Gov Sovereigns/Treasurys

Highlights Chart 12020 Returns 2020 Returns 2020 Returns After a tumultuous start to the year, corporate bonds rallied in 2020 H2, managing to eke out small annual gains versus Treasuries. Specifically, investment grade corporates outperformed duration-equivalent Treasuries by 4 basis points in 2020 and high-yield outperformed by 185 bps (Chart 1). Treasuries, for their part, bested cash by 7% on the year but returns have been trending down since August. As we look forward to 2021, the economic cycle is in what we call a sweet spot for spread product returns. Economic growth is above trend, but inflation is low and monetary conditions are highly accommodative. This macro back-drop will lead to positive spread product returns versus Treasuries and a moderate bear-steepening of the Treasury curve in 2021. However, stretched valuations for investment grade corporates mean that investors must be selective within spread product. We think the Ba credit tier offers the best risk-adjusted opportunity in the corporate bond space, and also recommend favoring tax-exempt municipal bonds over equivalent-quality investment grade corporates. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-matched Treasury index by 79 basis points in December and by 4 bps in 2020. The investment grade corporate index eked out a small gain relative to the duration-matched Treasury index in 2020. Corporates underperformed Treasuries by 18% from the beginning of the year until March 23, the day that the Fed stopped the bleeding in credit markets by unveiling its suite of emergency lending facilities. With the Fed’s backstops in place, the corporate index went on to outperform Treasuries by 22% between March 23 and the end of the year (Appendix A). As we noted in our 2021 Key Views Special Report, the corporate bond index option-adjusted spread is not quite back to its pre-COVID low.1 However, valuation is close to all-time expensive after adjusting for changes in the index’s average credit rating and duration. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. As noted, the macro environment of above-trend growth and accommodative Fed policy is very positive for spread product returns. However, better value exists outside of the investment grade corporate space. In particular, we advise investors to look at Ba-rated high-yield corporates and tax-exempt municipal bonds. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 190 basis points in December and by 185 basis points in 2020. Ba-rated junk bonds outperformed duration-matched Treasuries by 431 bps in 2020, while B-rated and Caa-rated bonds lagged by 13 bps and 238 bps, respectively. Since the March 23 peak in spreads, Ba-rated bonds outperformed Treasuries by 33%, B-rated bonds outperformed by 30% and Caa-rated bonds outperformed by 36% (Appendix A). We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is in line with historical averages.2   Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only seven defaults occurred in November, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms.    Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Cyclical Sweet Spot The Cyclical Sweet Spot Table 3BCorporate Sector Risk Vs. Reward* The Cyclical Sweet Spot The Cyclical Sweet Spot   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in December but underperformed by 17 bps in 2020. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 10 bps on the month to reach 61 bps (Chart 4). This is higher than the 58 bps offered by Aa-rated corporate bonds, the 49 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a material risk for MBS investors. The elevated spread suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). Our view is that expected prepayment losses embedded in MBS spreads (aka the option cost) are too low relative to this pace of refinancing. Last year’s spike in the mortgage delinquency rate was driven by households that were granted forbearance by the federal government’s CARES act (panel 4). The risk for MBS holders is that these households will not be able to resume their regular mortgage payments when the forbearance period ends this spring. While the situation bears close monitoring, our sense is that excess savings built up during the past nine months will be sufficient to prevent a surge of bankruptcies when the forbearance period ends. The recent stimulus package provides households with even more assistance. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 62 basis points in December but underperformed by 161 bps in 2020. Sovereign debt outperformed duration-equivalent Treasuries by 176 bps in December but underperformed by 98 bps in 2020. Foreign Agencies outperformed the Treasury benchmark by 7 bps in December but underperformed by 640 bps in 2020. Local Authority debt outperformed Treasuries by 146 bps in December but underperformed by 86 bps in 2020. Domestic Agency bonds outperformed by 14 bps in December but underperformed by 9 bps in 2020. Supranationals outperformed by 2 bps in December and by 3 bps in 2020. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, 2020’s dollar weakness was mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia, South Africa and Indonesia are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 56 basis points in December but underperformed by 286 bps in 2020 (before adjusting for the tax advantage). We upgraded municipal bonds to “maximum overweight” in our recent 2021 Key Views Special Report.3 Attractive valuations are the main reason for this move. First, spreads between Aaa-rated municipal bonds and equivalent-maturity Treasuries are elevated compared to history across the entire yield curve (Chart 6). Second, municipal bonds look even more attractive relative to duration and quality-matched credit. The Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage). The same is true for the Bloomberg Barclays General Obligation index beyond the 12-year maturity point (panel 3). While the failure to include state & local government aid in the recent relief bill is a big blow to municipal budgets that are already stretched, we think municipal bond spreads offer more-than-adequate compensation for default/downgrade risk. State & local governments are already engaging in austerity measures that will help protect bondholders (bottom panel) and State Rainy Day Fund balances were at all-time highs heading into the COVID downturn. Both of these things should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in December. The 2/10 Treasury slope steepened 13 bps to 81 bps. The 5/30 Treasury slope steepened 7 bps to 129 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and the recently passed fiscal relief bill will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels.        TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 141 basis points in December and by 117 bps in 2020. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 22 bps and 18 bps on the month. They currently sit at 2.01% and 2.07%, respectively. Core CPI rose 0.22% in November, pushing the year-over-year rate from 1.63% to 1.65%. Meanwhile, 12-month trimmed mean CPI fell from 2.22% to 2.09%, narrowing the gap between trimmed mean and core (Chart 8). We anticipate further narrowing in 2021 Q1 and therefore expect core CPI to print relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven inflation rate looks somewhat elevated on our Adaptive Expectations Model (panel 2).4 Inflation pressures may moderate once the core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure in the first half of this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel).   ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in December and by 98 bps in 2020. Aaa-rated ABS outperformed the Treasury benchmark by 12 bps in December and by 81 bps in 2020. Non-Aaa ABS outperformed by 33 bps in December and by 207 bps in 2020 (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 is quite negative for ABS. However, as we explained in a recent report, we don’t anticipate a material impact on spreads.5 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality is strong. As we first explained last June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).6 Faced with an income boost and few spending opportunities, many households paid down consumer debt. Given the recently passed additional fiscal support and the substantial savings that have already accrued, we see household balance sheets as being in a good place. As such, we advise moving down-in-quality to pick up extra spread in non-Aaa ABS.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 113 basis points in December but underperformed by 57 bps in 2020. Aaa Non-Agency CMBS outperformed Treasuries by 58 bps in December and by 56 bps in 2020. Non-Aaa Non-Agency CMBS outperformed Treasuries by 277 bps in December but underperformed by 360 bps in 2020 (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted.7 Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 50 basis points in December and by 105 bps in 2020. The average index spread tightened 7 bps in December to reach 49 bps (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, will only purchase what is “needed to sustain smooth market functioning”. This is nonetheless a backstop of the market, and it does not change our overweight recommendation.   Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities The Cyclical Sweet Spot The Cyclical Sweet Spot Appendix B: 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 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot 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 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot 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 85 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 85 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Cyclical Sweet Spot The Cyclical Sweet Spot Appendix C: 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 11Excess Return Bond Map (As Of December 31ST, 2020) The Cyclical Sweet Spot The Cyclical Sweet Spot   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 4 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

This is US Bond Strategy’s final report of the year. Our regular publication schedule will resume on January 5th with our Portfolio Allocation Summary for January 2021. We wish you a happy, healthy and prosperous new year.   Highlights Interest Rate Policy: The Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to “well-anchored” levels. We don’t expect Fed liftoff in 2021. Balance Sheet Policy: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities: The Fed will not undertake efforts to subvert Congress and re-establish its emergency lending facilities in 2021. However, the absence of the facilities will not have a negative impact on financial markets. Fiscal/Monetary Coordination: Looking beyond 2021, we see the lines between fiscal and monetary policy continuing to blur. The Fed will be increasingly incentivized to dip its toes into the fiscal arena and fiscal policymakers will let it. Feature Chart 1An Eventful Year An Eventful Year An Eventful Year It would be an understatement to say that 2020 was a busy year for the Federal Reserve. The Fed cut rates to the zero bound when the recession struck in March. It also exploded its balance sheet to fresh all-time highs and rolled out brand-new emergency lending facilities to support flagging credit markets (Chart 1). Then, to top it all off, the Fed concluded a Strategic Review of its monetary policy strategy in August and officially adopted an Average Inflation Target. This report touches on the market implications of 2020’s big Fed moves, but its focus is on what the Fed is likely to do in 2021. The first three sections discuss how we see the Fed’s interest rate policy, balance sheet policy and emergency lending facilities evolving next year. The final section considers a longer time horizon as it discusses what might be the next frontier for monetary policy: increased cooperation between monetary and fiscal authorities. Interest Rate Policy With the fed funds rate at its effective lower bound, bond investors will spend 2021 trying to determine the eventual start date and magnitude of the next tightening cycle. This will be especially complicated because the Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. We discussed the implications of the move toward Average Inflation Targeting in a September Special Report.1 To quickly recap, the Fed made three main changes that will influence our outlook for interest rate policy in 2021. First, the Fed edited its Statement on Longer-Run Goals and Monetary Policy Strategy to include a new interpretation of its price stability mandate. The new Statement reads: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.2 Second, the Fed modified its Statement on Longer-Run Goals and Monetary Policy Strategy to signal that it will rely less on labor market indicators to forecast future inflation. In its old Statement, the Fed talked about minimizing “deviations of employment from the Committee’s assessments of its maximum level.” The revised Statement talks about mitigating “shortfalls of employment from the Committee’s assessment of its maximum level.” In other words, the Fed is saying that it will be less inclined to view an unemployment rate below its estimated natural level (NAIRU) as a signal that inflation is about to accelerate. The Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. Finally, at the September FOMC meeting, the Fed translated the changes it made to its Statement on Longer-Run Goals and Monetary Policy Strategy into more explicit guidance about when it will consider lifting rates off the zero bound. That guidance is as follows: … it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.3 The Timing Of Liftoff Table 1A Checklist For Liftoff The Fed In 2021 The Fed In 2021 Digging into the new guidance, we identify three criteria for lifting rates off the zero bound (Table 1). First, the unemployment rate must reach levels consistent with the Committee’s assessments of NAIRU. Currently, those estimates range from 3.5% to 4.5% (Chart 2). Practically, we view this as the least important of the three criteria. NAIRU estimates are revised based on what happens with inflation, and the Fed has already acknowledged that it is now less inclined to view a sub-NAIRU unemployment rate as an inflationary signal. In short, if inflation were to rise sustainably above 2% with the unemployment rate still at 5%, the Fed would simply revise up its NAIRU estimates and begin the rate hike cycle. Chart 2Criteria For Lifting Rates Criteria For Lifting Rates Criteria For Lifting Rates The Fed’s second criterion for lifting rates is also the most specific. Inflation must rise to 2 percent before the Fed will consider hiking rates. In a recent speech, Fed Vice-Chair Richard Clarida said he interprets this to mean that 12-month PCE inflation must be at least 2% before the Fed will consider hiking (Chart 2, bottom panel).4 This is helpful for bond investors. We can be certain that no rate hikes will occur at least until 12-month PCE inflation reaches 2%. Finally, the Fed also wants to be certain that inflation is “on track to moderately exceed 2 percent for some time.” This means that the event of 12-month PCE reaching 2% won’t automatically lead to a rate increase. The Fed must also view inflation gains as sustainable. This will likely become an issue in the first half of 2021 when we know that base effects will push 12-month PCE sharply higher, possibly even above 2%. However, we also know that those gains will be short lived.5 Of course, the Fed also knows about the impact of base effects and it will look past any temporary jump in inflation in H1 2021. More generally, while we advise investors to not pay much attention to the Fed’s NAIRU estimates, the unemployment rate will play a role in the Fed’s determination of whether above-2% inflation is sustainable. That is, the Fed is more likely to view above-2% inflation as sustainable if the unemployment rate is 4% than it is if the unemployment rate is 6%. What Does The Market Think? The bond market has been quick to price-in the big shift in the Fed’s interest rate guidance. At present, the overnight index swap curve is priced for a single 25 basis point rate hike in mid-2023 and only one more by mid-2024 (Chart 3). We see a good chance that the Fed’s three liftoff criteria are met before then, a view that forms the basis of our below-benchmark portfolio duration recommendation for 2021.6 In addition, the New York Fed’s Survey of Market Participants shows that only 43% of respondents expect liftoff before the end of 2023 and only 31% before the end of 2022 (Table 2A). This is further evidence that bond yields have room to rise if it looks like the Fed’s three liftoff criteria will be met in 2022 or the first half of 2023. Finally, the New York Fed’s survey shows that market participants understand the Fed’s three liftoff criteria and that differences in opinion about the timing of liftoff reflect differences in views about the economic outlook, not differences in understanding the Fed’s reaction function. The bulk of survey respondents think that the unemployment rate will be between 3.5% and 4.2% (consistent with the Fed’s NAIRU estimates) and that 12-month PCE inflation will be between 2.2% and 2.5% at the time of liftoff (Table 2B). Chart 3The Fed May Lift Rates Sooner Than Markets Expect The Fed May Lift Rates Sooner Than Markets Expect The Fed May Lift Rates Sooner Than Markets Expect Table 2ALiftoff Expectations The Fed In 2021 The Fed In 2021 Table 2BMarkets Understand The Fed’s Guidance The Fed In 2021 The Fed In 2021 The Pace Of Tightening And Why We’re Watching Inflation Expectations We’ve seen the three criteria upon which the Fed will condition its decision to hike rates off the zero bound. But the timing of liftoff is not the only thing that bond investors need to consider. We also need to get a sense of how quickly rate hikes will proceed once the next tightening cycle begins. According to the Fed’s interest rate guidance, even after liftoff the Fed will seek to maintain accommodative monetary conditions until it has achieved its price stability goal under its new Average Inflation Target. Recall that this goal is defined as achieving “inflation that averages 2 percent over time”. This is somewhat vaguer than the Fed’s liftoff guidance. Over what time period should we seek to hit average 2% inflation? One option is to start calculating the average when the new regime was adopted in August. In that case, average PCE inflation is running at 0.96%, well below 2%. Alternatively, we could calculate average inflation since the Fed last cut rates to zero in March 2020 (1.50%) or average inflation since the Fed cut rates to zero in December 2008 (1.43%). The point is that the Fed has not given us a clearly defined target. Differences in opinion about the timing of liftoff reflect differences in views about the economic outlook. For this reason, it’s important for bond investors to understand why the Fed has shifted to an Average Inflation Target. The reason has to do with trying to re-anchor inflation expectations. Box 1 shows an example of an Expectations-Augmented Phillips Curve, the Fed’s go-to framework for thinking about inflation. As the accompanying quote from Janet Yellen explains, the Fed thinks about inflation’s long-run trend as being driven by expectations. Shocks to economic slack and import prices can cause inflation to deviate from its long-run trend, but expectations drive the trend itself. This makes it critical for a central bank to keep expectations well anchored near its inflation target. Box 1The Expectations-Augmented Phillips Curve (aka The Fed’s Inflation Model) The Fed In 2021 The Fed In 2021 This is the underlying rationale for the Fed’s Average Inflation Target. The Fed has observed that inflation expectations have been too low in recent years. In the Fed’s model, this signals that inflation’s long-run trend has shifted down. In order to get expectations back up to target, the Fed understands that it will probably need to accept a period of above-target inflation. Since economic agents have just experienced a long period of sub-2% inflation, it will probably require a significant period of above-2% inflation before their expectations sustainably shift higher.7 To sum it all up, the Fed will seek to keep monetary conditions accommodative, and thus supportive for risk assets, until inflation expectations are deemed to be re-anchored. At that point, monetary policy will shift to a neutral or restrictive stance and risk asset performance will be challenged. But don’t just take our word for it. Here is what Vice-Chair Clarida said in a recent speech (referenced above): It is important to note, however, that the goal of the new framework is to keep inflation expectations well anchored at 2 percent, and, for this reason, I myself plan to focus more on indicators of inflation expectations themselves – especially survey-based measures – than I will on the calculation of an average rate of inflation over any particular window of time. It is clear that inflation expectations will dictate the eventual pace of Fed tightening. But the question of what measure of inflation expectations to track remains unresolved. Measures of inflation expectations fall into three main categories: Market-based measures Survey measures Trend measures Market-based measures are derived from inflation-linked bonds. Specifically, we derive TIPS breakeven inflation rates for different time horizons by taking the difference between a nominal yield and TIPS yield of the same maturity. In this publication, we often refer to the 10-year and 5-year/5-year forward TIPS breakeven inflation rates and have found