sufficiently tight for the Fed to deliver its first rate hike in December 2022, and that rate hikes will proceed more quickly than what is currently priced in the yield curve. US bond investors should maintain below-benchmark portfolio duration. The Fallout In Bond Markets Bonds sold off sharply last Thursday and again yesterday morning. At the time of publication, the 30-year Treasury yield had risen from 1.81% on Wednesday to 2.02% (Chart 6). The 10-year Treasury yield had risen from 1.30% to 1.49% (Chart 6, panel 2). The 5-year yield is up to 0.98% from 0.85% on Wednesday (Chart 6, panel 3), and the 2-year yield is up to 0.28% from 0.24% (Chart 6, panel 4). The yield curve has also steepened since Wednesday, though the 2/10 slope remains well below its March peak (Chart 7). The trend during the past few months has been one of curve steepening out to the 5-year maturity point (Chart 7, panel 2) and flattening beyond that point (Chart 7, bottom 2 panels). Recent market action has led to some steepening beyond the 5-year maturity, but so far that steepening is minor compared to the flattening move we’ve witnessed since the spring. Chart 6Treasury Yield Trends Treasury Yield Trends Treasury Yield Trends Chart 7Treasury Curve Trends Treasury Curve Trends Treasury Curve Trends Nominal Curve We have been recommending a position short the 5-year bullet and long a duration-matched barbell consisting of the 2-year and 10-year notes, and we think this trade will continue to outperform. First, the 5-year/5-year forward Treasury yield is back above 2%, consistent with median estimates of the long-run neutral fed funds rate from the New York Fed’s Surveys of Market Participants (2%) and Primary Dealers (2.25%) (Chart 6, bottom panel). We think it will be difficult for the 5-year/5-year forward yield to rise much above these levels, which makes curve flattening more likely than steepening going forward.3 Second, we updated our work on yield curve scenarios to incorporate recent market action and some new information gleaned from last week’s SEP. In this analysis we estimate fair value levels for different parts of the yield curve as of the end of 2022 based on a scenario for the path of the fed funds rate. For example, if we assume that Fed liftoff occurs in December 2022 and rate hikes proceed at a pace of 75 bps per year (the median pace in the SEP) until the fed funds rate levels-off at 2.08% (consistent with a 2%-2.25% range for the long-run neutral fed funds rate), we calculate that the 2-year yield has 74 bps of upside between now and the end of 2022. This is slightly more than the 65 bps of upside in the 5-year yield and much more than the 37 bps of upside in the 10-year yield (Table 1). Comparing this expected change to what is already discounted in the forward curve, we see that both the 2-year and 10-year yields are expected to exceed their forwards by 6 bps. The 5-year yield is expected to exceed its forward by 16 bps. Table 1Treasury Curve Scenario Analysis Damage Assessment Damage Assessment To us, the message is clear. We want to remain short the 5-year note versus a duration-matched 2/10 barbell. Real & Inflation Curves Chart 8Real & Inflation Curves Real & Inflation Curves Real & Inflation Curves The increase in the 10-year nominal yield since last Wednesday was roughly evenly split between the real and inflation compensation components. Interestingly, inflation drove a greater proportion of the increase at the front-end of the curve, and the 2-year real yield actually fell. We maintain a neutral recommendation on TIPS versus nominal Treasuries, but this week we recommend taking advantage of recent market action by implementing some curve trades across the real and inflation curves. Specifically, we note that the cost of short-maturity inflation compensation remains well above the cost of long-maturity inflation compensation (Chart 8). Going forward, the cost of front-end inflation compensation will fall as inflation moderates from its current extremely high level. Meanwhile, the cost of long-maturity inflation compensation will remain sticky near the Fed’s target levels. This will lead to a steepening of the inflation curve (Chart 8, panel 2). The combination of a steeper inflation curve and a flatter nominal curve will lead to a much flatter real yield curve (Chart 8, bottom 2 panels). The 2-year real yield, in particular, has a lot of upside if inflation moderates, as we expect, and the 2-year nominal yield rises in line with the projections shown in Table 1. Bottom Line: Investors should remain short the 5-year bullet versus a duration-matched 2/10 barbell on the nominal Treasury curve. Investors should also enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. A Quick Update On Emerging Market Bonds The collapse of Chinese real estate behemoth Evergrande dominated headlines for most of the past week, though so far there has been little contagion into USD-denominated credit markets. Unsurprisingly, the spread on Chinese corporate and quasi-sovereign bonds has widened, and there has been some passthrough into both the High-Yield EM USD Corporate & Quasi-Sovereign Index and the High-Yield EM USD Sovereign Index (Chart 9). However, investment grade EM credit spreads have been relatively unaffected by the turmoil, as have US corporate bond spreads (both IG and HY) (Chart 9, bottom 2 panels). While the Evergrande drama – and weakening Chinese economic growth in general – could weigh on USD-denominated EM bond performance in the near-term, we see an excellent buying opportunity in investment grade EM bonds on a 6-12 month horizon. Investment grade EM Sovereigns outperformed credit rating and duration-matched US corporate bonds in the early months of the recovery but have lagged during the past few months (Chart 10). The same is true for the investment grade EM Corporate and Quasi-Sovereign index (Chart 10, panel 3). This is not to say that EM bond performance has been poor – the EM Sovereign index is still up 97 bps versus duration-matched Treasuries on the year – it has simply failed to keep pace with the stellar performance of US corporate bonds. Chart 9No Contagion No Contagion No Contagion Chart 10EM Bonds Versus US Corporates EM Bonds Versus US Corporates EM Bonds Versus US Corporates But that recent stellar performance of US investment grade corporate bonds has left spreads in the sector near historically tight levels. In last week’s report we ran some scenarios for US investment grade corporate bond returns during the next 12 months and concluded that excess returns versus Treasuries are probably capped at 85 bps.4 This makes the current spread advantage in EM Sovereigns (Chart 10, panel 2) and EM Corporates & Quasi-Sovereigns (Chart 10, bottom panel) very compelling. This will be especially true if Emerging Market growth accelerates in 2022 on the back of increased Chinese stimulus and a COVID vaccination campaign that is already picking up steam.5 Bottom Line: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 2 Chart 3B shows that 4 participants expect core PCE inflation of 1.9%-2.0% in 2023, but the SEP also reveals that the minimum forecast for core PCE in 2023 is 2.0%. In other words, all 4 participants in that range are forecasting 2.0%, not 1.9%. 3 For more details on the relationship between our 5-year/5-year forward yield target and the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 For a recent debate about the outlook for Emerging Market assets please see last Friday’s Webcast: https://www.bcaresearch.com/webcasts/detail/458 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Global Inflation: Most central banks, led by the Fed, have stuck to the narrative that surging inflation is a temporary phenomenon that will not require an aggressive monetary policy response. However, global supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will prove to be longer lasting, leading to higher global bond yields. Real Bond Yields: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Feature The month of September has often not been kind to financial markets and September 2021 is already providing many reasons for investors to be nervous. Slowing global growth momentum, uncertainty over the Delta variant, yet another US Debt Ceiling debate in D.C. and worries about excessive Chinese corporate leverage and contagion risks from the looming Evergrande default are all valid reasons for market participants to become more risk averse. On top of that, the monetary policy backdrop is threatening to become less overwhelmingly supportive for markets with the Fed set to begin tapering its asset purchases. Chart of the WeekInflation Expected To Slow But Remain Above Bond Yields Inflation Expected To Slow But Remain Above