that a range of 2.3% to 2.5% has historically been consistent with periods when inflation expectations were deemed “well anchored” (Chart 4A). One potential issue with using market-based measures of inflation expectations is that TIPS prices can sometimes move around for reasons unrelated to changing inflation expectations. That is, regulations or broader portfolio diversification concerns could change the risk premium an investor is willing to accept from TIPS, even if that investor’s underlying inflation view is unchanged. Academics have made attempts to solve this problem by using affine term structure models to decompose yields into various components. Chart 4B presents one such model from D’Amico, Kim and Wei (DKW).8 The DKW model splits the TIPS breakeven inflation rate (or inflation compensation) into an inflation expectation, a liquidity premium that compensates investors for the lower liquidity in TIPS compared to nominal Treasuries and an inflation risk premium that represents the extra compensation investors require to take inflation risk. We are skeptical of the usefulness of affine term structure models. In general, these models have too few inputs to reliably generate the components they purport to measure. However, the Fed clearly pays some attention to the DKW decomposition. If a future increase in TIPS breakeven inflation rates is driven entirely by movement in the liquidity or inflation risk premium components, it would be reasonable to question whether the Fed will react. Chart 4AInflation Expectations: Market-Based Measures The Fed In 2021 The Fed In 2021 Chart 4BA Decomposition Of TIPS##br## Breakevens The Fed In 2021 The Fed In 2021 Survey measures of inflation expectations are exactly that: Responses from surveys, usually of professional forecasters or households (Chart 4C). One drawback of survey measures compared to market-based measures is that they are updated less frequently. Another is that survey respondents, particularly households, may only be able to distinguish very large swings in prices. That said, the Fed tracks a wide range of survey measures and they were even singled out by Vice-Chair Clarida as being particularly important in the above quote. Trend inflation measures are statistical measures of the trend in the actual PCE or CPI inflation data. Chart 4D shows both a very simple trend measure, the 10-year annualized rate of change, and a slightly more complex trend measure based on an exponential smoothing rule. Academics have developed even more complex trend inflation measures.9 The logic behind these measures is that expectations tend to adapt only slowly to changes in the actual inflation data. Chart 4CInflation Expectations: Survey Measures The Fed In 2021 The Fed In 2021 Chart 4DInflation Expectations: Trend Measures The Fed In 2021 The Fed In 2021 Finally, we should point out a relatively new measure that the Fed will be using to track inflation expectations going forward. It is called the Common Inflation Expectations Index and it is a composite of 21 different survey and market-based inflation measures (Chart 4E), no trend inflation measures are included.10 Chart 4EIntroducing The Common Inflation Expectations Index The Fed In 2021 The Fed In 2021 To summarize, the Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to levels that are considered “well anchored”. Once that happens, the Fed will no longer have an incentive to keep monetary conditions accommodative and risk asset performance will be challenged. Charts 4A-4E in this report provide a wide array of different measures of inflation expectations to monitor. We will keep an eye on all of them, but in particular, we will track the Common Inflation Expectations Index’s progress back to 2.1% and the 5-year/5-year forward TIPS breakeven inflation rate’s progress back to a range of 2.3%-2.5%. While we don’t expect the Fed’s rate hike criteria to be met in 2021, a 2022 liftoff is possible if the COVID vaccine spurs a rapid economic recovery. However, we do expect that, in 2021, the market will start to price-in an earlier liftoff date and quicker pace of tightening than is currently discounted, thus pushing bond yields higher. The Financial Conditions Wildcard Chart 5Financial Conditions Financial Conditions Financial Conditions Our base case view is that the eventual pace of Fed tightening will be determined by inflation expectations. However, there is one wildcard that could cause the Fed to abandon its inflation expectations goal and tighten policy earlier. That wildcard is financial conditions. Presently, financial asset valuations are a mixed bag (Chart 5). Corporate bond spreads are tight, but not at all-time expensive levels. Equity P/E ratios are very elevated, but equities don’t look expensive compared to bonds. If these valuations stay relatively stable, the Fed will continue to rely on inflation expectations to guide the pace of tightening. However, if inflation expectations take a long time to rise, it is conceivable that such a long period of low interest rates could lead to historically stretched financial asset valuations. In short, if inflation doesn’t return within the next couple of years, the Fed may have to tighten policy to take the wind out of an asset bubble that might otherwise burst and lead to an economic recession. We stress that we are not yet close to this point and that the bar for the Fed to abandon its inflation goal will be very high, but we would place financial conditions alongside inflation expectations as the two most important variables to monitor to assess the eventual pace of Fed tightening. Balance Sheet Policy With the funds rate pinned at zero and the Fed’s interest rate guidance essentially set in stone, changes to the pace and composition of asset purchases are the principal tool that the Fed will use to provide more or less immediate monetary accommodation in 2021. The Fed is currently purchasing $80 billion of Treasuries and $40 billion of Agency MBS each month, with Treasury purchases spread out across the yield curve. If this pace and distribution of Treasury purchases is maintained in 2021, the Fed will end up purchasing less and less of the Treasury flow. The Treasury Department has a stated policy goal of increasing the average maturity of the outstanding debt and it has been pursuing that goal by raising the amount of coupon issuance at the expense of bills. The Treasury has already given us its planned coupon issuance schedule for Q4 2020 and Q1 2021. Chart 6 shows that net Fed coupon purchases will gradually decline as a percentage of gross issuance, assuming the Treasury follows through with its plan and the Fed’s balance sheet policy is unchanged. Chart 6The Path For Treasury Supply And Fed Demand The Fed In 2021 The Fed In 2021 Can The Fed Do More? … Will The Fed Do More? It is possible that the Fed will use its balance sheet to provide more monetary easing in 2021. There are two ways it could do this. First, it could simply increase the monthly pace of asset purchases. Alternatively, it could keep the same pace of purchases but shift Treasury buying toward the long-end of the curve. The idea here would be to prevent long-dated yields from rising too quickly. One or both of these changes could happen in 2021, but only if the economy experiences a negative growth shock or risk asset prices (equities and corporate credit) fall significantly. In that case, the Fed will want to be seen as responding to a negative shock, but absent that, the Committee seems comfortable with its current balance sheet strategy. Chart 7Rate-Sensitive Sectors Have Recovered Rate-Sensitive Sectors Have Recovered Rate-Sensitive Sectors Have Recovered Some have suggested that, even if the economic recovery stays on track, the Fed will try to use its balance sheet to lean against rising long-maturity bond yields. We doubt this. First, it is not obvious that the Fed would be able to stop the 10-year Treasury yield from rising to a range of, say, 1.25% to 1.5% by increasing bond purchases in that maturity range by a few billion dollars. As long as the Fed’s interest rate guidance is unchanged, the market’s interest rate expectations will continue to exert a powerful influence on bond yields across the entire curve. Unless the Fed announces a cap on long-dated bond yields, and pledges to buy enough securities to enforce that cap, we are skeptical about the effectiveness of just changing the quantity of asset purchases. Second, it is also not clear that a 10-year Treasury yield between 1.25% and 1.5%, in the context of a steepening yield curve and improving economic growth, would be a problem for either the economy or risk assets. In fact, these sorts of environments tend to be very positive for risk asset performance.11 It is only when the Fed is shifting to a more restrictive monetary policy stance and the yield curve is flattening that bond yields start to exert a negative influence on the economy and risk assets. Even if the Fed is not worried about a moderate bear-steepening of the Treasury curve, a case could be made for providing more easing right now in order to spur a quicker recovery. This question was posed to Chair Powell several times at the last FOMC press conference. In response, Powell noted that the sectors of the economy that are most sensitive to interest rates – residential investment and consumer spending on durable goods – have already recovered (Chart 7). The lagging sectors of the economy – particularly consumer spending on services – cannot recover until the COVID vaccine is widely distributed, irrespective of the level of interest rates. In our view, this is an acknowledgement that the Fed does not see much value in trying to provide further accommodation through the balance sheet channel. All in all, our base case scenario is that the Fed will maintain its current pace and maturity distribution of asset purchases throughout 2021. However, it will increase the pace and/or lengthen the maturity if there is a significant shock to the economy and/or financial markets. Later in 2021, if the recovery stays on track, Fed communications will increasingly take up the issue of when it will be appropriate to taper its pace of asset purchases. The Exit From Asset Purchases And The Possibility Of A Taper Tantrum Chart 8Remember The Taper Tantrum Remember The Taper Tantrum Remember The Taper Tantrum The Fed has already given us a timeline for how it will wind down its asset purchases. According to the minutes from the November FOMC meeting, most participants support a timeline where the Fed will start tapering its pace of asset purchases sometime before the first rate hike. It will then begin lifting interest rates and will stop purchases altogether sometime after that. At the December FOMC meeting, the Fed gave us additional guidance on when it will start the tapering process. Unfortunately, this guidance is quite vague and only confirms the fact that tapering will start before the liftoff date. Specifically, the Fed said that tapering will begin when “substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” Because the guidance around the timing of the tapering process is quite vague, we think it’s possible that it could sneak up on investors and lead to a sharp upward re-adjustment in rate hike expectations, and thus a bond sell-off. In essence, a tamer version of the 2013 Taper Tantrum is possible in late-2021 or 2022. On May 22, 2013, Fed Chair Ben Bernanke explained the Fed’s plan to eventually start tapering its asset purchases. Because investors took this to mean that the rate hike cycle would start much sooner than anticipated, the bond market underwent a sharp re-adjustment. The market quickly went from pricing-in only 35 bps of rate hikes over the next 24 months to 116 bps, and Treasury returns fell precipitously as a result (Chart 8). The Fed has learned a few lessons about communications since then, and it will do its best to keep market expectations aligned with its own strategy. However, unless firmer guidance is provided about when tapering will begin, the risk of a hawkish surprise around the tapering announcement remains.  Bottom Line: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities In addition to cutting rates to zero and massively scaling up the size of its balance sheet, the Fed also responded to the COVID recession by launching a slew of emergency lending facilities, some re-treads from the financial crisis and some brand new. Facilities to support the corporate bond market (The Primary and Secondary Market Corporate Credit Facilities) and the Municipal Liquidity Facility were particularly successful at capping bond spreads versus Treasuries, even if their actual usage was quite low. In fact, corporate bond spreads peaked on the very day that the Fed announced its corporate credit facilities in March (Chart 1). More recently, however, Treasury Secretary Steve Mnuchin refused to authorize the continuation of most of the Fed’s emergency lending facilities beyond the end of the year. We wrote in November that, even with the Treasury taking back the funds used to set up the facilities, the Fed could re-launch them in 2021 if incoming Treasury Secretary Janet Yellen provides her approval.12 However, a late addition to the recently passed fiscal stimulus package appears to prohibit the re-authorization of the facilities without Congressional approval. At the time of publishing, we have not been able to see the details of the new provision, so there remains some uncertainty about what the Fed can and cannot do in this regard. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all. Nonetheless, while the new bill raises interesting questions about Fed independence in the long-run, we doubt that markets will respond negatively to the absence of the Fed’s emergency facilities in 2021. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all (Table 3). Table 3Usage Of The 2020 Federal Reserve Emergency Lending Facilities The Fed In 2021 The Fed In 2021 In short, we don’t see the Fed going out of its way to re-establish the facilities in 2021 because it will become clear that they are no longer needed. The Next Regime Shift In Fed Policy: Fiscal/Monetary Coordination The adoption of an Average Inflation Target represents a major regime shift in Federal Reserve policy. In the final section of this report, we expand our horizon beyond 2021 and speculate about what the next major regime shift for the Fed might be. The 2020 recession made two things crystal clear. First, traditional fiscal policy becomes essentially impotent once interest have been reduced to the zero-lower-bound. Once there, Fed policy is most impactful when it focuses on lending to the private sector. Lending to the private sector through an emergency lending facility is an act that blurs the distinction between monetary and fiscal policy. This was made abundantly clear by Congress’ recent push to legislate the Fed’s activities in this arena. Second, it is difficult for fiscal policy to act quickly enough during an economic downturn. While the CARES act was delivered in a timely manner, it has taken many months to pass a follow-up bill. The Fed’s independence allows it to act immediately when it is economically necessary, while Congress’ increasing polarization makes swift action a challenge. If we take these two observations to their logical conclusion, and throw in the strong chance that the traditional channels of monetary policy will be increasingly blocked in the future as rates bump up against zero, it seems to us that the strict separation of responsibilities between fiscal and monetary policymakers will fade over time. More specifically, greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities. Further, Congress will be more than happy to allow this encroachment as it finds itself unable to respond effectively in times of crisis. Of course, this will also lead to periodic push-back as some members of Congress fret about the Fed’s over-reach, but we expect this push-back will be the exception rather than the rule. Greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities.  In fact, the best idea might be for fiscal and monetary policymakers to join together proactively to craft programs that can be deployed during the next recession. One example of such an idea was recently presented by Julia Coronado and Simon Potter.13 Coronado and Potter’s idea relies on the use of instant payment processing technology (which the Fed is already working on) to create digital accounts at the Federal Reserve for every household. Once those accounts are in place, the federal government could issue Recession Insurance Bonds, zero coupon bonds with some pre-determined face value, and grant one bond to every household in the country. Then, during the next economic downturn, the Fed could decide to do a “people’s QE” where it buys all the Recession Insurance Bonds leaving every household with a direct cash payment equal to the face value of the bond. This scheme directly addresses the two main problems we named earlier. It is fiscal policy, not monetary policy, so it can still be effective at the zero-lower-bound. Also, Congress can take its time to deliberate on the bill that authorizes the creation of the Recession Insurance Bonds, as this can be done proactively during a period of economic recovery. Then, the Fed can use its ability to move quickly during the next downturn to “activate” the bonds and deliver the fiscal stimulus that Congress actually passed years earlier. While likely not a story for 2021, we see increased cooperation between monetary and fiscal policymakers as the next big regime shift for the Fed.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 4 https://www.federalreserve.gov/newsevents/speech/clarida20201116a.htm 5 For a more complete discussion of our 2021 inflation outlook please see “BCA Outlook 2021: A Brave New World”, dated November 30, 2020, available at bca.bcaresearch.com 6 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 7 This is the theory of adaptive expectations and we use it to model changes in the 10-year TIPS breakeven inflation rate. For further details please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 8 https://www.federalreserve.gov/econres/notes/feds-notes/tips-from-tips-update-and-discussions-20190521.htm 9 Fed Governor Lael Brainard references several of these trend measures in this recent speech: https://www.federalreserve.gov/newsevents/speech/brainard20201021a.htm&…; 10 More details on how this aggregate measure is constructed can be found here: https://www.federalreserve.gov/econres/notes/feds-notes/index-of-common-inflation-expectations-20200902.htm 11 For more details on how corporate credit performs during different yield curve environments please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 13 https://www.piie.com/publications/policy-briefs/reviving-potency-monetary-policy-recession-insurance-bonds

Highlights Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global bond yields see some upward pressure as growth picks up, but global real yields will stay negative with on-hold central banks actively seeking an inflation overshoot. Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. The rise in global bond yields we anticipate will be relatively moderate, with US Treasury yields rising the most. Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields (core Europe, Japan, UK). Also overweight Peripheral European debt given supportive monetary and fiscal policies that are helping to reduce credit risk (Italy, Spain, Portugal). The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Overweight global inflation-linked bonds versus nominal government debt. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. Upgrade US high-yield to overweight through higher allocations to lower rated credit tiers, while downgrading US investment grade, where valuations are far less compelling, to neutral. Favor US corporates versus euro area equivalents, of all credit quality, based off less attractive euro area spread valuations. Within US$-denominated emerging market debt, favor corporates over sovereigns. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2020. Please join me for a webcast this coming Friday, December 18 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook followed by a Q&A session. Best wishes for a very safe, healthy and prosperous 2021. We’ve all earned that after a difficult 2020 that none of us will soon forget. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2021 report, “A Brave New World”, outlining the main investment themes for next year based on the collective wisdom of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2021. In a follow-up report to be published in the first week of the New Year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2021 BCA Outlook The tone of the BCA 2021 Outlook was generally positive, with conclusions that are supportive for the outperformance of risk assets relative to safe havens like government bonds (Chart 1). Chart 1How To Play Recovery & Reflation In 2021 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Global growth will strengthen over the course of next year, after an initial soft patch related to the late-2020 COVID-19 economic restrictions in Europe and the US. Economic confidence will improve as the COVID-19 vaccines become more widely distributed, at a time of ongoing substantial monetary and fiscal stimulus in most important countries. A major release of pent-up demand is likely, fueled by the surge in private sector savings in the US and Europe after households and businesses cut back on spending because of the pandemic. The lingering impact of China’s substantial fiscal and credit stimulus in 2020 will still be felt throughout the world for most of 2021, even with Chinese authorities likely to begin curtailing the expansion of credit around mid-year. The tremendous amount of global spare capacity created by the virus and associated economic restrictions will keep inflation subdued in most countries. Thus, both monetary and fiscal policymakers will be under no pressure to pre-emptively tighten policy. The pace of monetary/fiscal stimulus will inevitably slow on a rate-of-change basis after the massive ramp up of government spending, income support, loan guarantees and central bank asset purchases. However, policymakers are expected to pull any and all of those levers once again in the event of a severe pullback in economic growth or a major bout of financial market turbulence. After a wild 2020 in a US election year, geopolitical uncertainty is expected to recede a bit next year. Although US-China tensions will remain elevated even under the incoming Biden administration, European politics are expected to be a tailwind for financial markets. A UK-EU Brexit deal is expected to be reached given economic realities, increased fiscal cooperation within the EU will support fiscally weaker countries like Italy, and the threat of the US imposing tariffs on Europe will disappear after Donald Trump leaves office. Our Four Main Key Views For Global Fixed Income Markets In 2021 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. Chart 2COVID-19 Lockdowns Will Not Last Forever COVID-19 Lockdowns Will Not Last Forever COVID-19 Lockdowns Will Not Last Forever COVID-19 was the elephant in the room for financial markets in 2020, influencing sentiment whenever cases flared up or subsided. Yet the impact diminished steadily since the first wave of the virus stretched beyond China in the spring. The broad span of global risk assets – equities, corporate credit, industrial commodities – has performed very well during the current, and much larger, surge in cases occurring in the US and Europe. One big reason for this is that investors now understand that lockdowns, and the associated drag on economic growth, do not last forever. In addition, investors know that policymakers in most countries will react to any sharp downturn in economic confidence with more fiscal and monetary stimulus to help offset the negative growth impact of the lockdowns. In Europe, many European governments enacted harsh national lockdowns in a bid to “flatten the curve” during the latest surge. This has helped successfully reduce the growth rate of new cases and hospitalizations (Chart 2). This will eventually lead to an easing of restrictions, and a recovery in economic activity, in early 2021. While US case numbers are also surging, the response by governments has been much less widespread, and severe, compared to Europe. There is little political appetite (even with a new president) for another wave of harsh restrictions along the lines of what took place last spring. Some slowing of economic activity is inevitable because of increased regional restrictions in large states like California and New York, as is already evident in some late-2020 data. However, any downturn should not be expected to last long with the growth rate of US COVID-19 hospitalizations having already peaked. The big game-changer, of course, is the introduction of COVID-19 vaccines which have already begun to be distributed in the UK and US. While there are uncertainties related to the operational logistics of a worldwide vaccine rollout, including whether enough people will voluntarily choose to be vaccinated to achieve herd immunity on a global scale, the very high announced efficacy levels of the various vaccines mean that an end of the pandemic is now achievable. Investors should see through the current surge in COVID-19 cases, and any short-term hiccup in economic growth, and focus on the bigger picture of the introduction of the vaccine and the positive implications for global economic confidence in 2021. Growth has already been holding up well in the US and China in the final months of 2020, with both manufacturing and services PMIs remaining solidly above the 50 line indicating expanding activity. As the euro area lockdowns begun to ease up, growth there will catch up, which already appears to be underway with the sharp uptick in the December PMI data (Chart 3). Those three regions account for one-half of worldwide GDP, so that is already a solid footing for global growth entering 2021. A sustained improvement in the pace of global economic activity is important, as it is becoming increasingly harder for governments to sustain the extreme levels of policy stimulus delivered in 2020. In China, policymakers are starting to rotate their focus away from aggressive stimulus and fighting deflation back to the cautious risk management approach to credit expansion that was in place prior to COVID-19. BCA Research’s China strategists expect the latest Chinese credit cycle to peak by mid-2021, with the credit impulse set to decline in the second half of the year (Chart 4). Combined with the tightening of monetary conditions through a strengthening yuan and higher local interest rates, some slowing of Chinese growth is inevitable. Although given the lags between stimulus and growth, the impact is more likely to be felt toward year-end and into 2022 – good news for much of the global economy that still relies heavily on exporting to China as an engine of growth. Chart 3A Growth Recovery Without Inflation A Growth Recovery Without Inflation A Growth Recovery Without Inflation Chart 4China Stimulus Will Peak Out By Mid-2021 China Stimulus Will Peak Out By Mid-2021 China Stimulus Will Peak Out By Mid-2021 Overall global fiscal policy is on track to be less supportive in 2021. The latest estimates from the IMF show that the “fiscal thrust”, or the change in the cyclically-adjusted primary budget balance relative to potential GDP, in most developed economies will turn negative next year (Charts 5A and 5B). Such a swing is inevitable given the sheer magnitudes of the fiscal stimulus measures first introduced to combat the economic damage from COVID-19 that will not be repeated in 2021. By the same token, less fiscal stimulus will be necessary if overall global growth improves, especially if vaccines can be successfully distributed to much of the world. Chart 5ANegative Fiscal Thrust In 2021 … Negative Fiscal Thrust In 2021 ... Negative Fiscal Thrust In 2021 ... Chart 5B… But Governments Will Spend More If Needed ... But Governments Will Spend More If Needed ... But Governments Will Spend More If Needed What does all this mean for global government bond yields? We believe that it signals a continuation of the trends seen towards the end of 2020 – a slow grind higher in longer-term yields, led by better growth and rising inflation expectations, but without any need to discount a move to tighter monetary policy because of a sustained overshoot of realized inflation. The current economic projections of the Fed, ECB, Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) all show that policymakers there expect unemployment rates to remain above pre-pandemic levels to at least 2023 (Chart 6). At the same time, central banks are also projecting inflation to be below their target levels/ranges over that same period. In response, the forward guidance from these central banks has been very dovish, with policy interest rates expected to remain at current levels at or near 0% for at least the next two to three years. Interest rate markets have taken the hint, with a very low expected path for rates over the next few years discounted in overnight index swap curves. Chart 6Central Banks Projecting A Slow Return To Full Employment 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Chart 7Markets Expect Years Of Negative Real Policy Rates Markets Expect Years Of Negative Real Policy Rates Markets Expect Years Of Negative Real Policy Rates The implication of this is that central banks are projecting a sustained, multi-year period where policy rates will remain below forecasted inflation (Chart 7). Or put more simply, central banks are consistently signaling that negative real interest rates will persist for a long time. This means that one of the most oft-discussed “oddities” of global bond markets in 2020 - the persistence of negative real long term bond yields in most major economies, most notably in the US Treasury market, even as inflation expectations increase – is unlikely to disappear in 2021. Those negative real yields reflect, to a large part, the expectation that real global policy rates will stay persistently negative (Chart 8). At some point in 2021, markets could challenge this dovish guidance from central banks that could temporarily push up both future interest rate expectations and longer-term real yields, especially in the US. However, it is more likely that central banks will not validate that move higher in yields for fears of pre-emptively short-circuiting an economic recovery. Such a hawkish shift could be more plausibly delivered in 2022 at the earliest, with the Fed the most likely candidate to change its guidance. Summing up all of the above points with regards to our recommendations on overall management of government bond portfolios, we arrive at the following conclusions (Chart 9): Chart 8Rising Inflation Breakevens With Stable Negative Real Yields Rising Inflation Breakevens With Stable Negative Real Yields Rising Inflation Breakevens With Stable Negative Real Yields Chart 9Moderately Higher Global Bond Yields In 2021 Moderately Higher Global Bond Yields In 2021 Moderately Higher Global Bond Yields In 2021 Duration exposure should be set below-benchmark. Our forward-looking Duration Indicator, comprised of leading economic indicators and economic expectations data, is strongly signaling that global yields should head higher in 2021. Position for a bearish steepening of yield curves. This will be driven more by rising longer-term inflation expectations, as the short-ends of yield curves will remain anchored by dovish on-hold central banks. Key View #2: Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields Moving beyond the overall global duration view, there are significant country allocation decisions that derive from our outlook for 2021. First and foremost, we recommend underweighting US Treasuries in global bond portfolios, as we anticipate the biggest increase in developed market bond yields next year to occur in the US. We expect the benchmark 10-year Treasury yield to rise to the 1.25% to 1.5% range sometime in 2021. This move will come mostly through higher inflation expectations. The 10-year TIPS breakeven inflation rate is expected to reach the 2.3-2.5% range that we have long considered to be consistent with the market pricing in the Fed sustainably achieving its 2% inflation goal. Any additional Treasury yield increases beyond our 2021 forecast range would require the Fed to shift to a more hawkish stance signaling future rate hikes. With the Fed now operating with an Average Inflation Target framework, allowing for temporary overshoots of inflation after periods when inflation was below the Fed’s 2% target, the hurdle for such a shift in Fed guidance is much higher than in previous years. The Fed has also changed the nature of its forward guidance compared to years past, signaling that any future monetary tightening will only occur once actual inflation has sustainably returned to the 2% target. That means that the Fed will no longer pre-emptively choose to hike rates on merely a forecast of higher inflation – it will first need to see a sustained period of higher inflation materialize before considering any tightening. Thus, any move beyond our expected 1.25% to 1.5% range on US Treasuries would require a hawkish signal by the Fed that it intends to begin removing monetary accommodation through rate hikes. Under the Average Inflation Target framework, that will not happen in 2021 but could happen the following year if inflation stays at or above 2% over the course of next year. Turning to other countries, we recommend favoring bond markets with a lower historical “yield beta” to US Treasuries. In other words, we prefer overweighting counties where government bond yields are typically less correlated to changes in Treasury yields. We show those historical yield betas, using 10-year yields, in Chart 10. Importantly, the betas are calculated only for periods when Treasury yields are moving higher. We call this “upside beta”, which is a useful tool to identify which bond markets are more sensitive to selloffs in the US Treasury market. Chart 10Favor Lower Beta Government Bond Markets In 2021 Favor Lower Beta Government Bond Markets In 2021 Favor Lower Beta Government Bond Markets In 2021 The highest “upside beta” countries among the major developed markets are Australia, Canada and New Zealand, while the lowest “upside beta” countries are Germany, France and Japan. The UK is in the middle of those two groupings, although the trend over the past few years suggests that it is transitioning from a high-beta to low-beta country. Note that for all countries shown, the upside yield betas are below one, indicating that no market should be expected to see a bigger rise in yields than the US. Strictly based on our forecast of higher Treasury yields and calculated yield betas, we would recommend more overweight allocations to markets in the lower-beta group and more underweight allocations to the higher-beta group. We are comfortable recommending overweights to the lower-beta group of Germany, France, Japan and the UK. Although among the higher-beta group, we are reluctant to recommend underweighting all three countries because of the policy choices of their central banks. The RBA, BoC and Reserve Bank of New Zealand (RBNZ) have all enacted aggressively large quantitative easing (QE) programs in 2020 as a way to provide additional monetary stimulus after cutting policy rates to near-0%. The BoC stands out as being extremely aggressive on QE with its balance sheet expanding more than three-fold on a year-over-year basis (Chart 11). Chart 11More Divergence In The Pace Of Global QE More Divergence In The Pace Of Global QE More Divergence In The Pace Of Global QE None of these three central banks has discussed slowing the pace of purchases anytime soon. In the case of the RBA and RBNZ, they have gone as far as signaling the role of QE in dampening their bond yields to help stem the appreciation of their currencies. They may have limited success in driving down yields further, however. Measures of bond valuation like the term premium, which typically move lower when QE accelerates, have bottomed out across the developed markets even as central banks have absorbed a greater share of the stock of government debt in 2020 (Chart 12). Yet even if QE can no longer drive yields lower, it can limit how much yields can increase when under cyclical upward pressure. For this reason, we do not expect government bond yields in Australia, Canada or New Zealand to behave in line their historical higher yield beta that would make them clear underweight candidates in a period of rising US Treasury yields, as we expect. Net-net, we recommend that investors focus underweights solely on US Treasuries within global government bond portfolios. This suggests that yield spreads between Treasuries and other bond markets should continue to widen, as has been the case over the final few months of 2020 (Chart 13). We recommend neutral allocations to Australia, Canada and New Zealand, while overweighting core Europe, Japan and the UK. Chart 12More QE Is Less Impactful In Pushing Down Bond Yields More QE Is Less Impactful In Pushing Down Bond Yields More QE Is Less Impactful In Pushing Down Bond Yields Chart 13US Treasuries Will Continue To Underperform In 2021 US Treasuries Will Continue To Underperform In 2021 US Treasuries Will Continue To Underperform In 2021 We also are maintaining our overweight recommendation on Italian and Spanish government debt, which was one of our most successful calls of 2020. We view those markets more as a credit spread story versus core Europe, rather than a directional yield instrument like US Treasuries or German Bunds. On that basis, the spread of Italian and Spanish yields versus German yields has room to compress even further, as both are strongly supported by ECB bond purchases. Also, the introduction of the European Union’s €750bn Recovery Fund is a strong signal of greater fiscal co-operation within Europe – another important factor that has helped reduce the risk premium (credit spread) on Italy and Spain. When looking at the yields currently on offer in the developed world, Italy and Spain offer very attractive yields in a global low-yield environment (Table 1). Stay overweight. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Key View #3: Overweight global inflation-linked bonds versus nominal government debt We have discussed the importance of rising inflation expectations as a core driver of the rise in global bond yields that we expect in 2021. This has been in the context of improving global growth, reduced spare economic capacity and central banks staying very dovish, all of which are necessary ingredients to boost depressed inflation expectations. A weaker US dollar will also play a significant role in that boost to inflation expectations and bond yields that we expect next year. The decline in the greenback seen in the latter half of 2020 has been driven by the typical factors (Chart 14): Chart 14More Negatives Than Positives For The USD More Negatives Than Positives For The USD More Negatives Than Positives For The USD The Fed’s aggressive rate cuts, dating back to 2019, have reduced much of the relative interest rate attractiveness of the US dollar Accelerating global growth after the sharp worldwide plunge in growth in Q2/2020 benefitted non-US economies more, eliciting a standard decline in the “anti-growth” US dollar Uncertainty and risk aversion declined after the initial COVID-19 shock at the start of 2020, easing the safe haven demand for dollars. Looking ahead, rate differentials continue to point to additional downward pressure on the US dollar, even with the moderate rise in longer-term US Treasury yields that we expect next year. Risk aversion and uncertainty should also decline in a dollar-bearish fashion with the US presidential election behind us and the COVID-19 vaccine ahead of us. Improving global growth should also be supportive of more dollar weakness, especially as Europe recovers from the current lockdown-driven slowdown. A weaker US dollar is a key variable to trigger faster global inflation through the link between the currency and global traded goods prices. On a rate-of-change basis, a weakening US dollar has a strong negative correlation to the growth rate of world export prices and commodity prices (Chart 15). Thus, more USD weakness in 2021 will lift realized global inflation through commodities and traded goods prices, especially against a backdrop of faster global growth. Chart 15Global Reflation Through A Weaker USD Global Reflation Through A Weaker USD Global Reflation Through A Weaker USD Chart 16Stay Overweight Global Inflation-Linked Bonds In 2021 Stay Overweight Global Inflation-Linked Bonds In 2021 Stay Overweight Global Inflation-Linked Bonds In 2021 BCA Research’s commodity strategists expect oil prices to move higher next year on the back of an improving demand/supply balance, with the benchmark Brent price of oil averaging $63/bbl over the course of 2021. A weaker USD could provide additional upside to that forecast, giving a further lift to realized inflation rates around the world. To position for this boost to inflation via a weaker dollar and rising commodity prices, we recommend that fixed-income investors continue holding a core allocation to inflation-linked bonds versus nominal government debt. We have maintained that recommendation since last spring after the collapse of global breakeven inflation rates that left breakevens very undervalued according to our fair value models (Chart 16).2 The valuation case is far less compelling now after the steady climb in breakevens over the latter half of 2020, with only French and Japan breakevens below fair value. However, given our expected backdrop of improving global growth and highly accommodative global monetary policy, breakevens are likely to continue to climb to more expensive levels. Our preferred allocations are to US and French inflation-linked bonds, while we would be cautious on Australian inflation-linked bonds which appear extremely overvalued on our models. Key View #4: Within an overweight allocation to global corporate debt, overweight US high-yield versus US investment grade and favor all US corporates versus euro area equivalents. Global corporate bond markets have enjoyed a spectacular rally over the final three quarters of 2020 after the huge pandemic related selloff of last February and March. The benchmark index yields for investment grade corporates in the US, euro area and UK have all fallen back below pre-COVID levels, while index yields for high-yield in the same three regions are back at the pre-COVID lows (Chart 17). The story is similar on a credit spread basis. The benchmark index option-adjusted spread (OAS) for investment grade corporates is only 11bps away from the pre-COVID low in the US and 4bps from the pre-COVID low in the euro area, with the UK spread now slightly below the pre-pandemic low (Chart 18). High-yield spreads still have some more room to compress with US, euro area and UK junk index spreads 67bps, 68bps and 110bps above the pre-pandemic low, respectively. Chart 17Corporate Bond Yields Falling To New Lows Corporate Bond Yields Falling To New Lows Corporate Bond Yields Falling To New Lows Chart 18Corporate Bond Spreads Approaching Pre-COVID Lows Corporate Bond Spreads Approaching