Bond Yields Inflation Expected To Slow But Remain Above Bond Yields One other source of angst that markets seem less concerned about is inflation. Markets have generally come around to the view of most major central banks, led by the Fed, that the surge in inflation seen this year has been all pandemic related - base effect comparisons to 2020 and temporary supply chain squeezes – and will not last into 2022. Yet we have seen very strong realized global inflation readings in the August data, beyond the point of maximum base effect comparisons versus a year ago, while supply squeezes and soaring shipping costs are showing no signs of slowing as we approach the fourth quarter. Global bond markets have made a collective bet that current high rates of inflation will prove to be temporary. Developed market bond yields are all trading well below actual inflation, as are riskier fixed income asset classes like US and European high-yield (Chart of the Week). While consensus expectations are calling for some rise in government bond yields in 2022, yields are expected to remain below inflation. Those persistent negative real yield expectations remain the biggest source of vulnerability for global bond markets. If inflation turns out to be “less transitory” than expected, nominal bond yields will need to move higher to reprice both real yields and the risk of more hawkish central bank responses to sustained high inflation. A Persistent Inflation Threat From Supply Chain Disruptions Chart 2A Broad-Based Surge In Global Inflation A Broad-Based Surge In Global Inflation A Broad-Based Surge In Global Inflation Our base-case view remains that global inflation will slow in 2022, but not by enough to prevent the major developed market central banks from tapering asset purchases. We expect the Fed to begin buying fewer bonds in January. Central banks that have already begun to slow the pace of quantitative easing (QE) like the Bank of Canada and Bank of England will likely continue to taper as fast, if not even faster, than the Fed. Even the ECB will likely not roll the full amount of the expiring Pandemic Emergency Purchase Program (PEPP) into the existing pre-COVID asset purchase programs, resulting in a mild form of tapering next year. Our view on global inflation has been predicated on an expected shift away from more externally-driven inflation towards more sustainable domestic price pressures stemming from tightening labor markets and the closing of pandemic output gaps (Chart 2). So the mix of inflation in most developed market countries will be more “core” and less “non-core” inflation driven by higher commodity prices and global supply chain disruptions. Yet there is little sign that those non-core inflation pressures are slowing, particular in price gauges most exposed to supply chains like producer price indices (PPI). US PPI inflation climbed to 15-year high of 8.3% on a year-over-year basis in August, while annual growth in the euro area PPI hit 12.1% in July – the fastest pace in the 30-year history of that data series (Chart 3). Surging PPI inflation reflects global price pressures, with import prices expanding at double-digit rates in both the US and Europe. Some of that more externally driven price pressure stems from commodity markets. While the prices for some notable commodities like lumber and iron ore have seen significant retracements from pandemic-era highs over the past several months, more economically sensitive commodities like aluminum and natural gas have all seen very strong price increases (Chart 4). Copper and oil prices are also holding firm, although both are off 2021 highs. Chart 3No Sign Of Slowing Global Inflation At The Producer Level No Sign Of Slowing Global Inflation At The Producer Level No Sign Of Slowing Global Inflation At The Producer Level The price momentum of overall commodity price indices like the CRB Raw Industrials has clearly rolled over, but has held up much better than would be expected given signs of slowing global growth. Chart 4Commodity Markets Still More Inflationary Than Disinflationary Commodity Markets Still More Inflationary Than Disinflationary Commodity Markets Still More Inflationary Than Disinflationary The current depressed level of the China credit impulse, and the flat year-over-year change of the global PMI, would typically be associated with flat commodity prices rather than the current 34% annual growth rate (Chart 5). A lack of sustained upward pressure on the US dollar is likely helping keep commodity prices, which are priced in dollars, more elevated than expected. Even more important, however, are the low inventories for many commodities relative to firm demand (which largely explains the current surge in aluminum and natural gas prices). This mirrors a broader global economic trend towards companies running lower inventories relative to sales, which has been exacerbated by the economic uncertainties of the COVID-19 pandemic. The US overall business inventory-to-sales ratio is now at the lowest level in the history of the series (Chart 6). Chart 5Commodity Price Inflation Peaking, But Not Slowing Much Commodity Price Inflation Peaking, But Not Slowing Much Commodity Price Inflation Peaking, But Not Slowing Much Chart 6Supply Squeezes Are Likely To Persist Supply Squeezes Are Likely To Persist Supply Squeezes Are Likely To Persist Before the pandemic, firms have gotten away with running very lean inventories because of globalized supply chains that allow firms to maintain the minimum amount of inventory to meet demand. Yet “just-in-time” inventory management only works when suppliers can deliver raw materials or finished goods in a timely fashion at low cost. The pandemic has blown up that model, making it much harder to deliver products and materials from critical countries like China. Global shipping costs have exploded higher and are showing no signs of slowing (bottom panel), while supplier delivery times remain well above historical averages according to measures like the US ISM index. Those higher costs are feeding through into overall inflation measures, particularly for the components most exposed to supply chain disruption. In Chart 7, we show a breakdown of the overall CPI inflation data for the US, euro area, UK and Canada. The groupings shown in the chart are based on an analysis done by the Bank of Canada back in August to measure pandemic impacts on Canadian inflation.1 The top panel of the chart shows the contribution to overall inflation for elements most exposed to supply constraints (like autos and durable goods). The second panel of the chart shows the contribution from sectors more exposed to increased demand as economies reopen from pandemic restrictions, like dining at restaurants and travel. The remaining panels of the chart show the contributions from energy prices and all other components not covered in the top three panels. Chart 7Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Chart 8High US Inflation May Not Prove To Be So Transitory High US Inflation May Not Prove To Be So Transitory High US Inflation May Not Prove To Be So Transitory The conclusion from our chart is that supply disruptions have added more to US and Canadian inflation so far in 2021, while reopening demand has been more meaningful for UK and US inflation. The pickup in euro area inflation has been mostly an energy price story, although reopening demand has started to contribute to the rising trend of overall inflation. The implication from this analysis is that persistent supply chain disruptions could become a bigger issue for future inflation – and monetary policy decisions – in the US and Canada. The acceleration of US realized inflation in 2021 has already begun to broaden out from the most volatile components, according to measures like the Dallas Fed Trimmed Mean PCE (Chart 8). Faster inflation is also feeding through into higher US consumer inflation expectations according to surveys from the New York Fed and the University of Michigan. Those increases are not deemed to be temporary, with longer-term inflation expectations now moving higher. The New York Fed’s survey shows that inflation is expected to be 4% over the next three years, two full percentage points above the Fed’s target, which must be ringing some alarm bells on the FOMC. Chart 9European Consumers Are Waking Up To Higher Inflation European Consumers Are Waking Up To Higher Inflation European Consumers Are Waking Up To Higher Inflation Consumer inflation expectations are also starting to perk up outside the US. The YouGov/Citigroup survey shows an expectation of UK inflation over the next 5-10 years of 3.5%, while the Bank of England/Kantar survey is at 3% over the next five years (Chart 9, top panel). Both