Pre-COVID Lows Corporate Bond Spreads Approaching Pre-COVID Lows Supportive monetary policy has played a huge role in the global credit rally. Central banks have used their balance sheets aggressively to help ease financial conditions, including the direct buying of corporate bonds by the Fed, ECB and BoE. Looking ahead to 2021, it is clear that credit markets are still benefitting from loose monetary policy while also enjoying a tailwind from better global growth. The global high-yield default rate is rolling over and the US default rate has clearly peaked (Chart 19). There is now less of a need for direct buying of corporates by central banks with credit markets seeing major investor inflows with a robust pace of corporate bond issuance. Corporate bond markets can now walk on their own with the support of central bank crutches. This means that investors should pivot away from the more cautious “buy what the central banks are buying” approach that we had advocated for much of 2020 and be more selectively aggressive. First and foremost, that means increasing allocations to US high-yield corporate debt, both out of US investment grade and euro area corporates. Default-adjusted spreads in the US, which measure the high-yield index OAS net of realized default losses, will look far more attractive as the US default rate peaks (Chart 20). If the US default rate moves back below 5% over the next year from the current 8% rate, the US default-adjusted spread will climb back into positive territory. This will compare more favorably to the default-adjusted spread for euro area high-yield, which has been higher because the euro area default rate did not suffer a major spike this year despite the sharp downturn in euro area growth back in the spring. Chart 19Easy Money Policies Supporting Global Credit Easy Money Policies Supporting Global Credit Easy Money Policies Supporting Global Credit Chart 20High-Yield Looks More Attractive With Fewer Defaults In 2021 High-Yield Looks More Attractive With Fewer Defaults In 2021 High-Yield Looks More Attractive With Fewer Defaults In 2021 US high-yield also looks most attractive using our preferred metric of pure spread valuation, the 12-month breakeven spread. This measures the amount of spread widening that must occur over a one year period for corporate debt to have the same return as a duration-matched position in government bonds. We compare this “spread cushion” to its own history in a percentile ranking to determine if spreads look relatively attractive. Within US corporate debt, the 12-month breakeven spread for investment grade credit is down to the 5th percentile, suggesting virtually no room for additional spread tightening (Chart 21). For US high-yield credit, the 12-month breakeven spread is still relatively elevated at the 60th percentile level, suggesting more room for spread compression. Within euro area corporates, the 12-month breakeven percentile rankings for investment grade and high-yield are at the 27th and 28th percentile, respectively, suggesting a more limited scope for spread compression compared to US high-yield (Chart 22). Chart 21Move Down In Quality Within US Corporates Move Down In Quality Within US Corporates Move Down In Quality Within US Corporates Chart 22No Compelling Value In Euro Area Corporates No Compelling Value In Euro Area Corporates No Compelling Value In Euro Area Corporates When comparing the 12-month breakeven spreads of all corporate debt in the US, euro area and UK, broken down by credit tier, to a more pure measure of spread risk - duration times spread – the attractiveness of lower-rated US junk bonds is most compelling (Chart 23). In particular, US B-rated and Caa-rated junk spreads offer very high 12-month breakeven spreads relative to spread risk. Chart 23Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Adding it all up, it is clear that lower-rated US high-yield debt offers an attractive value proposition for 2021. This is especially true given the positive global growth and monetary policy backdrop. The annual growth rate of the combined balance sheets of the Fed, ECB, BoE and Bank of Japan has been an excellent leading indicator of the excess return of US high-yield US Treasuries (Chart 24). The surge in balance sheet growth of 2020 is pointing to strong US high-yield bond performance versus Treasuries, and an outperformance of lower-rated US high-yield, in 2021. Chart 24Upgrade US High-Yield To Overweight Upgrade US High-Yield To Overweight Upgrade US High-Yield To Overweight Chart 25Within EM USD Credit, Favor Corporates Over Sovereigns Within EM USD Credit, Favor Corporates Over Sovereigns Within EM USD Credit, Favor Corporates Over Sovereigns This leads us to shift to an overweight stance on US high-yield, while downgrading US investment grade to neutral, as our key global spread product recommendation for 2020. Within other corporate credit markets, we recommend only a neutral allocation to euro area corporate credit, given the relatively less attractive valuations. Finally, within the emerging market US dollar denominated universe, we continue to recommend an overweight stance on corporates versus sovereigns, as the former will benefit more in 2021 from the lagged effect of Chinese credit stimulus and central bank balance sheet expansion in 2020 (Chart 25).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research The Bank Credit Analyst, "Outlook 2021: A Brave New World", dated November 30, 2020, available at bca.bcaresearch.com. 2 Our breakeven inflation models use the growth rate of oil prices in local currency terms and a long-term moving average of realized inflation as the inputs. Recommendations Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Below-Benchmark Portfolio Duration: The economic recovery will continue (and even accelerate) in 2021. Meanwhile, the Fed’s forward interest rate guidance is already as dovish as it will get. Keep portfolio duration below-benchmark in 2021, targeting a level of 1.25% to 1.5% for the 10-year Treasury yield.  Overweight TIPS Versus Nominal Treasuries: We remain overweight TIPS versus nominal Treasuries for the time being but are actively looking for an opportunity to get tactically underweight. This opportunity could emerge in the first half of 2021 when core and trimmed mean inflation re-converge and when the 10-year TIPS breakeven inflation rate looks expensive on our model.  Own Nominal Yield Curve Steepeners, Real Yield Curve Steepeners And Inflation Curve Flatteners: The nominal yield curve will continue to trade directionally with yields. Therefore, higher yields will coincide with a steeper nominal curve in 2021. Rising inflation and the Fed’s new Average Inflation Target both argue for a flatter inflation curve in 2021. We also recommend a real yield curve steepener as a high octane play on both a steeper nominal curve and flatter inflation curve. Overweight Spread Product Versus Treasuries: We see the economy as entering what we call “Phase 1” of the economic cycle in 2021, an environment of above-trend growth, low inflation and accommodative monetary policy. This is an environment where spread product typically performs very well relative to Treasuries. Move Down In Quality Within Corporates: Investment grade corporates will outperform Treasuries in 2021, but the potential for further spread compression is limited. Junk spreads have more room to tighten, and the Ba credit tier looks particularly attractive from a risk/reward perspective A Maximum Overweight Allocation To Municipal Bonds: Tax-exempt municipal bonds offer the best opportunity in the US fixed income space. Investors should adopt a maximum overweight allocation, and in particular, they should shift some allocation out of investment grade corporates and into Munis with the same credit rating and duration, but with a greater after-tax yield. Feature BCA published its 2021 Outlook on November 30. 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 six key US fixed income views for 2021. This report is limited to the six key investment views listed on page 1, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2021” report that will delve into our outlook for the Fed next year. Outlook Summary First, a brief summary of the main economic views presented in BCA’s 2021 Outlook:1 The third wave of COVID infections will be a drag on economic activity in 2020 Q4 and 2021 Q1, but inventory re-stocking and the large build-up of household savings will prevent the US economy from falling into a double-dip recession. Ultimately, the vaccine roll-out will cause US GDP to grow well above trend in 2021. Inflation is likely to spike in the first half of 2021 due to base effects and the re-opening of some service sectors that were shuttered during the pandemic. But this initial surge will dissipate in the second half of the year. The wide output gap that opened in 2020 will persist in 2021 and will prevent a broad-based acceleration in consumer prices. The Fed’s forward interest rate guidance is as dovish as it will get. A large portion of the Outlook is devoted to considering longer-run economic and political trends that were accelerated by the global policy response to COVID-19. Specifically, rising populism, heavier corporate regulation and a greater appetite for MMT-like taxing and spending policies. The ultimate outcome of these trends will be significantly higher inflation, on the order of 3% to 5%, in the second half of the decade. Key View #1: Below-Benchmark Portfolio Duration Chart 1Treasury Yields In 2020 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The economic recovery will continue (and even accelerate) in 2021. Meanwhile, the Fed’s forward interest rate guidance is already as dovish as it will get. Keep portfolio duration below-benchmark in 2021, targeting a level of 1.25% to 1.5% for the 10-year Treasury yield. Our recommendation to maintain below-benchmark portfolio duration rests on two key pillars. The first is BCA’s view that the economic recovery will continue in 2021 and will even accelerate once enough of the population has received the COVID vaccine. The second pillar is our view that the Federal Reserve’s reaction function is as dovish as it will get. In other words, having already laid out the conditions that must be in place for it to begin the next rate hike cycle, the Fed will not undertake further efforts to guide interest rates lower in the face of economic recovery. Chart 1 provides a bit more context for our assessment of Fed policy. This year, economic growth and inflation expectations troughed in March and moved rapidly higher throughout the summer. Bond yields, however, stayed relatively flat between March and August. The reason is that, even as the economic outlook improved, the Fed was steadily guiding markets towards a dramatic shift in its forward interest rate guidance. Specifically, the adoption of an Average Inflation Target – a pledge to allow a moderate overshoot of the 2% inflation target to make up for past downside misses. The result of the Fed’s dovish shift is that the increase in inflation expectations between March and August was entirely offset by falling real yields (Chart 1, panel 3), leaving nominal yields close to unchanged. However, the Fed made its Average Inflation Target official at the Jackson Hole Symposium in August. Then, in September, it formalized its forward rate guidance by promising not to lift rates off the zero bound until inflation reaches 2% and is expected to moderately overshoot for a while. These events changed the dynamic in the bond market. The Fed is no longer trying to guide markets towards a more dovish reaction function. That reaction function is now officially in place, and presumably in the market price. Indeed, nominal bond yields have risen in concert with improving economic conditions since August, and we expect that trend to continue in 2021. Our Golden Rule of Bond Investing states that we should set portfolio duration by considering our own expectations for future changes in the fed funds rate relative to what is already priced in the yield curve. Appendix A at the end of this report shows that the Golden Rule once again performed well in 2020. Looking ahead, the market is currently pricing-in one full 25 basis point rate hike by mid-2023 and then only one more by mid-2024 (Chart 2). We see high odds that inflation could sustainably reach 2% – the Fed’s stated criteria for lifting off the zero bound – before that, necessitating some Fed tightening in 2022. Chart 2Market Priced For Liftoff In 2023 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income How High Could Yields Go In 2021? To answer this question, we first look at the 5-year/5-year forward Treasury yield relative to survey estimates of the longer-run equilibrium fed funds rate. In theory, long-dated forward yields should be relatively insulated from near-term shifts in the policy rate and should settle near levels consistent with estimates of the equilibrium fed funds rate. In practice, we find that the 5-year/5-year forward Treasury yield does settle near these levels, but only during periods of global economic recovery when investors are presumably more inclined to envision the closing of the output gap and an eventual neutralizing of monetary policy. Notice that during the past two global growth upturns, 2013/14 and 2017/18, the 5-year/5-year forward Treasury yield peaked close to survey estimates of the long-run equilibrium fed funds rate from the New York Fed’s Survey of Market Participants and the Survey of Primary Dealers (Chart 3A). If the same thing happens next year, the 5-year/5-year forward Treasury yield will rise to a range of roughly 2% to 2.25%, 54 bps to 79 bps above current levels. Chart 3AHow High Can Yields Rise? 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 3BLess Upside In 10y Than In 5y5y 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We see less upside next year for the benchmark 10-year yield than for the 5-year/5-year forward. Long-dated forward rates are not mathematically influenced by the near-term outlook for the policy rate, but the yield on the 10-year Treasury note embeds those expectations. Since it is unlikely that inflation will be strong enough to prompt a Fed rate hike in 2021, the yield curve will steepen as the economic outlook improves and the 10-year yield will rise by less than the 5-year/5-year forward. Looking at Chart 3B, next year’s bond market moves will look a lot more like 2013/14 than like 2017/18. The Fed kept rates at zero in 2013/14. This led to yield curve steepening and caused the 10-year Treasury yield to peak at a level well below survey estimates of the long-run equilibrium fed funds rate. In contrast, the Fed was hiking rates in 2017/18. This led to a flatter yield curve and caused the 10-year yield to peak at around the same level as the 5-year/5-year forward. All in all, while we could see the 5-year/5-year forward Treasury yield reach a range of 2% to 2.25% next year, we expect the 10-year Treasury yield to reach a range of 1.25% to 1.5%. Will The Fed Use Its Balance Sheet To Stop Treasury Yields From Rising? By far, the most common disagreement we’ve received from clients on our call for higher bond yields is that the Fed will simply use its balance sheet to prevent any increase in long-maturity yields. We don’t see this as having a meaningful impact. For one, the Fed will only take significant steps to ease monetary policy if it looks like the economic recovery is under threat. This would require a large tightening of financial conditions, meaning significantly lower stock prices and wider corporate bond spreads. We don’t see a 1.25% to 1.5% 10-year Treasury yield in the context of a steepening yield curve, low inflation and improving economic growth as likely to cause such an event. Granted, the Fed could take more minor actions, like keeping the same pace of purchases but shifting them further out the curve, but a significant tightening of financial conditions is likely required for them to increase the monthly pace of bond buying. Second, even if the Fed does decide to ramp up the pace of bond buying (either overall or only at the long-end of the curve), if it keeps the same forward interest rate guidance, then bond yields will be driven by the market’s perceived progress toward the conditions that would prompt the start of the next tightening cycle. It won’t matter how many bonds the Fed buys in the meantime. Our Golden Rule of Bond Investing has a strong track record that it achieves by focusing only on changes in the fed funds rate relative to expectations. It does not consider asset purchases at all, and we are also inclined to view them more as a distraction. Key View #2: Overweight TIPS Versus Nominal Treasuries Chart 4Adaptive Expectations Model 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We remain overweight TIPS versus nominal Treasuries for the time being but are actively looking for an opportunity to get tactically underweight. This opportunity could emerge in the first half of 2021 when core and trimmed mean inflation re-converge and when the 10-year TIPS breakeven inflation rate looks expensive on our model. TIPS breakeven inflation rates fell dramatically when the COVID crisis struck in March, but they then rebounded just as quickly and are now near fair value according to our Adaptive Expectations Model (Chart 4). Our model forecasts the future 12-month change in the 10-year TIPS breakeven inflation rate based on where the rate currently sits relative to several different measures of actual CPI inflation. Right now, our model is looking for a 12 basis point decline in the 10-year breakeven rate during the next year, but this forecast will rise if CPI prints strongly in the coming months, which is exactly what we expect. Chart 5Expect Higher Inflation In H1 2021 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income As noted in the above Outlook Summary, base effects and the re-opening of some service sectors will cause inflation to jump in the first half of 2021. A good way to see this is to look at the gap between 12-month core and trimmed mean CPI (Chart 5). Core inflation fell dramatically in March and April and is now in the process of bouncing back. Meanwhile, trimmed mean inflation measures were much more stable in the spring because they filtered out those sectors that experienced huge negative inflation prints during quarantine.   We think the gap between core and trimmed mean CPI is a good guidepost for our TIPS strategy. As long as the gap remains wide, we see upside risks to inflation. However, once the gap closes, that will signal that the “snapback phase” from re-opening the economy is over and that inflation pressures will moderate in line with the wide output gap. Shelter inflation is one of the components of inflation that is most sensitive to the output gap, and it has already been rolling over in line with the rising unemployment rate (Chart 5, bottom panel). Overall, our TIPS strategy in 2021 is to remain overweight TIPS versus nominal Treasuries for the time being. However, we are actively looking for an opportunity to get tactically short TIPS versus nominals. This could occur sometime in the first half of 2021 when core and trimmed mean inflation have re-converged and when (hopefully) the 10-year TIPS breakeven inflation rate looks more expensive on our model. Key View #3: Own Nominal Yield Curve Steepeners, Real Yield Curve Steepeners and Inflation Curve Flatteners Chart 62/5/10 Butterfly Spread Valuation 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The nominal yield curve will continue to trade directionally with yields. Therefore, higher yields will coincide with a steeper nominal curve in 2021. Rising inflation and the Fed’s new Average Inflation Target both argue for a flatter inflation curve in 2021. We also recommend a real yield curve steepener as a high octane play on both a steeper nominal curve and flatter inflation curve. Nominal Yield Curve With the funds rate pinned at zero and the Fed unlikely to actually lift it until 2022 (at the earliest), it is quite clear that the slope of the nominal yield curve will continue to trade directionally with yields as we head into 2021. That is, with volatility at the front-end of the curve completely suppressed, the yield curve will steepen when yields rise and flatten when they fall. In that context, we recommend complementing our below-benchmark portfolio duration view with nominal yield curve steepeners. Our preferred way to implement a nominal yield curve steepener is to buy the 5-year Treasury note and short a barbell consisting of the 2-year note and 10-year note. Allocations to the 2-year and 10-year should be weighted so that the duration of the 2/10 barbell matches that of the 5-year note. As we have explained in prior research, this sort of position is designed to profit from 2/10 yield curve steepening and it has worked well during the past few months (Chart 6).2  The one problem with this 5 over 2/10 trade is that it is not cheap. The 5-year yield is below the yield on the 2/10 barbell (Chart 6, panel 3) and the 5-year bullet looks expensive on our fair value model (Chart 6, bottom panel). However, we should also note that the 5-year looked much expensive during the last period of zero-bound rates in 2012. Given today’s very similar policy environment, we could see the 5-year yield getting even more expensive in 2021. Inflation Curve Chart 7Favor Inflation Curve Flatteners... 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Our second recommended yield curve position relates to the inflation curve, either the TIPS breakeven inflation curve or the CPI swap curve. Here, we recommend owning inflation curve flatteners for two reasons. First, short-maturity inflation expectations are more sensitive to the actual inflation data than long-maturity expectations. We saw a prime example of this relationship in 2020. The 2-year CPI swap rate plunged into negative territory when inflation fell in March while the 10-year CPI swap rate held relatively stable in comparison (Chart 7). Subsequently, the 2-year CPI swap rate rose much more quickly than the 10-year rate this summer as inflation rebounded. Looking ahead, with inflation biased higher in the first half of 2021, we should see greater upside in short-maturity inflation expectations than in long-maturity ones. The Fed’s adoption of an Average Inflation Target is the second reason to favor inflation curve flatteners. If the Fed is ultimately successful at achieving an overshoot of its 2% inflation target, it will mean that the Fed will be attacking its inflation target from above rather than from below for the first time since the 1980s. Logically, the inflation curve should be inverted in this sort of environment. This means that the inflation curve still has a lot of room to flatten from current levels (Chart 7, bottom panel). Real Yield Curve Chart 8...And Real Yield Curve Steepeners 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The Fisher Equation tells us that real yields are simply the difference between nominal yields and inflation expectations. Viewed that way, it is easy to see that – all else equal – a steeper nominal curve will lead to a steeper real yield curve. Meanwhile, a flatter inflation curve will also lead to a steeper real yield curve. In that sense, a real yield curve steepener is just a combination of the nominal curve steepener and inflation curve flattener that we already mentioned (Chart 8). As inflation rises, it will pressure short-dated inflation expectations higher relative to long-dated ones. This will exert bull-steepening pressure on the real yield curve. Meanwhile, investors starting to price-in eventual rate hikes will lead to nominal yield curve steepening. This will exert bear-steepening pressure on the real yield curve. With that in mind, a real yield curve steepener is a high conviction position for us in 2021. We have less conviction on the outright direction for real yields, though we suspect that long-maturity real yields have already troughed for the cycle. Key View #4: Overweight Spread Product Versus Treasuries We see the economy as entering what we call “Phase 1” of the economic cycle in 2021, an environment of above-trend growth, low inflation and accommodative monetary policy. This is an environment where spread product typically performs very well relative to Treasuries.  Most spread sectors will likely end the year having underperformed duration-equivalent Treasuries in 2020. However, this simple fact obscures the actual pattern of spread movements that was witnessed during the year. Spreads widened sharply when COVID struck but they peaked on March 23, the same day that the Federal Reserve announced its slew of emergency lending facilities.3 Spread product has been outperforming Treasuries since then (see Appendix B), a trend we expect will continue in 2021. The phase of the economic cycle when the economy is just emerging from a recession is typically one where risk assets perform well. The principal reason to expect spread product outperformance to continue is that the phase of the economic cycle when the economy is just emerging from a recession is typically one where risk assets perform well. It tends to be an environment where economic activity is growing at an above-trend pace, but inflation is still low and monetary conditions are accommodative. This is the perfect environment for credit spreads to tighten. The slope of the yield curve is a useful variable for summarizing the above macro conditions and we often use it to define three phases of the economic cycle (Chart 9): Chart 9The Three Phases Of The Cycle 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Phase 1 is defined as the time between the end of the last recession and when the 3-year/10-year Treasury slope flattens to below 50 bps. Phase 2 is defined as when the 3-year/10-year Treasury slope is between 0 bps and 50 bps. Phase 3 is defined as the time between when the 3-year/10-year Treasury slope turns negative and the start of the next recession. As we are just now emerging from recession and the 3-year/10-year slope is above 50 bps and steepening, we see the economy as being firmly in Phase 1 of the cycle. Historically, this phase has been the best one for spread product returns relative to duration-matched Treasuries (Table 1). Table 1Corporate Bond Performance In Different Phases Of The Cycle 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The main risk to this view of spread product is that we are not yet emerging from the recession and the corporate default rate may have another leg higher. Our sense, however, is that the default rate has already peaked. Gross leverage (the ratio between total corporate debt and pre-tax corporate profits) and job cut announcements are two variables that correlate very tightly with the default rate (Chart 10). Starting with leverage, net earnings revisions – a leader profit indicator – have already troughed and the corporate financing gap has turned negative (Chart 11). A negative financing gap means that the corporate sector has sufficient retained earnings to cover its capital expenditures. In other words, most firms are flush with cash and they won’t need to issue more debt in the coming quarters. Further, job cut announcements have come down sharply during the past few months (Chart 11, bottom panel). Chart 10The Default Rate Correlates With Gross Leverage And Job Cuts 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 11Firms Have Enough Cash 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The above trends in corporate profits, corporate debt and job cut announcements are consistent with what we’re already seeing on the default front. The US corporate sector was experiencing upwards of 20 default events per month back in May, June and July. But only seven defaults occurred in November, following five in October and six in September (Chart 12). Chart 12The Default Rate Has Peaked 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income The bottom line is that the macro environment of above-trend growth, low inflation and accommodative monetary policy is one where we should expect spread product to outperform Treasuries. Relative valuation dictates which spread sectors we prefer over other ones, and the next two Key Views address this issue. Key View #5: Move Down In Quality Within Corporates Investment grade corporates will outperform Treasuries in 2021, but the potential for further spread compression is limited. Junk spreads have more room to tighten, and the Ba credit tier looks particularly attractive from a risk/reward perspective. As noted in the previous section, the macroeconomic environment is one where spread product should flourish. However, valuation in certain sectors could limit how much further spread tightening is possible. In particular, valuation looks to be a constraint for investment grade corporates. In absolute terms, investment grade corporate spreads look like they still have some room to compress (Chart 13). The overall index spread is 12 bps above its pre-COVID level. The Aa, A and Baa-rated spreads are 16 bps, 11 bps and 13 bps above, respectively. Only seven defaults occurred in November, following five in October and six in September. However, valuation looks much worse in risk-adjusted terms. Chart 14 shows the 12-month breakeven spread, i.e. the spread widening required for the sector to underperform Treasuries on a 12-month investment horizon. In addition, we re-weight the overall corporate index to ensure that it maintains a constant credit rating distribution over time, and we show all breakeven spreads as percentile ranks relative to their own histories. For example, a reading of 8% for the Baa credit tier means that the 12-month breakeven spread for the Baa credit tier has only been lower than it is today 8% of the time since our data begin in 1995. Chart 13IG Spreads Still Above ##br##Pre-COVID levels 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 14IG Looks More Expensive In Risk-Adjusted Terms 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Adding it all up, we think there is scope for investment grade corporates to modestly outperform Treasuries in 2021, but there are also more attractively priced sectors that investors may want to consider. Municipal bonds are one particularly attractive alternative to investment grade corporates (we discuss our view on municipal bonds in the next section), but investors are also advised to pick-up additional spread by moving down in quality within the corporate credit space. High-Yield corporate bonds have significantly more scope for tightening than their investment grade counterparts, with the overall junk index spread still 69 bps above its pre-COVID level (Chart 15). Within junk, the Ba credit tier looks like the best place to camp out from a risk/reward perspective. The incremental spread offered by Ba-rated junk bonds compared to Baa-rated corporates is elevated compared to history, 111 bps above its 2019 low (Chart 15, panel 2). In contrast, the additional spread pick-up you get from moving into the lower junk tiers (B & Caa) is more in line with typical historical levels (Chart 15, bottom 2 panels). Chart 15Ba-Rated Bonds Look Best 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Another reason to be cautious about chasing the extra spread in the B-rated and below credit tiers is that the High-Yield index is pricing-in a fairly rapid decline in the default rate for the next 12 months (Chart 16). If we assume a 25% recovery rate and target an excess spread of 150 bps above default losses,4 then we calculate a spread-implied default rate of 3.1%. That is, we should only expect junk bonds to outperform duration-matched Treasuries if the default rate comes in below 3.1% during the next 12 months. This would represent a steep decline of 5.3% from the 8.4% default rate we just witnessed during the past 12 months, but this sort of big drop in the default rate would not be out of line with what typically happens when the economy emerges from recession. For example, in the last recession, the 12-month default rate peaked at 14.6% in November 2009 and then fell to 3.6% by November 2010, a decline of 11%! Chart 16Spread-Implied Default Rate 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income All in all, we view the Ba-rated credit tier as the sweet spot within corporate credit in terms of offering the best combination of risk and reward. We also expect the default rate to fall quickly enough that the lower-rated junk credit tiers will outperform Treasuries, but the risk here is greater and the potential additional compensation is not historically elevated. Investment grade corporate spreads will remain tight, but have limited room to compress further. Investors are advised to look at Ba-rated corporates and municipal bonds instead.  Key View #6: A Maximum Overweight Allocation To Municipal Bonds Tax-exempt municipal bonds offer the best opportunity in the US fixed income space. Investors should adopt a maximum overweight allocation, and in particular, they should shift some allocation out of investment grade corporates and into Munis with the same credit rating and duration, but with a greater after-tax yield. At present, we think that tax-exempt municipal bonds represent the best opportunity in US fixed income. Muni spreads have certainly tightened since March, but valuation remains attractive relative to both Treasuries and investment grade corporates. First, let’s consider value relative to Treasuries (Chart 17). Spreads between Aaa-rated municipal bonds and maturity-matched Treasuries are elevated compared to history across the entire yield curve. 2-year Munis even offer a 3 bps yield pick-up over 2-year Treasuries before adjusting for the tax advantage. Further out the curve, value is worst at the 5-year part of the curve where the breakeven effective tax rate between Munis and Treasuries is 42%, slightly above the top marginal tax rate of 37%. But value improves again for longer maturities. The breakeven effective tax rate between 10-year Munis and Treasuries is 24% and it is a mere 10% for 30-year bonds.5 Next, we can look at relative value between Munis and credit. This is where the attractiveness of munis really stands out (Chart 18). After controlling for credit rating and duration, municipal revenue bonds offer a yield advantage over the Bloomberg Barclays Credit Index across the entire yield curve, before any adjustment is made for the municipal tax exemption. General Obligation (GO) Munis only offer a before-tax yield advantage over credit beyond the 12-year maturity point, but the GO Muni/credit spread is nonetheless historically elevated for all maturity buckets. Chart 17Muni/Treasury Yield Spreads 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart 18Munis Versus Credit 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income This is all well and good, but it could easily be countered that municipal bonds only offer such attractive valuations because the COVID recession has been an historically challenging period for state & local government balance sheets. If this period leads to a spate of downgrades and defaults, then municipal bonds no longer look cheap. All this is true, but we think investors’ worst fears in this regard will not be realized. For one thing, state & local governments have been very quick to clamp down on spending and cut employment (Chart 19). Coming out of the last recession, Muni/Treasury yield spreads had almost fully recovered by the time that state & local government austerity began. Also, state budgets were in pretty good shape heading into the COVID downturn, with all-time high Rainy Day Fund balances (Chart 19, bottom panel). Chart 19State & Local Austerity Has Begun 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income We recommend that investors take advantage of historically attractive municipal bond spreads by adopting a maximum overweight allocation. In particular, investors should shift allocation out of investment grade rated corporate bonds, where valuations are stretched, and into municipal bonds that offer the same credit rating and duration with a greater yield pick-up. Finally, Chart 20 shows the spread between different municipal bond sectors and the Bloomberg Barclays US Credit Index. We match the credit rating and duration in each case, but we make no adjustments for the municipal tax exemption. The message from Chart 20 is that the yield advantage in investment grade Munis is broad based, with the exception of the Electric sector. We also see that attractive valuations do not extend to high-yield Munis, which appear expensive relative to High-Yield Credit. Chart 20Municipal Bond Sector Valuation 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Appendix A:  The Golden Rule Of Bond Investing Our Golden Rule of Bond Investing says that we should determine what change in the fed funds rate is priced into the overnight index swap curve for the next 12 months, and then decide whether the Fed will deliver a hawkish or dovish surprise relative to that expectation. We contend that if the Fed delivers a hawkish surprise, then a below-benchmark portfolio duration positioning will pay off. Conversely, if the Fed delivers a dovish surprise, then an above-benchmark portfolio duration positioning will profit. Chart A1 shows how the Golden Rule has performed in every calendar year going back to 1990. We include year-to-date performance for 2020. In 31 years of historical data, our Golden Rule performed well in 23. It provided the wrong recommendation in 8 years, though 3 of those years were during the zero-lower-bound period between 2009 and 2015 when 12-month rate expectations were essentially pinned at zero.6 Chart A1The Golden Rule's Track Record 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income At the beginning of this year, the market was priced for 13 bps of rate cuts in 2020. The funds rate actually fell by 146 bps, leading to a dovish surprise of 133 bps. Based on a historical regression, we would expect a dovish surprise of 133 bps to coincide with a Treasury index yield that falls by 81 bps. In actuality, the index yield fell by 122 bps, more than our Golden Rule predicted. Chart A2 shows how close changes in the Treasury index yield have been to our Golden Rule’s prediction in each of the past 31 years. This regression between the change in Treasury index yield and the monetary policy surprise is the main source of error in our Treasury return forecasts. Chart A2Treasury Index Yield Changes Versus Fed Funds Surprises 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Based on our expected -81 bps index yield change, we would have expected the Treasury index to deliver 6.5% of total return in 2020 and to outperform cash by 5.5%. In actuality, the index earned 7.9% of total return and outperformed cash by 7%. Charts A3 and A4 show how index total and excess returns have performed relative to our Golden Rule’s expectations in each of the past 31 years. Chart A3Treasury Index Total Returns Versus The Golden Rule’s Predictions 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Chart A4Treasury Index Excess Returns Versus The Golden Rule’s Predictions 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Appendix B: Spread Product Performance In 2020 Table B1Spread Product Year-To-Date Performance 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Table B2Performance Since March 23 Announcement Of Emergency Fed Facilities 2021 Key Views: US Fixed Income 2021 Key Views: US Fixed Income Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2021: A Brave New World”, dated November 30, 2020, available at bca.bcaresearch.com 2 Please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 3 We discussed these facilities in detail in two Special Reports published jointly this year with our US Investment Strategy team. US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020 and US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup Part 2: Shocked And Awed”, dated July 28, 2020. Both reports available at usbs.bcaresearch.com 4 Our research has shown that this is the minimum excess spread investors should require to be confident that junk bonds will outperform duration-matched Treasuries. For more details please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 The breakeven effective tax rate is the effective tax rate that makes the after-tax muni yield the same as the Treasury yield. If the investor’s personal tax rate is above the breakeven effective tax rate, they will get an after-tax yield pick-up from owning the municipal bond over the Treasury. 6 We say the Golden Rule “worked” if a dovish surprise coincided with positive Treasury index excess returns versus cash, or if a hawkish surprise coincided with negative Treasury excess returns versus cash. Recommended Portfolio Specification

Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle A New Global Business Cycle A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Biden: No Trade War Or War With Iran? Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Geopolitical Risk And Global Policy Uncertainty Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? The Decline Of The Liberal Democracies? The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await EM Troubles Await EM Troubles Await Chart 6Global Arms Build-Up Continues Global Arms Build-Up Continues Global Arms Build-Up Continues   We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems China: Less Money, More Problems China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble China Struggles To Dismount Debt Bubble China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism China Will Slow De-Industrialization, Stoking Protectionism China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus China Already Reining In Stimulus China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 No Promise Of Major New Stimulus For Party Congress 2022 No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump The US-China Divorce Pre-Dates And Post-Dates Trump The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China Biden's Grand Alliance A Danger To China Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell The "Pivot To Asia" In A Nutshell The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Oil Market Share War Preceded The Last US-Iran Deal Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Still, Base Case Is For Rising Oil Prices Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat Biden Needs A Credible Threat Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election Europe Won The US Election Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk German Election Poses Political Risk, Not Investment Risk German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Post-COVID EU Elections Will Not Be A Cakewalk Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided Immigration Tailwind For Populism Subsided Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Europe Tough On Immigration Like US Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Warning Sign That Russia May Lash Out Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising Russian Geopolitical Risk Premium Rising Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