are above the Bank of England’s 2% inflation target. The European Commission confidence surveys have shown a sharp increase in the net share of respondents expecting higher inflation in the coming months (bottom panel), while the Bundesbank’s August consumer survey shows that Germans now expect 3.5% inflation over the next 12 months, up from 2% back in March. Bottom Line: Supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will last much longer than expected and force a bond-bearish repricing of future interest rate expectations. Negative Real Yields – The Achilles Heel For Bond Markets It is clear that supply chain disruptions are having a more lasting effect on global inflation than investors, and policymakers, expected earlier this year. Yet while both market-based and survey-based measures of inflation expectations are moving higher, interest rate markets are still pricing in a very dovish future path for policy rates of the major developed market central banks. For example, our 24-month discounters, which measure the change in interest rates over the next two years discounted in overnight index swap (OIS) curves, show that only 71bps, 61bps and 13bps of rate hikes are expected in the US, UK and euro area, respectively, by September 2023 (Chart 10). This continues a trend that we have highlighted in recent reports – the persistence of negative real interest rate expectations in the developed markets that is also keeping real bond yields in sub-0% territory. In the US, the OIS forward curve shows that the first Fed rate hike is expected in early 2023 with a very slow pace of rate increases over the following 2-3 years (Chart 11). The funds rate is expected to level off at 1.75% and stay there through 2030. At the same time, the CPI swap forward curve has inflation falling steadily over the next couple of years, but leveling off around 2.35% for the rest of the upcoming decade. Combining those two forward projections comes up with an implied path for the real fed funds rate that is persistently negative for the next ten years, “settling” at -0.6% by the end of the decade. Chart 10Bond Markets Exposed To More Hawkish Central Banks Bond Markets Exposed To More Hawkish Central Banks Bond Markets Exposed To More Hawkish Central Banks Chart 11US Real Yields Priced For Extended Fed Dovishness US Real Yields Priced For Extended Fed Dovishness US Real Yields Priced For Extended Fed Dovishness An even more deeply negative real rate path is discounted in the euro area forward curves. The ECB is expected to begin lifting rates in 2023, eventually moving out of negative (nominal) territory in 2026 before climbing to +0.5% by 2030 (Chart 12). Euro area CPI swaps are priced for a fall in inflation back below 2% over the next two years, eventually stabilizing at 1.75% over the latter half of the next decade. The real ECB policy rate is therefore expected to settle at -1.25% by 2030. In the UK, markets are discounting much of what has been seen in the years since the 2008 financial crisis – a Bank of England that does very little with interest rates. The central bank is expected to begin lifting rates in 2023, but only a handful of rate hikes are expected in the following years with Bank Rate only climbing to 1% and settling there for most of the upcoming decade. The UK CPI swap curve is discounting relatively high inflation over the next decade, settling at 3.6% in 2030. Thus, the market is discounting a long-run real Bank of England policy rate of -2.6%. This pricing of negative real policy rates so far into the future goes a long way to explain why longer-term real government bond yields have also been consistently negative in the US, Germany, UK and elsewhere in the developed markets. That can be seen in Charts 11, 12 and 13, where we have added the 10-year inflation-linked (real) bond yield for US TIPS, French OATis and UK index-linked Gilts. In all three cases, the 10-year real yield has “gravitated” towards the realized path of the real policy rate – the nominal rate minus headline CPI inflation – over the past two decades. Chart 12Negative Real Rates Forever In Europe? Negative Real Rates Forever In Europe? Negative Real Rates Forever In Europe? Chart 13BoE Not Expected To Do Much Over The Next Decade BoE Not Expected To Do Much Over The Next Decade BoE Not Expected To Do Much Over The Next Decade Chart 14Nominal Yields Will Move Higher If Negative Real Yields Persist Nominal Yields Will Move Higher If Negative Real Yields Persist Nominal Yields Will Move Higher If Negative Real Yields Persist Persistent low government bond yields, both in nominal and inflation-adjusted terms, have resulted in lower yields across the global fixed income markets as investors have been forced to take on more risk to find acceptable yields. This has resulted in a situation where nominal yields on riskier assets like US high-yield corporate bonds and Italian government debt are trading below prevailing headline inflation rates in the US and Europe (Chart 14). Bond investors would likely only be comfortable accepting such negative real yields on the riskier parts of the fixed income universe if a) inflation was expected to decline, and/or b) real yields on risk-free government bonds were expected to stay negative for longer as central banks stay dovish. In either case, the “bet” made by investors is that the inflation surge seen this year will indeed prove to be transitory, as central banks are forecasting. If that benign outlook proves to be incorrect and inflation stays resilient for longer – potentially because of the risk of lingering supply chain disruptions described earlier in this report - nominal bond yields will have to reprice higher to account for faster realized inflation (and, most likely, rising inflation expectations). This process will start in government bond markets, as global central banks will be forced to respond to stubbornly high inflation by turning more hawkish, first with faster tapering of QE bond buying and, later, with interest rate hikes. We continue to see persistent negative real yields as the biggest source of risk in developed economy bond markets over the next couple of years. Those yields discount a benign path for both inflation and future monetary policy that is looking increasingly less likely – especially with tightening labor markets and rising consumer inflation expectations already forcing central banks, led by the Fed, to move incrementally towards less accommodative policy settings. Bottom Line: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Stay below-benchmark on overall global duration exposure in fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have attempted to match the groupings shown in the Bank of Canada analysis as much as possible for the other countries, although there are some minor differences based on how each country’s consumer price index sub-indices are defined. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What If Higher Inflation Is Not Transitory? What If Higher Inflation Is Not Transitory? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Evergrande is just a canary in the coalmine warning of the vulnerability of global real estate, which is now trading on its highest valuation ever. US house prices are now more extended versus rents than at the peak of the credit boom. US bond yields cannot move up very far before severely choking mortgage demand and hence the housing market (not to mention the stock market). We reiterate our structural recommendation to own the US 30-year T-bond, whose ultimate low in yield will come in the next deflationary shock. New structural recommendation: buy the China 30-year government bond Stay structurally long real estate. Even though valuations are high, they will get even higher when 30-year bond yields reach their ultimate low.  Fractal analysis: Uranium and Palm Oil. Feature Chart of the WeekThe $300 Trillion Global Real Estate Market Dwarfs The $90 Trillion Global Economy The $300 Trillion Global Real Estate Market Dwarfs The $90 Trillion Global Economy The $300 Trillion Global Real Estate Market Dwarfs The $90 Trillion Global Economy The recent woes of China’s systemically important real estate developer Evergrande confirm the concern we voiced in our October 29, 2020 Special Report: The Real Risk Is Real Estate. To be clear, we do not expect any Evergrande default to topple the global financial dominoes á la 2008. The Chinese government is able and almost certainly willing to prevent its own Lehman moment. A more realistic concern is that the rich valuation of real estate, both in China and globally, is vulnerable to the slightest of shocks, and Evergrande is just a canary in the coalmine. Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock According to global real estate specialist Savills, four of the top six world cities for real estate inflation in 2021 are in China. Through just the first half of the year, prime real estate prices have surged by 14 percent in Shanghai, 13 percent in Hangzhou, 9 percent in Shenzhen, and 8 percent in Guangzhou.1 This surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. Today, prime real estate yields in China’s major cities are barely above 1 percent, just a third of the global average of 3 percent. From such nosebleed valuations, a fire sale of Evergrande’s inventory – as creditors tried to recover debts – could weigh down real estate prices. And the repercussions would extend beyond China’s property sector. Prime real estate yields in China’s major cities are barely above 1 percent, just a third of the global average of 3 percent. Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is (Chart I-2). Chart I-2Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock In turn, the ensuing ‘negative wealth effect’ would unleash a major headwind to household spending in the world’s second largest economy. Nosebleed Property Valuations Everywhere The precarious valuation of real estate is not just a Chinese concern. US house prices are now more extended versus rents than at the peak of the credit boom (Chart I-3). Chart I-3US House Prices Are Now More Extended Versus Rents Than At The Peak Of The Credit Boom US House Prices Are Now More Extended Versus Rents Than At The Peak Of The Credit Boom US House Prices Are Now More Extended Versus Rents Than At The Peak Of The Credit Boom Yet the phenomenon extends globally. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent.2 As a mathematical identity, this means that the bulk of the increase in global real estate prices is due to valuation expansion (Chart I-4). Savills confirms this by pointing out that its global prime residential yield has fallen below 3 percent for the first time, and constitutes the lowest global rental yield since the firm began tracking the data in 2005. Chart I-4The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion The culprit for the richest ever valuation of global real estate is the structural collapse in global bond yields. And the culprit for the structural collapse in bond yields is persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing (Chart I-5). Chart I-5The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields But now, policy makers risk being hoisted by their own petard. The tight relationship between bond yields and real estate yields means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, even a 10 percent correction amounting to $30 trillion would constitute a devastating negative wealth effect (Chart of the Week). Nosebleed Property Valuations Reinforce The Structural Case For 30-Year Bonds Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations obliterates the tailwind from inflating incomes. An easy way to understand this intense headwind is through the concept of affordability. In the US the 15-year mortgage rate tracks the 10-year T-bond yield plus a usually consistent spread of around 1 percent. Hence, if the 10-year T-bond yield rose from 1.3 to 2 percent, the mortgage rate would rise from 2.3 to 3 percent, a proportionate increase of 30 percent. For the marginal buyer using an interest-only mortgage, this means that already stretched affordability versus income would worsen by 30 percent.3 Therefore, for the marginal buyer to keep his bid on the property the same, his income would have to inflate by 30 percent. But in an inflationary shock that pushed up the bond yield by 0.7 percent, it is implausible that wages would rise by 30 percent. Let’s say, at a push, that wages rose by 10 percent. To keep affordability and mortgage demand the same, property prices would have to plunge by 20 percent. In fact, earlier this year we saw the extreme vulnerability of US mortgage demand to higher bond yields. When the bond yield collapsed at the start of the pandemic in 2020, the mortgage rate declined more sedately. Hence, in the early stage of bond yield rebound, the US mortgage rate did not increase (Chart I-6). Chart I-6In 2020, The US Mortgage Rate Briefly Decoupled From Its Usual Relationship With The Bond Yield In 2020, The US Mortgage Rate Briefly Decoupled From Its Usual Relationship With The Bond Yield In 2020, The US Mortgage Rate Briefly Decoupled From Its Usual Relationship With The Bond Yield But by early 2021, the mortgage rate had normalised its relationship with the bond yield, so the snap-up in yields earlier this year lifted mortgage rates point for point. The worrying result was that US mortgage applications for house purchases collapsed by one third (Chart I-7). Chart I-7As Bond Yields Rose Earlier This Year, US Mortgage Applications Collapsed By One Third As Bond Yields Rose Earlier This Year, US Mortgage Applications Collapsed By One Third As Bond Yields Rose Earlier This Year, US Mortgage Applications Collapsed By One Third Fortunately, the negative feedback from markets and the economy meant that the snap-up in bond yields was brief. As yields have subsequently fallen back, mortgage demand has stabilised. Yet the crucial lesson is that US bond yields cannot move up very far before severely choking mortgage demand and hence the housing market (not to mention the stock market). To repeat, US house prices are more stretched versus rents than at the peak of the credit boom in 2007. With this precarious dynamic, we reiterate our structural recommendation to own the US 30-year T-bond, whose ultimate low in yield will come in the next deflationary shock. As bond yields rose earlier this year, US mortgage applications collapsed by one third. But today we are adding a new structural recommendation. Given that Chinese real estate valuations are even more precariously balanced than those in the US, and that purchases have been lending-fuelled, Chinese long-dated bonds are an excellent structural investment for those investors who can accept the capital control risks. As a structural holding, buy the China 30-year government bond (Chart I-8). Chart I-8The Ultimate Low In The US And China 30-Year Bond Yield Is Still To Come The Ultimate Low In The US And China 30-Year Bond Yield Is Still To Come The Ultimate Low In The US And China 30-Year Bond Yield Is Still To Come As for the highly-valued real estate asset-class, the paradox is that valuations will reach their ultimate high when 30-year bond yields reach their ultimate low. Until then, stay structurally long real estate. Uranium Is The Latest ‘Meme Theme’ The recent near-vertical ascent in uranium plays have left many investors scratching their heads and wondering: what’s going on? The answer, in large part, is that uranium plays have become the latest ‘meme theme’. On Reddit’s Wall Street Bets forum, the Canadian uranium miner Cameco has become the second most discussed stock, with one post likening the current opportunity to that in Gamestop, the original meme stock. Of course, as in all meme themes, there must be a loose narrative to latch on to. In this case, it is that as a zero carbon-emitting source of energy, uranium demand should rise while supply remains tight. Still, fractal analysis suggests that meme investors have moved prices too far too fast. Elsewhere, fractal analysis suggests that the spectacular rally in palm oil is also susceptible to a reversal. In this case, the rally has been due to supply bottlenecks in Indonesia and Malaysia, which we expect ultimately to ease (Chart I-9) Chart I-9The Spectacular Rally In Palm Oil Is Susceptible To Reversal The Spectacular Rally In Palm Oil Is Susceptible To Reversal The Spectacular Rally In Palm Oil Is Susceptible To Reversal Nevertheless, this week our favoured trade is to short the meme theme rally in uranium plays (Chart I-10). A good expression is to short the UK stock Yellow Cake, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-10Short The Meme Theme Rally In Uranium Plays Short The Meme Theme Rally In Uranium Plays Short The Meme Theme Rally In Uranium Plays   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The other two cities in the top six are Los Angeles and Miami. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. 3 This calculation assumes an interest only mortgage. The increase would be less for a capital repayment mortgage, but it would still be substantial. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Global growth is peaking, but US growth is losing momentum relative to its peers. This has historically been negative for the greenback. Chinese monetary policy is no longer on a tightening path, and might ease going forward. As discounting mechanisms, cyclical currencies should outperform. Our bias is that non-US growth will outperform growth in the US over the next 12-18 months. This will lead to capital reallocation away from the US dollar. While US bond yields could rise towards 2%, real interest rates will remain low compared to history. Our recommendations remain the same: the DXY will struggle to punch above the 94-95 level, but will ultimately touch 80. Feature Chart I-1US Growth Momentum And The Dollar US Growth Momentum And The Dollar US Growth Momentum And The Dollar The DXY index is up for the year, but has twice failed to punch the 94 level. The first leg of the rally from January to March occurred within a context of rising global yields, led by the US. The second leg, starting in June was triggered by a perceived hawkish shift from the Federal Reserve. The common denominator for both legs of the rally was that US growth was outperforming growth in the rest of the world. But that is beginning to change. Bloomberg consensus forecasts show a sharp reversal in US growth momentum, relative to its peers (Chart I-1). Historically, this has put a firm ceiling on the greenback. Cycles And The US Dollar The dollar tends to fare worse early in the cycle when growth is rising but inflation is falling (Chart I-2). Admittedly, inflation prints in some developed markets like the US and Canada have been rather strong. But to the extent that these prints reflect transitory factors, it should allow global central banks to remain accommodative, supporting growth. The remarkable thing about Chart I-1 is that the rotation in growth from the US towards other countries has been broad based. Countries such as Canada, New Zealand, Brazil and Mexico are seeing a bottoming in growth momentum relative to the US (Chart I-3). Chart I-2The Dollar Fares Poorly Early In The Cycle Why The Ultimate Low In The Dollar Is Nigh Why The Ultimate Low In The Dollar Is Nigh Chart I-3A Rotation Of Growth From The US A Rotation Of Growth From The US A Rotation Of Growth From The US This bottoming in growth momentum is occurring at the same time as local central banks are becoming more orthodox about monetary policy. The Reserve Bank of New Zealand has ended quantitative easing. The Bank of Canada has cut asset purchases in half. Brazil, Mexico and Russia, among other emerging market countries are hiking interest rates. While it is true that inflation in some developed and emerging markets like Canada, the UK, Brazil and Russia is perking up, for most developed markets as a whole, inflation is actually surprising to the upside in the US (Chart I-4). China has been tightening policy amidst very low inflation. Currencies tend to be driven by real rates. A growth rotation away from the US, in addition to more orthodox monetary policies outside the US, will be negative for the greenback. Chart I-4US Relative Inflation And The Dollar US Relative Inflation And The Dollar US Relative Inflation And The Dollar What About Chinese Growth? Chinese growth expectations are still cratering relative to the US. The fiasco around the China Evergrande Group has also led to speculation that this could become a systemic event. For developed market currencies, especially those linked to China like the Australian dollar, this is a market-relevant event. Admittedly, offshore markets have started discounting a bigger depreciation in the RMB (Chart I-5). That said, the RMB has been rather resilient against the dollar suggesting that the risk of this becoming a systemic event is rather low (Chart I-6). Chart I-5The Evergrande Risk Is Not Yet Systemic The Evergrande Risk Is Not Yet Systemic The Evergrande Risk Is Not Yet Systemic Chart I-6Chinese Equities And The RMB Have Decoupled. Chinese Equities And The RMB Have Decoupled. Chinese Equities And The RMB Have Decoupled. We believe currency markets are sending the right signal. For one, the Evergrande debacle is occurring at a time when China is no longer tightening monetary policy. Chart I-7 shows that cyclical currencies in developed markets tend to be coincident with the Chinese credit impulse. As such, any easing in monetary policy will put a bottom in these currencies. Over the years, the Chinese bond market has become more and more liberalized. This two-way risk implies that zombies companies should be allowed to fail while unicorns flourish. It is true that regulatory control has been front and center in the current Chinese equity market malaise. That said, our bias is that liberalization is a reason why portfolio inflows into China continue to accelerate, as the economy moves closer to market-determined prices (Chart I-8). This has supported the RMB, a big weight in the Fed trade-weighted dollar. Chart I-7Chinese Policy And DM Currencies Chinese Policy And DM Currencies Chinese Policy And DM Currencies Chart I-8An Unrelenting Increase In Chinese Inflows An Unrelenting Increase In Chinese Inflows An Unrelenting Increase In Chinese Inflows A lot of EM debt is denominated in US dollars, which could be reprised for default risk. But on this basis, the Fed is ahead of the curve. This was the very reason the Federal Reserve introduced swap lines in 2020 with foreign emerging market central banks and made swapping FX reserves for dollars a permanent facility in its toolkit for monetary policy this year. Non-US domestic authorities have ample ability to decide which entities they allow to fail, and which they bail out from their USD obligations. Cross-currency basis swaps, a proxy for the cost of obtaining dollars offshore, remain well behaved (Chart I-9). Chart I-9No USD Funding Stress So Far In Developed Markets No USD Funding Stress So Far In Developed Markets No USD Funding Stress So Far In Developed Markets For developed market currencies, the implication is that China risks are currently overstated, while any upside surprise has not been meaningfully discounted. Gauging Investor Positioning The dollar tends to be a momentum currency. But at turning points, it pays to be a contrarian. Let’s begin with what is priced in. First, the overnight index swap curve (OIS) suggests that markets expect the Fed to hike interest rates faster than other G10 central banks (Chart I-10). This will not occur in a world where growth is stronger outside the US, and other central banks are well ahead in their tapering of asset purchases, pursuing much more orthodox monetary policy. Chart I-10The Market Remains Bullish On Fed Rate Hikes The Market Remains Bullish On Fed Rate Hikes The Market Remains Bullish On Fed Rate Hikes Chart I-11Speculators Are Bullish On ##br##The Dollar Speculators Are Bullish On The Dollar Speculators Are Bullish On The Dollar Second, at the beginning of this report, we highlighted the fact that the dollar is up this year. Part of the reason has been a pilling in of speculators into long greenback positions (Chart I-11). As a trading rule, it has usually been profitable to wait for net speculative positioning and moving averages to roll over before entering fresh dollar short positions (Chart I-12). On this basis, tactical investors might be a bit early, but its is also the case that the macroeconomic environment is moving against the dollar. Once markets start paying attention to the fact that global growth will rotate from the US, pinning the Fed into a more dovish stance, the dollar will quickly depreciate.   Chart I-12A Sentiment Trading Rule Will Wait For The Dollar To Roll Over More Broadly A Sentiment Trading Rule Will Wait For The Dollar To Roll Over More Broadly A Sentiment Trading Rule Will Wait For The Dollar To Roll Over More Broadly Often forgotten is that the dollar has tended to move in long cycles, usually 10 years between bull and bear markets. The US trade deficit (excluding oil) is hitting new fresh highs this year. These deficits need to be financed by foreign purchases of US securities, either by debt issued or equity raised. Investors could demand a discount to keep financing these deficits. Should the Congressional Budget Office estimates of the current trajectory of US deficits hold true, the dollar has about 10-15% downside from current levels (Chart I-13). Chart I-13Balance Of Payments Bode Negatively For The Greenback Balance Of Payments Bode Negatively For The Greenback Balance Of Payments Bode Negatively For The Greenback Our geopolitical strategists assign 80% odds to the passage of a bipartisan infrastructure bill, and 65% odds to the passage of a reconciliation bill. Either way, the US fiscal picture is set to deteriorate at a time when the Fed is comtemplating scaling back Treasury purchases. Interestingly, 10-15% downside in the US dollar is exactly what is needed to realign the currency competitively (Chart I-14). Consumer prices have been rising globally, but this has been especially pronounced in the US. To the extent that we live in a globalized world with flexible exchange rates, this should allow more competitive countries to see an increase in their trade balances. This is exactly what is occurring, with the US trade deficit hitting new lows. Chart I-14The Dollar Is Expensive On A PPP Basis The Dollar Is Expensive On A PPP Basis The Dollar Is Expensive On A PPP Basis Risks To The View Currency forecasts are obviously fraught with risks. The biggest risk to the view is a broad-based equity market correction, that reinvigorates inflows into US safe-haven bonds. We are cognizant that this is a risk worth monitoring. For example, investors are preferring to park cash in US Treasurys over gold, two competing safe-haven assets (Chart I-15). This has usually been positive for the greenback. But it also suggests investors view the Fed is going to be orthodox in monetary settings, tightening policy faster than the market expects. This boils down to a judgment call. The US market is much more vulnerable to rate changes than other markets (Chart I-16). As such, a hawkish shift by the Federal Reserve could significantly tighten financial conditions (through a stock market correction), setting the stage for an ultimate low in the dollar equity outflows. Chart I-15Safe-Haven Dollar Flows Face Technical Resistance Safe-Haven Dollar Flows Face Technical Resistance Safe-Haven Dollar Flows Face Technical Resistance Chart I-16Higher Bond Yields Will Be Negative For The US Market. Higher Bond Yields Will Be Negative For The US Market. Higher Bond Yields Will Be Negative For The US Market. Given this two-way risk, we are reintroducing our long CHF/NZD position that correlates well with currency volatility (Chart I-17). We are also long the yen on this basis. In terms of housekeeping, our long AUD/NZD trade was stopped out for a loss. As we iterated in our Aussie report, a lot of pessimism is embedded in the AUD, making it a potent candidate for a powerful mean-reversion rally. We recommend reinstating this position at current levels (a nudge above our stop loss). Chart I-17Buy CHF/NZD As A Hedge Buy CHF/NZD As A Hedge Buy CHF/NZD As A Hedge Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was strong: PPI continues to accelerate in the US, rising 8.3% year on year in August while CPI also remains strong at 5.3% on the headline print. Pricing pressures remain acute in the US. The empire manufacturing survey surprised to the upside in September. The headline number was 34.2 versus expectations of a 17.9 reading. Admittedly, this was driven by an increase in selling prices. Retail sales were surprisingly strong in August, with the control group rising 2.5% month on month versus expectations of a flat number. The US dollar DXY index was relatively flat this week. The markets are at a crossroads, gauging whether strong US data will maintain momentum or revert to a lower equilibrium. Our bias is towards the latter, but admittedly, there are two-way risks to this view.  Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data remains robust: Industrial production printed a solid 7.7% year-on-year growth in July. The trade surplus for July rose to €20.7 bn. The euro fell by 0.6% this week. The ECB has engineered a dovish tapering of asset purchases, but it remains the case as the interest rate expectations between the euro area and the US are at bombed out levels. This should support positive euro area surprises. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been on the weak side: Core machinery orders rose 11.1% year on year in July. Exports were strong in August, rising 34% while imports rose 40%. The yen was flat against the dollar this week. Currency volatility is currently depressed, and Japan has been performing poorly economically. To the extent that this is pandemic related, it sets the JPY up for a playable coil spring rebound. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 UK data remains on the mend: Industrial production came in at 3.8% year on year, above expectations. Average weekly earnings, including bonus payments, are rising 8.3% year on year as of July. Job gains continue. The July report pushed the unemployment rate from 4.7% to 4.6%. CPI and RPI remain rather sticky around the 3-5% level. House prices rose 8% year on year in July. The pound fell by 0.4% this week. The broad trend in the pound will now be dictated by what happens to both the dollar and the euro. The BoE is more hawkish than the Fed and the ECB should support gilt yields and the pound. A slowing in US economic momentum is also bullish for the sterling. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was slated to slow as we expected, and recent numbers highlight this: There were 146K job losses in August. This was well split between part time and full time. NAB business confidence and current conditions moderately improved in August. House price inflation is tracking the global wave, rising 16.8% year on year in Q2. The AUD fell 1% this week. We discussed the AUD at length in our report two weeks ago and believe current weakness is unwarranted. We are reinstating our long AUD/NZD trade this week. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: The current account deficit widened in Q2 to -3.3% of GDP. Q2 GDP was an upside surprise but will likely be torpedoed in Q3 by COVID-19. The NZD was down 0.25% this week. We continue to believe the NZD will fare well cyclically, likely touching 75 cents, but our bias remains that hawkish expectations from the RBNZ are already well priced. This will make the kiwi lag other commodity currencies like the Aussie. We are reinstating our long AUD/NZD trade. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been robust: The labor report was strong. Hiring came in at 90K, with a favorable tilt towards full-time work. The unemployment rate fell from 7.5% to 7.1%. The CPI report was equally robust. Core CPI was at 3.5% year on year with most measures of the BoC’s underlying gauge inching higher. Housing starts remained strong in August at 260K, a slight dip from July’s 271K. The CAD was up by 0.44% this week. Last week’s currency report was dedicated to the loonie. With strong oil prices, a relatively hawkish central bank, and easing on tightening pressures from China, the loonie should remain well bid. A minority government will also be bullish for the loonie, as we highlighted last week. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: PPI came in at 4.4% in August, an increase from July. The Swiss franc was down 0.22% this week. We are going long CHF/NZD as a hedge against rising currency volatility. Being long the yen also makes sense in this environment. However, given our view that risk sentiment will stay ebullient, the franc will lag the bounce in other cyclical currencies on a longer-term horizon. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Norwegian data is surprising to the upside: CPI was 3.4% year on year in August, above expectations. PPI rose 50% year on year in August. The trade balance posted a healthy surplus of NOK 42.6bn in August. The NOK was up 0.5% this week. We continue to be bullish Scandinavian currencies as a cyclical play on a lower US dollar. The NOK benefits from bombed-out valuations and a more orthodox central bank. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The most important data from Sweden this week was the CPI report: CPI rose from 1.7% to 2.1% in August. CPIF, the Riksbank’s preferred measure, accelerated to 2.4%. The SEK was flat this week. A bottoming in the Chinese credit impulse will be a positive impact on growth-sensitive Sweden. Meanwhile, this week’s positive CPI report should pare back expectations of more stimulus from the Riksbank. We are short both EUR/SEK and USD/SEK as reflation plays. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Strategic Holdings Tactical Holdings Limit Orders Closed Trades