This week, we present the BCA Central Bank Monitors Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions. The Chartbook has previously been published by BCA Research Global Fixed Income Strategy but, starting today, will be jointly published with BCA Research Foreign Exchange Strategy twice per year.  Given how expectations of monetary policy changes influence both bond yields and currencies, we see the Chartbook as a useful forum for cross-market analysis of fixed income and foreign exchange. We have Monitors for ten major developed market economies and, currently, all are below the zero line, indicating the need for continued easy global monetary policy (Charts 1A & 1B). The Monitors are all trending higher, however, as global growth and financial markets have steadily recovered from the brutal collapse spurred by the first wave of COVID-19 earlier this year. The recovery in the Monitors is consistent with two of BCA’s highest conviction views for 2021 – rising global bond yields, led by the US, but with additional weakness in the counter-cyclical US dollar. The compression in the US interest rate advantage this year is sufficient to allow for some upside, without derailing the dollar bear market. Chart 1ALess Easy Money Required... Less Easy Money Required... Less Easy Money Required... Chart 1B...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels   An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data that have historically been correlated to changes in interest rates.  The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors.  Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). Chart 2AA Rebound In Our CB Monitors... A Rebound In From Our CB Monitors... A Rebound In From Our CB Monitors... Chart 2B...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar.  We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Previously, the country coverage for the Monitors has included the US, euro area, UK, Japan, Canada, Australia, New Zealand and Sweden. In this report, we introduce new Monitors for Norway and Switzerland – countries with relatively small government bond markets but with actively traded currencies.  We have also revamped the individual component lists of the existing Monitors to include a broader range of economic and inflation data, as well as adding more measures of financial conditions like equity prices or corporate credit spreads. The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates.  Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). None of the Monitors is indicating a need for policymakers to turn more hawkish. At the moment, the common signal from the Monitors is that there is diminished pressure to ease global monetary policies compared to mid-2020. At the same time, none of the Monitors is indicating a need for policymakers to turn more hawkish. There are growing divergences between the individual Monitors, though, which are creating more interesting opportunities for relative bond and currency trades and portfolio allocations – as we discuss throughout the pages of this Chartbook. Fed Monitor: Less Pressure For More Easing Our Fed Monitor has rebounded sharply during the latter half of 2020 on the back of improving US economic growth momentum and booming financial markets. However, it is not yet signaling a need for the Fed to begin moving to a less accommodative policy stance (Chart 3A).    The US economy has recovered impressively from the COVID-19 recession, with real GDP expanding at an annualized 33% pace in Q3 and the ISM Manufacturing index reaching a two-year high in October. Rapid growth also fueled a recovery in the labor market, with the US unemployment rate falling from a peak of 14.7% in April to 6.7% in November. It will take a few years for the US economy to return to full employment, given the severity of this year’s recession. The IMF estimates that the US output gap will not be effectively closed until 2023, thus a sustained return of US inflation to the Fed’s 2% target will take time to develop (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BAn Improving US Economic Backdrop BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 3CThe US Dollar Is Countercyclical The US Dollar Is Countercyclical The US Dollar Is Countercyclical The recovery in the Fed Monitor has been led primarily by the financial and growth components (Chart 3C). The inflation components will be more relevant to time the start of the Fed’s next rate hiking cycle. The Fed’s recent shift to an Average Inflation Targeting framework means that US monetary policy will not be tightened based on a forecast of higher inflation, as the Fed has done in past cycles. This means that both US growth and inflation will be allowed to accelerate in 2021 without a pre-emptive hawkish response from the Fed. The result: additional downward pressure on the counter-cyclical US dollar, which tends to weaken when the Fed Monitor is rising (bottom panel). The current surge in US COVID-19 cases represents a near-term downside risk to US growth momentum, as evidenced by a string of softer data prints in November.  Another round of fiscal stimulus and, more importantly, the start of the vaccine distribution process will give a bigger lift to economic confidence and growth – and US bond yields - in the first half of 2021.  We recommend an underweight strategic allocation to US Treasuries within global government bond portfolios (Chart 3D). Chart 3DUpside For Treasury Yields Upside For Treasury Yields Upside For Treasury Yields BoE Monitor:  Subdued Inflation Requires A Dovish Stance Our Bank of England (BoE) Monitor has rebounded sharply from the Q2 collapse, but remains well below zero indicating the ongoing need for easy UK monetary policy (Chart 4A). To that end, the BoE increased the size of its Gilt quantitative easing (QE) program by £150bn last month. However, the central bank chose to not cut the Bank Rate from 0.1% into negative territory, despite many public flirtations with such a move by BoE officials in recent months. Both the output gap and unemployment gap show high levels of excess capacity in the UK economy that are projected to take years to unwind according to the IMF and OECD (Chart 4B). UK real GDP grew by 15.5% on a quarter-on-quarter basis in Q3, a big reversal from the -19.8% plunge in Q2, but more recent domestic data has softened with the UK under national lockdowns to fight a surge in COVID-19 cases. UK headline CPI inflation is threatening to dip into deflation, even with a soft pound. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUK Excess Capacity Will Take Years To Unwind BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 4CLingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Looking at the details of our BoE Monitor, all three main sub-components remain below the zero line, but with some diverging trends (Chart 4C). The inflation components remain very weak, but the growth components have almost rebounded back to the pre-pandemic level. The financial components have also recovered sharply thanks in no small part to the BoE’s highly accommodative monetary policy. The BoE Monitor has historically been positively correlated to the momentum of the UK currency, and the trade-weighted pound appears to have outperformed the weakness in the Monitor (bottom panel). The near term direction of the pound, however, is completely linked to the final stage of the UK-EU Brexit negotiations. A no-deal Brexit would likely see the gap between the momentum of the pound and our BoE Monitor close via a sharp fall in the currency.  If a trade agreement is reached, however, we would expect the convergence to happen via a rising Monitor catching up to a firming currency, driven by a likely improvement in portfolio inflows. With COVID-19 vaccines already starting to be administered in the UK, a “peaceful” resolution to the Brexit saga could give the UK economy a solid lift in 2021 – especially with the UK government preparing a big fiscal impulse.  Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields. Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields (Chart 4D). Given the lack of UK inflation, and with the BoE taking down a large share of new Gilt issuance via QE, UK bond yields will lag the rise in global bond yields that we expect in the first half of 2021, even if there is good news on Brexit. We continue to recommend an overweight stance on UK Gilts. Chart 4DExpect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise ECB Monitor: Price Deflation Leads To Asset Reflation Our European Central Bank (ECB) Monitor is in “easy money required” territory, but has rebounded significantly from the lows seen earlier in 2020 (Chart 5A). The ECB delivered on that easing message at the December policy meeting, increasing the size of its Pandemic Emergency Purchase Program by €500bn to €1.85tn and extending the end-date of the program from June 2021 to March 2022.  The central bank also extended the maturity date for its offer of heavily discounted funding (at rates as low as -1%) for bank lending to June 2022. The ECB needed to deliver another round of easing because the euro area has fallen back into deflation. Year-over-year headline CPI inflation reached -0.3% in November, while core inflation was not much further behind at +0.2% (Chart 5B). With much of Europe now under increased economic restrictions due to the latest surge in COVID-19 cases, the near-term downside risks to euro area growth could push inflation even deeper into negative territory in the coming months. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BLots Of Slack In The Eurozone BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 5CThe Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy Looking at the breakdown of our ECB Monitor, there is a very large divergence between the components. The inflation components are at the most depressed levels since the turn of the century, while the growth components have rebounded sharply (Chart 5C). The financial conditions components have now surged above the zero line, suggesting pressure on the ECB to tighten policy from robust European financial markets. Of course, booming markets are a direct result of the ECB’s dovish monetary stance, which includes the rapid expansion of its balance sheet and significant purchases of riskier sovereign bonds in Italy, Spain and even Greece.  The ECB realizes that it cannot cut policy interest rates any further into negative territory without harming the ability of the fragile European banking system to earn profits.  This effective floor on nominal policy rates, combined with deepening price deflation, has boosted real European interest rates.  The result is a steadily climbing euro, even as the ECB has continued to signal a continued dovish policy bias and an aggressive expansion of its balance sheet.  The weakening trend for the US dollar that we expect in 2021 will leave the ECB little choice but to continue doing what it has been doing – more asset purchases, more cheap funding for bank lending and extending the time duration of all its easing programs in an effort to keep European financial markets aloft while also limiting the damage from an appreciating euro.  The introduction of a COVID-19 vaccine should provide a lift to growth, but inflation is likely to remain very subdued without a weaker euro. Inflation is likely to remain very subdued without a weaker euro. The depressed level of the ECB Monitor suggests that there is additional scope for lower euro area bond yields (Chart 5D), although the impact will not be the same for all countries in the region.  Deeply negative German and French bond yields will likely not decline much in 2021, although they will not rise much either even as US Treasury yields move higher, making them good defensive overweights in a global bond portfolio. At the same time, Italian and Spanish bond yields will continue to grind lower as ECB buying and more European fiscal co-operation help further reduce the risk premium on Peripheral Europeans - stay overweight. Chart 5DEuropean Yields Should Lag The US European Yields Should Lag The US European Yields Should Lag The US BoJ Monitor:  Fighting Deflation, Once Again Our Bank of Japan (BoJ) Monitor has rebounded from the recent low but is still well below zero, indicating that easier monetary policy is required (Chart 6A). That will be hard for the BoJ to deliver, however - policy rates are already negative, the BoJ’s balance sheet has blown up to 128% of GDP, and a more dovish forward guidance is impossible as most market participants already believe the BoJ will keep rates untouched for years. Japan’s economic recovery is currently at near-term risk from a particularly sharp increase in COVID-19 cases, although Japan’s labor market did not suffer much from the pandemic-induced plunge in growth earlier this year (Chart 6B). Nonetheless, while the unemployment rate remains below the OECD’s estimate of full employment (4.1%), there remains significant excess capacity in Japan according the IMF output gap estimates, with headline CPI inflation now in mild deflation. Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BSignificant Excess Capacity In Japan BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 6CJapanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions The individual elements of the BoJ Monitor show a large divergence between the growth and inflation components, which are very depressed, and the more stable financial component (Chart 6C). The latter reflects the outstanding performance of Japanese equities in recent months, with some benchmark indices reaching levels last seen in the mid-1990s. The continued steady expansion of the BoJ’s balance sheet is clearly helping to underwrite easy financial conditions in Japan. While the BoJ is reaching some operational constraints with its asset purchases, owning nearly one-half of all JGBs and three-quarters of all Japanese equity ETF’s, the central bank has no choice but to continue buying assets to support financial conditions. Cutting policy interest rates deeper into negative territory is a non-starter given the negative impact sub-0% rates have had on the profitability of Japanese banks. The inability of the BoJ to further ease Japanese monetary policy is boosting real rates and supporting the yen. The historical correlation between the BoJ Monitor and the yen has not been as consistent as that seen in other countries, but since the 2008 financial crisis a deteriorating BoJ Monitor has tended to coincide with a rising yen – given the lower bound of policy rates.  The inability of the BoJ to further ease Japa-nese monetary policy is boosting real rates and supporting the yen.  The weakness of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should fall significantly (Chart 6D). However, the BoJ’s Yield Curve Control policy, with the central bank buying enough bonds to keep the 10yr JGB yield around 0%, is preventing JGB yields from plunging to the deeply negative yield levels seen in core Europe. This policy-induced stability of Japanese yields actually makes JGBs a defensive bond market when US Treasury yields are rising. Thus, we recommend an overweight stance on JGBs given our view that US bond yields have more upside. Chart 6DPolicy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable BoC Monitor:  No Choice But To Stay Ultra-Dovish Our Bank of Canada (BoC) Monitor has seen a much weaker rebound off the lows than some of our other Central Bank Monitors, indicating that the BoC cannot lay off the monetary gas pedal (Chart 7A). The BoC has already been aggressive in easing policy earlier this year, cutting the Bank Rate to 0.25%, initiating several liquidity facilities and quickly ramping up bond purchases. The central banks now owns around 40% of all Government of Canada bonds outstanding, from a starting point of essentially 0% before the pandemic, and has started to shift its purchases to longer maturity bonds in order to suppress risk-free yields and lower borrowing costs for households and business. While Canada did see a sharp recovery in GDP growth in Q3 – rising 8.9% on a non-annualized, quarter-on-quarter basis following the -11.3% drop in Q2 – the level of real GDP is still -5.2% lower than Q3 2019 levels.  The BoC has already significantly revised down its estimates of potential growth for 2020-22 by nearly one full percentage point due to the various negative shocks including COVID-19. Inflation remains weak because of significant economic slack – the BoC forecasts that CPI inflation will remain below its target until 2022 (Chart 7B).  Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanada: BoC Monitor BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 7CWeaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Within the details of our BoC Monitor, the weakness in the overall indicator is clearly driven by the depressed level of the growth components (Chart 7C). Heavy containment measures to fight the spread of COVID-19, combined with uneven recoveries in different sectors, have weighed on the Canadian economy. At the same time, the financial conditions components have been relatively stable, even with the rapid expansion of the BoC’s balance sheet. The Canadian dollar has clearly outperformed its typical positive correlation to the BoC Monitor (bottom panel), as the “loonie” has benefitted from rising global commodity prices and the overall depreciation of the US dollar. Both of those trends are likely to remain in place in 2021 as global growth gains upward momentum, which should keep the Canadian dollar well supported – and also force the BoC to stay dovish to prevent an even greater rise in the currency. We currently recommend a neutral stance on Canadian government bonds within global fixed income portfolios. In more normal times, a backdrop of accelerating economic growth and rising commodity prices would typically push Canadian yields higher and justify an underweight stance – particular given the relatively high historical “yield beta” of Canada to changes in US bond yields  (Chart 7D). However, with the BoC forced to stay aggressive with its QE program to dampen Canadian yields and suppress the rising Canadian dollar, Canadian government bonds are likely to outperform their normal high-beta status as US Treasury yields continue to drift higher in 2021. Chart 7DAn Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields RBA Monitor: Not Out Of The Woods Yet Our Reserve Bank of Australia (RBA) monitor remains in “easier policy required” territory despite a strong rebound after bottoming in April (Chart 8A).  Since our last update, the RBA has slashed the official cash rate once more to 0.1%, largely in an effort to contain the surging Australian dollar. The unemployment gap in Australia has staged a tentative recovery but is set to remain elevated and recover only gradually going forward, according to the IMF’s forecast (Chart 8B). The RBA actually sees unemployment ticking up slightly in the near term as the eligibility conditions for the JobSeeker program tighten. Inflation, meanwhile, will have a tough time reaching the target 2-3% band in the absence of wage price pressures. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BA Lot Of Slack In The Australian Economy BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 8CFinancial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Breaking down our RBA monitor into its constituent growth, inflation, and financial conditions components, we see a sharp rebound led by financial conditions which, taken in isolation, are calling for tighter monetary policy (Chart 8C). This comes as no surprise with the RBA growing its balance sheet at an unprecedented rate. The growth component, meanwhile, has been driven by rebounding consumer and business sentiment data with Australia benefitting from Chinese reflation. We are also beginning to see a divergence in the historically tight correlation between the RBA monitor and the trade-weighted Australian dollar, as investors pile into the growth-sensitive currency with the Fed reflating the global economy. For its part, the RBA has tried to combat this by reiterating its support for its QE program and leaving the door open to further bond-buying. We can see the RBA’s core problem summarized in Chart 8D. The rise in Australian bond yields has cornered the RBA towards a more dovish tilt. Although RBA Governor Lowe has ruled out negative rates, the RBA has some bullets remaining, including shifting its purchases to the long-end of the curve. With that in mind, we feel confident reiterating our neutral stance on Australian sovereign debt. Chart 8DAustralian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor RBNZ Monitor: Between A Rock And A Hard Place Our Reserve Bank of New Zealand (RBNZ) monitor has rebounded slightly but is still calling for easing (Chart 9A). While the RBNZ has held its official cash rate steady at 0.25% since our last update, it has expanded its large-scale asset purchase (LSAP) program to a whopping NZD 100bn. Unemployment and output gaps indicate a good deal of slack in the New Zealand economy, with the output gap set to recover slightly faster than the unemployment gap, according to IMF forecasts (Chart 9B). Although inflation momentarily breached the 2% mark, it is expected to remain subdued as spare capacity and low tradables inflation weigh on the overall measure. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Is Set To Subside BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 9CThe Appreciating NZD Is A Problem The Appreciating NZD Is A Problem The Appreciating NZD Is A Problem As with neighboring Australia, financial conditions have led the rebound in the RBNZ monitor while the growth component has ticked up slightly and the inflation component remains subdued (Chart 9C). However, one of the variables in our model, house prices, has recently leapt to the forefront of the monetary policy discussion in New Zealand, with the government asking the RBNZ to cool the rapidly heating market. The RBNZ has responded by reinstating loan-to-value ratio restrictions but we cannot expect the bank to turn hawkish anytime soon, given recent appreciation in the New Zealand dollar, which not only hurts export competitiveness but also threatens import price inflation. Going forward, political pressure on the RBNZ will prevent it from taking an overly accommodative stance and has made it unlikely that the bank will go into negative rate territory next year. The momentum in NZ yields has largely kept pace with our RBNZ monitor despite the dramatic spike last month (Chart 9D). The RBNZ will increasingly have to find ways to suppress both bond yields and the New Zealand dollar without stimulating the housing market. Given these opposing forces, yields will likely move sideways, supporting our neutral stance on NZ sovereign debt. Chart 9DYields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Riksbank Monitor: Sluggish Recovery Ahead Our Riksbank monitor has rebounded but is still calling for easier policy (Chart 10A). Given the bank’s fraught relationship with negative rates and the associated financial stability concerns, it will likely deliver further stimulus in the form of asset purchases, which it has recently ramped up to SEK 700bn while also promising to step up the pace of purchases in the next quarter. Both output and unemployment gaps indicate slack in the Swedish economy, with OECD and IMF estimates pointing towards a gradual recovery (Chart 10B). While GDP in the third quarter did come out stronger than expected, it was likely just a temporary development. After failing to contain surging infections, the Swedish government has finally decided to impose restrictions, which will limit the recovery until we start to see mass immunization. The Riksbank does not expect inflation to be sustainably close to 2% until 2023. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BSweden Is Set For A Slow Recovery BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 10CThe Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank Looking at the components of the Riksbank monitor, all of them are currently below zero, implying a need for easier policy (Chart 10C). The growth component rebounded strongly on the back of improving exports and sentiment data. On the currency side, we have seen strong appreciation in the trade-weighted Krona this year, far exceeding the levels implied by our Riksbank monitor. This could dampen export growth in the small, open economy, making it a prime concern for policymakers. While the Riksbank monitor fell drastically, Swedish government bond yields remained largely rangebound this year, with the 10-year yield hovering around zero (Chart 10D). The bottom line is that yields for the most part are reflecting expectations of a policy rate stuck at 0%, that the Riksbank is unwilling to cut and cannot afford to hike. Chart 10DSwedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Norges Bank Monitor: On A Recovery Path Our Norges Bank Monitor is improving from very depressed levels, but still remains well below the zero line. This is signaling that continued monetary accommodation is still needed, but emergency settings are no longer appropriate (Chart 11A). Consistent with the message from the Monitor, Norges Bank governor Øystein Olsen has pledged to keep interest rates at zero for the next couple of years, before a gradual rise begins. The central bank also continues to extend emergency F-loans to commercial banks at 0%, to encourage much needed lending to Norwegian firms. The rebound in Q3 mainland GDP (which excludes oil & gas production) was the strongest on record. The unemployment rate has also declined from a high of 10.4% to 3.9% for the month of November. That said, there was a small tick up in November, a sign that the second wave of COVID-19 engulfing the euro area is beginning to bite into Norwegian growth. Underlying inflation remains above well above target, while headline inflation is slowly rebounding. But given that the output gap is expected to remain wide into 2021, these trends should flatten, rather than accelerate (Chart 11B). Chart 11ANorway: Norges Bank Monitor Norway: Norges Bank Monitor Norway: Norges Bank Monitor Chart 11BNorwegian Inflation Is At Target BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 11CThe Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The key improvement in our Norges Bank Monitor has come from the growth component, which is very close to the zero line (Chart 11C). Not surprisingly, the Monitor shows a very tight correlation with the trade-weighted currency, suggesting the latter is an important valve in adjusting monetary conditions. As an oil-producing economy, the drop in the krone cushioned the crash in oil prices. A recovery will benefit the krone.  The correlation between the Monitor and Norwegian bond yields has become more robust (Chart 11D). This suggest yields in Norway should participate as global yields modestly grind higher. Within a global bond portfolio, our default stance is neutral, as the market is thinly traded. Chart 11DNorwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher SNB Monitor: More Currency Weakness Needed Our Swiss National Bank (SNB) Monitor has shown very tepid improvement, as the SNB has maxed out its policy options (Chart 12A). Interest rates have been at -0.75% since 2015, making the currency channel the only valve to ease monetary conditions. To achieve this, the central has been heavily expanding its balance sheet via the accumulation of foreign assets and reserves. Switzerland has seen a less powerful rebound in Q3 GDP at 7.2%, compared to the euro zone where growth stood at 12.5%. Meanwhile, Q4 data is likely to disappoint as Switzerland was hit harder by the second COVID-19 wave. Labor market tightness has eased, with the unemployment rate at a 2020 high of 3.4%. This will continue to suppress inflationary pressures, which are now the weakest since the 2008 Global Financial Crisis (Chart 12B). Chart 12ASwitzerland: SNB Monitor Switzerland: SNB Monitor Switzerland: SNB Monitor Chart 12BThe Swiss Economy Is Deflating BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 12CThe Swiss Franc Is Too Strong The Swiss Franc Is Too Strong The Swiss Franc Is Too Strong Looking at the components of our SNB Monitor, both growth and inflation are anchoring down the indicator. The message is that Switzerland needs a weaker currency, especially relative to its trading partners (Chart 12C). This concern is repeatedly echoed by SNB governor Thomas Jordan. As such, the Swiss franc should lag other European currencies, including the euro and Swedish krona.  The SNB Monitor does a good job at capturing shifts in Swiss bond yields. Constrained by the lower bound, they were not really able to fall when the pandemic was raging in March. By the same token, they should lag any modest increase in global bond yields, as suggested by the Monitor (Chart 12D). Like Norway, our default stance on Swiss bonds is neutral in a global portfolio, given low market liquidity. Chart 12DSwiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing   Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Shakti Sharma Research Associate shaktiS@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com

Highlights Chart 1Bond Yields & The CRB/Gold Ratio Bond Yields & The CRB/Gold Ratio Bond Yields & The CRB/Gold Ratio In our last report of November, we noted that the rising COVID case count was likely to lead to a challenging few months for the US economy, but we also questioned whether financial markets would pay attention or whether they would stay focused on the vaccine roll-out and eventual economic recovery. We now have our answer. November’s employment report was the worst since April, but the Treasury curve has bear-steepened, credit spreads have come in and TIPS have outperformed nominals. What’s more, the jump in the CRB Raw Industrials / Gold ratio suggests that the 10-year Treasury yield has even more near-term upside (Chart 1). With a vaccine on the horizon and Congress closing in on a fiscal relief package, investors should stay positioned for the reflation trade on a 6-12 month horizon: below-benchmark portfolio duration, nominal and real yield curve steepeners, inflation curve flatteners, overweight TIPS versus nominals and overweight corporate bonds rated Ba and higher. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 233 basis points in November, bringing year-to-date excess returns up to -74 bps. The strong rally in corporate bonds since March has culminated in extremely tight valuations for investment grade corporates. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. We retain a positive outlook on corporate credit despite these stretched valuations. In our view, an environment where the economy is recovering and where the Fed will be very cautious about scaling back accommodation is the exact sort of environment where we should expect a lot of enthusiasm for spread product and, as a result, extremely tight spreads. We will not be surprised if our 12-month breakeven spread percentile rank valuation measure reaches its all-time expensive level within the next couple of months. While the macro environment makes it difficult to turn negative on investment grade corporates, we acknowledge that other sectors may offer better opportunities, particularly in the higher credit tiers. Specifically, we find better value in tax-exempt municipal bonds than in corporates and recommend that investors favor the former over the latter. At the sector level, we continue to recommend overweight allocations to subordinate Bank bonds, Healthcare and Energy bonds. We also advise underweight allocations to Technology and Pharmaceutical bonds. Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Stay Positioned For Reflation Stay Positioned For Reflation Table 3BCorporate Sector Risk Vs. Reward* Stay Positioned For Reflation Stay Positioned For Reflation High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 382 basis points in November, bringing year-to-date excess returns up to -5 bps. After last month’s strong outperformance, Ba-rated junk bonds are now beating duration-equivalent Treasuries by 267 bps, year-to-date. The B and Caa credit tiers are lagging by 179 bps and 548 bps, respectively. We still view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We remain underweight B-rated and lower junk bonds for now as those securities are pricing-in a relatively optimistic outlook for the default rate. But, an imminent vaccine roll-out makes that outlook appear more realistic and we could soon upgrade the lower-rated junk credit tiers when we think the value is exhausted in the Ba-rated and higher securities. Looking at value for the junk index as a whole, we see that the index is pricing-in a default rate of 3% for the next 12 months, significantly below the 8.3% that was observed during the most recent 12-month period (panel 3). However, only four corporate issuers defaulted in October down from a monthly peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology and Energy bonds. We are underweight the Healthcare and Pharmaceutical sectors. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview MBS: Underweight Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by one basis point in November, dragging year-to-date excess returns down to -39 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 1 bp on the month, and it currently sits at 64 bps (Chart 4). This is significantly higher than the 59 bps offered by Aa-rated corporate bonds, the 53 bps offered by Agency CMBS and the 25 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a risk for MBS investors. It suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). All else equal, this elevated refinancing activity will pressure MBS spreads wider. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 64 basis points in November, bringing year-to-date excess returns up to -222 bps. Sovereign debt outperformed duration-equivalent Treasuries by 157 bps on the month, bringing year-to-date excess returns up to -269 bps. Foreign Agencies outperformed the Treasury benchmark by 46 bps in November, bringing year-to-date excess returns up to -647 bps. Local Authority debt outperformed Treasuries by 139 bps in November, bringing year-to-date excess returns up to -228 bps. Domestic Agency bonds outperformed by 10 bps, bringing year-to-date excess returns up to -23 bps. Supranationals outperformed by 9 bps, bringing year-to-date excess returns up to +2 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, this year’s dollar weakness has occurred mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia and South Africa are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 130 basis points in November, bringing year-to-date excess returns up to -340 bps (before adjusting for the tax advantage). Municipal bond spreads tightened sharply relative to both Treasuries and Corporates in November, but they remain exceptionally attractive relative to history (Chart 6). In fact, as we showed in a recent report, the Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage).1 This is also true for the Bloomberg Barclays General Obligation (GO) index beyond the 12-year maturity point. Eight-to-twelve-year maturity GO bonds trade only 1 basis point through the Credit index, implying a breakeven effective tax rate of 4%. Six-to-eight-year maturities trade 11 bps through the Credit index, implying a breakeven effective tax rate of 16%. Extraordinary valuation is the main reason for our recommendation to overweight municipal bonds. The severe ongoing state & local government credit crunch is a concern, but it is a risk we are willing to take. It now looks possible that a relief package containing some federal funds for state & local governments will be passed before the end of the year. This would alleviate a lot of the concern. But even in the absence of federal assistance, the combination of austerity measures (bottom panel) and all-time high State Rainy Day Fund balances should help stave off a wave of municipal downgrades. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell The Treasury curve bull-flattened in November, but then bear-steepened sharply during the first week of December. All told, the 2/10 Treasury slope is currently 81 bps, 7 bps steeper than at the end of October. The 5/30 Treasury slope is 131 bps, 4 bps steeper than at the end of October. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and/or further fiscal stimulus will speed this process up. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year note and 10-year notes. This position is designed to profit from 2/10 curve steepening.     Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels. Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 70 basis points in November, bringing year-to-date excess returns up to -23 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 8 bps and 5 bps on the month. They currently sit at 1.91% and 1.96%, respectively. Core CPI was flat in October and the year-over-year rate dropped from 1.73% to 1.63%. The 12-month trimmed mean CPI fell even more – from 2.37% to 2.22% – so the gap between core and trimmed mean inflation continued to narrow (Chart 8). We expect further narrowing in the months ahead, and therefore expect core CPI to come in relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is now somewhat expensive according to our Adaptive Expectations Model (panel 2).2 Inflation pressures may moderate once core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure sometime next year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview ABS: Overweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in November, bringing year-to-date excess returns up to +82 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to +68 bps. Non-Aaa ABS outperformed by 17 bps, bringing year-to-date excess returns up to +174 bps (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of the year is quite negative for ABS. However, as we explained in a recent report, we don’t expect a material impact on spreads.3 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality remains quite robust. As we first explained back in June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).4  Faced with an income boost and few spending opportunities, many households took the opportunity to pay down consumer debt. Granted, further income support from Congress is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 85 basis points in November, bringing year-to-date excess returns up to -168 bps. Aaa Non-Agency CMBS outperformed Treasuries by 71 bps on the month, bringing year-to-date excess returns up to -2 bps. Non-Aaa Non-Agency CMBS outperformed by 127 bps, bringing year-to-date excess returns up to -620 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the imminent expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted.5  Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in November, bringing year-to-date excess returns up to +55 bps. The average index spread tightened 6 bps on the month. It currently sits at 53 bps, above typical historical levels (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, it is only purchasing what is “needed to sustain smooth market functioning”. This is nonetheless a Fed back-stop of the market, and it does not change our overweight recommendation.    Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Stay Positioned For Reflation Stay Positioned For Reflation Appendix B: 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 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 4TH, 2020) Stay Positioned For Reflation Stay Positioned For Reflation 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 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 4TH, 2020) Stay Positioned For Reflation Stay Positioned For Reflation 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 70 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 70 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Stay Positioned For Reflation Stay Positioned For Reflation Appendix C: 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. Chart 11Excess Return Bond Map (As Of December 4TH, 2020) Stay Positioned For Reflation Stay Positioned For Reflation 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.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Political Risk Will Dominate In A Pivotal Month For The Bond Market”, dated October 13, 2020, available at usbs.bcaresearch.com 2 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Inflation Breakeven Trades: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, as breakevens in both countries are no longer below the fair values implied by our models. We are initiating a new trade this week, going long French 10-year inflation-linked bonds versus French nominal OATs, as French breakevens remain below fair value. Yield Curve Butterfly Trades: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Cross-Country Spread Trades: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months. Feature Dear Client, Next week, we will be jointly publishing our semi-annual Central Bank Monitor Chartbook along with our colleagues at BCA Research Foreign Exchange Strategy. You will receive that report a few days later than usual on Friday, December 11. We will return to our regular publishing schedule on Tuesday, December 15 with our 2021 Key Views report outlining our main investment themes and ideas for the upcoming year. Best Regards, Rob Robis As we enter the final weeks of an incredibly eventful and (unfortunately) all too memorable 2020, our attention now turns to investment ideas for the coming New Year. This week, all BCA Research clients will receive the 2021 Outlook report, detailing the key themes and recommendations from all our strategists. We will follow that up with our own 2021 Global Fixed Income Strategy outlook report later this month. The waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio. In addition, the waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio (Table 1). Several of our suggested trades have generated a solid profit (like inflation breakeven wideners) but have now outlived their original rationale. Others, like some of our yield curve trades in Europe, have not gone as we expected and should therefore be closed out. Table 1Changes To Our Tactical Overlay Portfolio A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades As a reminder to our regular readers, our Tactical Overlay is a portfolio of individual trade ideas within the global fixed income space with an investment horizon of six months or less. These differ from our more typical strategic (6-12 month) recommendations that also populate our model bond portfolio. Ideas for our Tactical Overlay trades often stem from our fair value models, but can also be plays on events that we expect will be market relevant on a near-term basis, like central bank meetings. All recommended trades are implemented using specific securities, rather than generic Bloomberg tickers or bond indices. This allows for a more transparent process where clients can follow along with the performance of our trades. Evaluating Our Tactical Inflation-Linked Breakeven Trades We currently have two open tactical trade recommendations involving inflation-linked bonds: Long 10-year Italian inflation-linked bonds vs short 10-year Italian bond futures Long 10-year Canadian inflation-linked bonds vs short 10-year Canadian bond futures We initiated both of these trades back in June of this year, as well as an additional trade involving US TIPS, based on the output of our inflation breakeven fair value framework. In our models, we regress 10-year inflation breakevens on the annual rate of change of oil prices in local currency terms and a multi-year moving average of realized headline inflation.1 At the time of our mid-year report, inflation breakevens were too low on our models in the majority of developed market countries with inflation-linked bonds – a lingering after-effect of the COVID-19 shock to global growth in the second quarter of 2020 (Chart 1). Since then, 10-year inflation breakevens have caught up to fair value in the US, Germany, Italy and Canada, and have even moved above fair value in the UK and Australia. Chart 1A Big Shift In Inflation Breakeven Valuations A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades In June, we also entered into a US 10-year TIPS breakeven widening trade, but we took profits on the trade once US breakevens returned back to our model fair value estimate in September. We now see a similar situation in Canada (Chart 2) and Italy (Chart 3) where breakevens have converged to our model-implied fair value. Chart 2Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model A move above fair value is possible, but could be harder to achieve with the Canadian dollar and euro steadily trending higher which could weigh on the market’s view on future inflation in Canada and Italy. We are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively.  Thus, we are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. The Italian returns were boosted considerably by the long side of this trade, as we entered the position when the 10-year real yield was +1.05% and which has since collapsed to -0.05% on the back of the massive rally in Italian bonds. One place where breakevens still look attractively cheap, trading close to one standard deviation below our model fair value, is in France (Chart 4). This contrasts with the breakevens in Italy and Germany that have fully converged to fair value. Thus, we are entering a new trade this week, going long the on-the-run 10yr French inflation-linked bond (OATi) and shorting French bond futures (Euro-OATs). The hedge ratio used for this trade to keep both legs duration matched, given the much shorter duration of the OATi relative to nominal French bonds, is 0.49 (see the Tactical Overlay table on page 17 for specific details on the securities used in the trade). Chart 3Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Chart 4French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model Bottom Line: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, while initiating a new breakeven widening position in France, based on the output of our breakeven fair value models. Evaluating Our Yield Curve/Butterfly Spread Trades Back in July, we initiated a series of yield curve butterfly spread trades in the US, UK, Italy and France.2 Butterfly spreads compare the yield of a single bond (bullets) to that of a duration-neutral combination of bonds with shorter and longer maturities relative to the bullet (barbells). Our valuation models produce fair value estimates of various butterfly combinations based on the relation of the butterfly spreads to the slope of the yield curve. We then combine those valuations with our own macro views on the future slope of yield curves to come up with potential value-based curve trades.3 We now evaluate our four existing curve trades in turn. Long UK 3/20 Barbell vs. 10-Year Bullet Our original rationale for entering this trade was two-fold. Firstly, this position was the most attractive butterfly combination in terms of the standardized deviation of the spread from its model-implied fair value. Secondly, there was a relatively low correlation between nominal UK bond yields and inflation breakevens--meaning that we could see a rise in long-dated inflation expectations that did not also push up nominal bond yields by a proportional amount. This made the trade consistent with our overall macro view back in July that the Gilt curve would flatten (the same rationale applies to the other two long barbell versus short bullet trades, or “flatteners”, in France and Italy that we discuss below). Unfortunately, our rationale did not play out as expected (Chart 5). Instead of reverting to fair value, the butterfly spread was mostly flat while the bullet grew more expensive relative to the barbell, driven by a rise in the model fair value. This in turn was due to significant steepening in the underlying 3/20 curve, contrary to our expectations. We also saw a significant overall upward shift in the overall UK Gilt curve, which generated losses on our long barbell position (which has a higher interest rate convexity) that overwhelmed the profits on our short bullet position. Going forward, there are good technical and strategic reasons to exit this trade. The butterfly spread is not yet at levels where it tends to mean-revert (second panel). In addition, Joe Biden’s US election victory has also increased the odds of a Brexit deal, which would put bear-steepening pressure on the UK Gilt curve. With that in mind, we are closing our Long UK 3/20 Barbell vs. 10-Year Bullet for a loss of -0.17%. Long France 2/30 Barbell vs. 5-Year Bullet Our rationale for entering this flattener was the same as in the UK. However, we fared quite a bit better here. The underlying 2/30 curve did flatten, as we expected, however, the butterfly spread itself moved further away from fair value, with the bullet component becoming relatively more expensive (Chart 6). So, as with the UK, the returns on this trade can be largely explained by the relative outperformance of the barbell component due to its higher convexity. In France, however, the effect worked to our favor as the yield curve shifted downwards significantly. The positive returns on the long French 30-year OAT component, where yields have been nearly slashed in half since July, dominated the other parts of the trade - even with the 30-year bond only being a small piece (11%) of the duration-weighted barbell Chart 5UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model Chart 6France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model Although we did make profits on the flattener, it turned into a convexity bet that was not our original intention. Seeing as our underlying logic did not work out as expected, we are not comfortable remaining in this position. Thus, we are closing our France butterfly trade for a profit of 0.56%. Long Italy 5/30 Barbell vs. 10-Year Bullet As with the UK and France, we entered this trade based on its attractive model-based valuation and the relatively low correlation between inflation breakevens and nominal yields in France. Our expectation of flattening in the underlying 5/30 curve did not bear out as it remained mostly flat (Chart 7). We did see some reversion in the butterfly spread towards our model-implied fair value, which helped us make profits on our trade. Again, we cannot ignore the effect of convexity when looking at the outperformance of the barbell component. Yields fell dramatically across the Italian curve in one of the clearest examples of the yield-chasing behavior we have been describing this year.4 As Italian yields continue their race to the bottom, supported by ECB asset purchases and perceptions of more fiscal co-operation between the countries of Europe, there is a chance that this trade will continue to perform by virtue of its exposure to the long end of the Italian curve. However, as our original bias towards curve flattening did not play out, we prefer to maintain our exposure to Italian government debt via an overweight allocation in our model bond portfolio instead. We therefore close our Long Italy 5/30 Barbell vs. 10-Year Bullet for a profit of 0.83% Long US 7-Year Bullet vs. 5/10 Barbell The US was the only region where we initiated a “steepener” trade, with a long bullet versus short barbell combination that does well when the yield curve steepens. We chose this particular 5/7/10 butterfly as it was the most attractive steepener available based on our model-implied valuation that also fit our fundamental macro bias back in July towards US Treasury curve steepening – a view that we still hold today. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Our rationale for initiating the trade was borne out, with the underlying 5/10 Treasury curve steepening and the butterfly spread tightening towards fair value (Chart 8). Our trade was supported by a continued rebound in long-dated US inflation expectations as well as the US election result, the most bond-bearish event of the year. Chart 7Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Chart 8US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model Going forward, we see good reasons to maintain this trade. The butterfly spread, after briefly reaching expensive levels, is back to being attractively valued. Even if the residual were to dip back below zero, it would still have room to become more expensive, shoring up our trade. This trade also remains the most attractive of all the steepener trades on a model-implied valuation basis, removing any incentive to rotate towards another part of the curve. The odds favor more reflationary Treasury curve steepening after the US election. President-elect Biden has a stated goal of more fiscal stimulus, while his selection of Janet Yellen as Treasury Secretary signaling increased cooperation between monetary and fiscal authorities. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Bottom Line: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Evaluating Our Cross-Country Yield Spread Trades We currently have two recommended trades involving plays on the spread between government bonds: Long 5-year New Zealand government bonds versus short 5-year UK Gilts, currency-hedged into GBP We initiated this trade on August 25, and to date the trade is severely underwater with a total return of -1.8%.5 That loss comes from the long New Zealand leg of the trade, as the 5-year NZ bond yield has increased by 34bps from our entry level. Chart 9A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations The rationale for this trade was based on our assessment of the relative probability of the Bank of England (BoE) and Reserve Bank of New Zealand (RBNZ) moving to a negative interest rate policy. Both central banks hinted strongly at such a move throughout the summer months as part of their efforts to support pandemic-stricken economies. Our view back in late August was that it was more likely that the RBNZ would choose negative rates, as New Zealand had far lower inflation expectations than the UK and, unlike the British pound, the New Zealand dollar was not undervalued. This trade was initially profitable, but all that changed rapidly during the month of November. The RBNZ disappointed investor expectations on a move to negative rates at the November 11 monetary policy meeting. The central bank elected instead to increase the size of its existing quantitative easing program, while giving no hint that negative rates were coming soon. The response was a sharp move higher in both New Zealand bond yields and the New Zealand dollar (Chart 9). There was an even more violent adjustment in yields and the currency last week, after New Zealand Finance Minister Grant Robertson wrote a letter to RBNZ Governor Adrian Orr asking the central bank to change its policy remit to include controlling New Zealand house price inflation. Markets interpreted this blatant political pressure on the central bank as the end of any hopes of negative rates in New Zealand, with bond yields and the currency spiking higher once again. House prices have surged after the RBNZ aggressively cut interest rates earlier this year, with a rapidly rising share of new mortgages having higher loan-to-value ratios (Chart 10). House price inflation is now running at 19.8%, and Finance Minister Robertson did cite deteriorating housing affordability and inequality as the basis for his letter to the RBNZ. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. This shatters the underlying rationale for our long New Zealand/short UK yield spread trade (Chart 11). Chart 10RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices Thus, we are choosing to cut our losses and close out our recommended trade. Long 10-year German Bunds versus short 10-year US Treasuries Chart 11Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade We initiated this recommendation on October 27, and to date the trade is running a small loss of -0.17%.6 The rationale behind the trade was two-fold: Our valuation model for the 10-year UST-Bund yield spread showed that the spread was far below fair value; We turned more bearish on US Treasuries just before the US presidential election, downgrading our recommended allocation to underweight while also upgrading more defensive Germany – with its low yield-beta to US Treasuries - to overweight. The trade initially performed well, driven by faster growth and inflation in the US versus the euro area (Chart 12). The Treasury selloff has stalled of late, but we view this as more a consolidative pause than a near-term peak in yields. Chart 12Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread With our Treasury-Bund valuation model still showing that the spread is too tight, and with the spread not looking overly stretched versus its 200-day moving average (Chart 13), we are keeping our US versus Germany trade in our Tactical Overlay portfolio. Chart 13Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Bottom Line: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, " How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Yield Curve Trades: Netting Returns With Butterflies", dated July 7, 2020, available at gfis.bcaresearch.com. 3 Readers looking for more detailed background on butterfly trades and our yield curve modelling framework should refer to the July 7, 2020 Strategy Report where we initiated these trades. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rates Club", dated August 26, 2020, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Global Bond Implications Of Rising Treasury Yields", dated October 27, 2020 available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Please note that there will be no US Bond Strategy report next week. We will publish December’s Portfolio Allocation Summary on December 8th, followed by our Key Views For 2021 on December 15th and a Special Report titled “The Fed In 2021” on December 22nd. Highlights Duration: Weaker Q4 economic growth could cause Treasury yields to fall in the near-term, but knowledge of a vaccine coming in 2021 will limit the downside. Investors should maintain below-benchmark portfolio duration on a 6-12 month horizon. Fed: The Treasury’s decision to let the Fed’s emergency lending facilities expire is unlikely to have a meaningful impact on credit spreads, and it may even increase the odds of getting another fiscal stimulus bill through Congress. Spread Product: Value is quickly disappearing from high-rated corporate bonds, and municipal bonds look like an attractive alternative. Stay overweight municipal bonds and corporate bonds rated Ba and higher. Avoid junk bonds rated B and lower. Feature Increasingly, financial markets look caught in a tug-of-war between two competing economic outlooks. On the one hand, the US sits on the precipice of what is likely to be a dark winter. COVID hospitalizations are breaking through prior peaks and deaths are following closely behind (Chart 1). On the other hand, excellent results from vaccine trials offer a ray of light in the not-too-distant future. Focusing on the next 1-to-2 months, economic activity is poised to slow. This is partly because many states will respond to the surging case count by enacting stricter lock-down measures (Chart 2). In fact, New York shuttered schools just last week. But even in the absence of stricter quarantine laws, consumers will certainly exercise greater caution this holiday season. Already, consumer sentiment looks to be waning at a time when more than 700 thousand people are filing new unemployment claims each week (Chart 2, bottom 2 panels). Chart 1A Dark Winter A Dark Winter A Dark Winter Chart 2Look For Slower Growth In Q4 Look For Slower Growth In Q4 Look For Slower Growth In Q4 With consumer sentiment souring at a time when the household income support from the CARES act has expired, it is only a matter of time before consumer spending dips. Added to that, last week’s decision by the Treasury Department to call in the funds used to back-stop the Fed’s emergency lending facilities demonstrates that Donald Trump’s administration will be increasingly erratic during the next two months.1 Chart 3Treasury & Corporate Excess Returns Treasury & Corporate Excess Returns Treasury & Corporate Excess Returns Heightened political uncertainty during a period of slowing economic growth should point to lower bond yields and wider credit spreads in the near term. But, at least so far, the market reaction has been muted (Chart 3). Treasuries have strengthened somewhat during the past week. Treasury returns in excess of cash are running at +735 bps, year-to-date. This is up from +617 bps on November 10th. However, year-to-date investment grade corporate returns in excess of duration-matched Treasuries just hit -121 bps, the highest since February. Year-to-date High-Yield excess returns have dipped to -72 bps, after peaking at -39 bps on November 9th. It’s possible that investors need more evidence of weakening economic growth before the market impact is really felt. Or, it could simply be that forward-looking markets are much more focused on news about the COVID vaccine, and that investors are willing to tolerate a couple months of poor growth if they are confident that better times lie ahead. It’s also conceivable that financial markets would look through a spate of poor economic data if investors believed that more fiscal stimulus is on the way. Given the protracted nature of fiscal negotiations so far, it’s fair to be skeptical that a deal can be struck. But with the election now over, the House Democrats and Senate Republicans may have a greater incentive to compromise on a small relief bill, on the order of $1 trillion or less. According to surveys, a compromise deal would curry favor with voters of all political stripes. Most Republicans, Democrats and Independents support further fiscal aid (Table 1). What’s more, having a timeline for vaccine distribution could make negotiations less contentious, since any stimulus can be sold as the final COVID relief bill before a vaccine is available. Finally, it’s possible that Treasury Secretary Steve Mnuchin’s gambit will pay off, and that policymakers will view the funds being returned by the Fed as “free money” that should be re-deployed in the form of fiscal support. All in all, we are optimistic that a moderately-sized relief bill will be passed, if not this year then early next year. Table 1The Public Supports Another Round Of Stimulus Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? Investment Implications Chart 4Better Value In Munis Than IG Corporates Better Value In Munis Than IG Corporates Better Value In Munis Than IG Corporates With regards to our outlook for Treasury yields, we could see yields dip during the next month or two as the economic data weaken. However, we expect the knowledge that a vaccine is on the horizon will prevent yields from falling that much. We also could see progress made on a fiscal stimulus package, which would offset any downward pressure on yields. With that in mind, we advise investors to maintain below-benchmark portfolio duration on a 6-12 month horizon. On spread product, our investment conclusion is similarly colored by the tug of war between a negative near-term economic outlook and the positive news of a COVID vaccine. We recommend maintaining our current positioning: overweight investment grade corporates and Ba-rated junk, underweight junk bonds rated B and lower. If we do get some spread widening during the next month or two, driven by negative economic news or the expiry of the Fed’s emergency lending facilities, we would view that as an opportunity to get more aggressive by upgrading the lower-rated junk credit tiers. One caveat to our positive view on corporate credit is that value has deteriorated markedly in recent months, particularly for higher-rated investment grade corporates (Chart 4). At the same time, tax-exempt municipal bonds offer an exceptional spread pick-up relative to both Treasuries and equivalently-rated corporate bonds (Chart 4, bottom panel). We recommend that investors favor municipal bonds over corporate credit, particularly at the upper-end of the credit spectrum. The value in high-rated investment grade corporates has deteriorated markedly. Bottom Line: Maintain below-benchmark portfolio duration on a 6-12 month horizon. Stay overweight investment grade corporates and Ba-rated junk, while avoiding high-yield bonds rated B and below. Stand ready to upgrade low-rated junk bonds if spreads widen significantly during the next two months. Favor municipal bonds over equivalently-rated corporate credit, particularly at the upper-end of the credit spectrum. Treasury – Fed Disaccord As mentioned above, last week’s big news was that Treasury Secretary Steve Mnuchin sent a letter to the Federal Reserve saying that he would (a) not authorize an extension of some of the Fed’s emergency lending facilities beyond December 31st and (b) would like the Fed to return the unused funds that the Treasury Department had allocated to serve as the equity back-stop for those facilities. Though the Fed issued a statement saying that it would prefer to extend the facilities, Chair Powell eventually acceded to both requests. This means that the Secondary and Primary Market Corporate Credit Facilities (SMCCF & PMCCF), the Municipal Liquidity Facility (MLF), the Main Street Lending Facilities (MSLF) and the Term Asset-Backed Securities Loan Facility (TALF) will all cease operations at the end of the year.