Highlights Fed: The Fed will be forced to clarify its definition of “maximum employment” in 2022, and the path of inflation will ultimately dictate how far the Fed tries to push the labor market. We expect Fed rate hikes to start in December 2022 and that the pace of hikes will proceed more quickly than is currently priced in the yield curve. Duration: Investors should maintain below-benchmark portfolio duration in anticipation of a rate hike cycle starting in December 2022. Yield Curve: Investors should position in Treasury curve flatteners. Specifically, we recommend shorting the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Feature Chart 1Bonds De-Coupled From Inflation In 2021 Bonds De-Coupled From Inflation In 2021 Bonds De-Coupled From Inflation In 2021 One of our themes this year is that US bond investors should pay more attention to the employment data than the inflation data.1 This is because the Fed has successfully convinced markets that it will not lift rates until “maximum employment” is achieved, even if inflation is strong.2 This story has played out during the past few months as bond yields have remained low despite surging prices (Chart 1). Our view is that the muted reaction in bonds is due to the widespread belief that the labor market remains far from “maximum employment” and that rate hikes are therefore a long way off. In this environment, only surprisingly strong employment prints can upset the market’s narrative and send bond yields higher. This playbook for the bond market will continue to function for the next few months. Strong employment data will pull bond yields higher and disappointing employment data will push them down. Inflation prints will be largely irrelevant for the market. But this will change next year. In fact, we see the employment data taking a back seat to the inflation data in the minds of bond investors in 2022. A More Explicit Definition of “Maximum Employment” Must Emerge In 2022 Almost everyone agrees that the US labor market is far from “maximum employment” today, but that will no longer be the case in 2022. The Appendix to this report shows the average monthly nonfarm payroll growth that is required to reach different possible definitions of “maximum employment” by a few specific future dates. For example, we calculate that average monthly nonfarm payroll growth of 414 thousand would cause the unemployment rate to reach 3.8% and the labor force participation rate to reach 63% by the end of 2022. Our sense is that the US economy will be able to add more than 414 thousand jobs per month between now and December 2022. This means that if Fed officials believe that an unemployment rate of 3.8% and a participation rate of 63% meet the definition of “maximum employment”, then they will start to lift interest rates by then. This example sets the scene for what will become next year’s most important monetary policy debate. What constitutes “maximum employment”? Does our example of a 3.8% unemployment rate and a 63% participation rate meet the definition? Or does the Fed have different targets in mind? The Fed will be forced to clarify its position on the topic as the labor market gets closer to reasonable definitions of “maximum employment”. Our sense is that, as of now, there are a range of views on the committee with some FOMC participants taking a more hawkish view of how much slack is left in the labor market and some adopting a more dovish posture. We outline the differences between the hawkish and dovish positions below, but ultimately the path of inflation in 2022 will determine which camp wins out. If inflation remains high next year, then the Fed will be quicker to declare that the labor market is at “maximum employment”, and vice-versa. The Fed’s reliance on the inflation data to settle the argument of what constitutes “maximum employment” will make inflation the most important economic indicator for bond yields in 2022. Labor Market Slack: The Hawkish Case Chart 2The Unemployment Rate Is Falling Fast The Unemployment Rate Is Falling Fast The Unemployment Rate Is Falling Fast The hawkish case for the US labor market reaching “maximum employment” sooner rather than later was outlined nicely last month by our own Bank Credit Analyst.3 First, the Bank Credit Analyst points out that the US labor market was likely beyond “maximum employment” before COVID-19 struck. The implication being that the Fed may move to lift interest rates before the unemployment and participation rates fully recover their pre-pandemic levels. Notice that the unemployment rate (adjusted for the post-COVID surge in people employed but absent from work) was 3.5% in February 2020, well below the Congressional Budget Office’s 4.5% estimate of the natural rate of unemployment (Chart 2).4 Today, the adjusted unemployment rate is 5.5%, not that far above the 3.5%-4.5% range of FOMC participant estimates of the natural rate. If this year’s rate of decline continues, the unemployment rate will hit 4.5% by January 2022 and 3.5% by May 2022. Of course, we know that the Fed takes a broader view of labor market utilization than just the unemployment rate. In particular, we observed sharp declines in labor force participation rates across a wide range of demographic groups when the pandemic struck last year (Chart 3). While the Fed will want to see some improvement in labor force participation, it might be unrealistic to expect the overall labor force participation rate to return to its pre-pandemic level. This is because the aging of the US population imparts a structural downtrend to the participation rate. The dashed line in Chart 4 shows where the participation rate would be if the rate of labor force participation of every individual age cohort remained constant at its February 2020 level. Even in this case, the greater flow of people into the older age groups causes the part rate to fall over time. The message from Chart 4 is that even if the participation rates of every age cohort tracked by the Bureau of Labor Statistics rebound to their February 2020 levels, we would still only expect an overall participation rate of 62.8% by the end of 2022, significantly below the 63.3% seen in February 2020. Chart 3Labor Force Participation By Age Cohort Labor Force Participation By Age Cohort Labor Force Participation By Age Cohort Chart 4The Demographic Downtrend In Participation The Demographic Downtrend In Participation The Demographic Downtrend In Participation On top of the demographic argument, we also notice that the pandemic led to a surge in the number of retired people last year, a number that continues to rise quickly (Chart 5). While we should probably expect some increase in the flow of people coming out of retirement to re-join the labor force as the economy recovers, it’s also logical to assume that there will be at least some hysteresis among the retired population. That is, the longer someone is retired, the less likely they are to re-enter the labor force at all. To the extent that the increase in retired people is sticky, it may be ambitious to expect a full convergence of the 55-year+ part rate back to February 2020 levels (Chart 3, bottom panel). All else equal, this will cause the labor market to reach “maximum employment” more quickly than even our demographic trendline for participation suggests. Chart 5A Surge In Retirees A Surge In Retirees A Surge In Retirees The question of how many FOMC participants agree with the above arguments remains open, but our sense is that there are some who will be eager to declare that “maximum employment” has been achieved before we see a full rebound in the unemployment and participation rates back to pre-COVID levels. For example, Fed Vice-Chair Richard Clarida mentioned the “demographic trend” in labor force participation in his most recent speech.5 Also, Dallas Fed President Robert Kaplan said the following in a recent interview: We’ve had 3 million retirements since February 2020. […] Some of these workers will come back into the workforce, but some of these workers are 55 and older and they’re in reasonably good financial shape and COVID has caused them to re-think whether they really want to re-enter the workforce.6 Labor Market Slack: The Dovish Case There are also good arguments on the side of those who think that an appropriate definition of “maximum employment” involves an unemployment rate closer to 3.5% than 4.5% and a participation rate that does return to pre-COVID levels, and maybe even moves higher. First, a study from the Federal Reserve Bank of Kansas City noted that the bulk of the recent increase in the number of retired people is explained, not by an increase in the number of retirements, but by a reduction in the flow of people from retirement back into the workforce (Chart 6).7 This suggests that pandemic-related health risks are the likely culprit behind the increase in the number of retired people, casting doubt on the idea that the increase in retired people will be sticky. Chart 6Increased Retirees: A Closer Look 2022 Will Be All About Inflation 2022 Will Be All About Inflation Second, there is a strong case to be made that even the February 2020 labor force participation rate is not high enough to meet the definition of “maximum employment”. If we look at the participation rates for 25-54 year old men and women, we see that both were in strong uptrends prior to the pandemic (Chart 7), and there is every reason to believe that they would have continued to move higher if COVID hadn’t cut the recovery short. Chart 7Part Rates Were Rising Pre-Pandemic Part Rates Were Rising Pre-Pandemic Part Rates Were Rising Pre-Pandemic Consider what some FOMC participants were saying prior to the pandemic: The strong labor market is also encouraging more people in their prime working years – ages 25 to 54 – to rejoin or remain in the labor force, […] So far, we have made up more than half the loss in the Great Recession, which translates to almost 2 million more people in the labor force. But prime age participation could still be higher. - Jerome Powell, November 20198 Whether participation will continue to increase in a tight labor market remains to be seen. But I note that male prime-age participation still remains below levels seen in previous business cycle expansions. - Richard Clarida, November 20199 In a more recent interview, Minneapolis Fed President Neel Kashkari expressed skepticism about the idea that labor force participation is destined to remain in a long-run structural downtrend and said that he’s “not convinced we were actually at maximum employment before the COVID shock hit us.” He also said: Getting [labor force participation] and employment-to-population at least back to where they were before [the pandemic], but not necessarily even declaring victory when we do that. I think that’s a reasonable thing for us to try to achieve.10   Inflation: The Ultimate Argument Settler What the above arguments make clear is that there are good reasons to think that the US labor market will reach some policymakers’ definitions of “maximum employment” perhaps by as early as the middle of next year. However, there are also some policymakers who will adopt a more dovish view of what constitutes “maximum employment”. Ultimately, the path of inflation will determine which camp wins out. This is because the entire concept of “maximum employment” is only meaningful when viewed alongside inflation. If employment is pushed beyond its “maximum”, it definitionally means that labor market tightness is leading to unwanted inflationary pressures. With that in mind, the Fed will increasingly refer to the inflation data next year as it tries to make its definition of “maximum employment” more precise. Crucially, what will matter for the Fed (and for the bond market) is where inflation is next year, not where it is right now. Right now, core inflation is well above the Fed’s price stability target, but it is well known that the recent increase in inflation is concentrated in a few sectors – COVID-impacted services and autos – where prices will decelerate as post-pandemic bottlenecks ease (Chart 8). Just as the Fed ignored surging prices in those sectors this year, it will ignore plunging prices in those sectors next year. What will matter for monetary policy is whether core inflation excluding COVID-impacted services and autos remains contained or rises above levels consistent with the Fed’s target (Chart 8, bottom panel). The Fed will also be inclined to declare that “maximum employment” has been achieved if wage growth is accelerating. Currently, there is some evidence of rising wages but also some major supply bottlenecks in the labor market, as evidenced by the all-time high in job openings (Chart 9). Labor supply constraints should ease next year, but the Fed will be watching closely to see if wage growth moderates in kind or continues to increase. Chart 8Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Watch CPI (ex. COVID-Impacted Services And Autos) In 2022 Chart 9Watch Wages In 2022 Watch Wages In 2022 Watch Wages In 2022 Finally, the Fed will keep a close eye on inflation expectations next year. In particular, it will monitor the Common Inflation Expectations Index and the 5-year/5-year forward TIPS breakeven inflation rate (Chart 10). If either of these indicators break above levels consistent with the Fed’s 2% inflation target, then policymakers will be more inclined to think that “maximum employment” has been attained. Chart 10Watch Inflation Expectations In 2022 Watch Inflation Expectations In 2022 Watch Inflation Expectations In 2022 Bottom Line: The Fed will be forced to clarify its definition of “maximum employment” in 2022, and the path of inflation will ultimately dictate how far the Fed tries to push the labor market. The key indicators to monitor to decide when the Fed will declare that “maximum employment” has been attained are: core inflation excluding COVID-impacted services and autos, wage growth, inflation expectations and the prime-age (25-54) labor force participation rate (Chart 3, panel 2). Investment Implications For bond markets, the question of when the Fed decides that the labor market has reached “maximum employment” is crucial because it will determine the start of the next rate hike cycle. At present, the overnight index swap curve is priced for Fed liftoff in January 2023 and for a total of 78 bps of rate hikes by the end of 2023 (Chart 11). Chart 11Rate Hike Expectations Rate Hike Expectations Rate Hike Expectations Our expectation is that the Fed will start lifting rates in December 2022 and that rate hikes will proceed more quickly than what is currently priced in the market. The unemployment rate will be close to 3.5% by December 2022 and inflation will be sufficiently above the Fed’s target that policymakers will be inclined to view the labor market as at “maximum employment”. Investors should run below-benchmark duration in US bond portfolios to profit from this outcome. We also recommend that investors position for a flatter yield curve by the end of 2022. Specifically, we recommend shorting the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Table 1A shows fair value estimates for the 2-year, 5-year and 10-year yields as of the end of 2022 assuming the market moves to price-in the following path for the fed funds rate: The first 25 bps rate hike occurs in December 2022 Rate hikes proceed at a pace of 100 bps per year The fed funds rate levels-off at a terminal rate of 2.08%11 Table 1ATreasury Curve Fair Value Estimates: December 2022 Liftoff Scenario 2022 Will Be All About Inflation 2022 Will Be All About Inflation In that example, the 2-year and 5-year yields both rise by much more than the 10-year yield and both exceed the change that is priced into the forward curve by more than the 10-year yield. Table 1B shows the results from a similar scenario, the only difference is that the liftoff date is pushed back to March 2023. Both the 2-year and 5-year yields also rise by more than the 10-year yield in this scenario, though the delayed liftoff dampens the relative upside in the 2-year yield. Table 1BTreasury Curve Fair Value Estimates: March 2023 Liftoff Scenario 2022 Will Be All About Inflation 2022 Will Be All About Inflation Bottom Line: Investors should maintain below-benchmark portfolio duration and position in Treasury curve flatteners in anticipation of a rate hike cycle that will start in December 2022. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.8% and a participation rate of 62.8%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +414k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date 2022 Will Be All About Inflation 2022 Will Be All About Inflation Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents 2022 Will Be All About Inflation 2022 Will Be All About Inflation Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Watch Employment, Not Inflation”, dated June 15, 2021. 2 Specifically, the Fed’s forward guidance states that it will not lift interest rates until (i) inflation is above 2%, (ii) inflation is expected to remain above 2% for some time and (iii) the labor market has reached “maximum employment”. 3 Please see Bank Credit Analyst Special Report, “The Return To Maximum Employment: It May Be Faster Than You Think”, dated August 26, 2021. 4 For details on the adjustment we make to the unemployment rate please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021. 5 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm 6  https://www.bloomberg.com/news/articles/2021-08-09/dallas-fed-president-rob-kaplan-on-the-economy-and-monetary-policy-right-now?sref=Ij5V3tFi 7 https://www.kansascityfed.org/research/economic-bulletin/what-has-driven-the-recent-increase-in-retirements/ 8 https://www.federalreserve.gov/newsevents/speech/powell20191125a.htm 9 https://www.federalreserve.gov/newsevents/speech/clarida20191114a.htm 10 https://www.bloomberg.com/news/articles/2021-08-16/neel-kashkari-on-the-fed-s-quest-to-get-to-full-employment?srnd=oddlots-podcast&sref=Ij5V3tFi 11 We assume a target range of 2% to 2.25% for the terminal fed funds rate. We also assume that the effective fed funds rate trades 8 bps above the lower-end of its target band, as is presently the case. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns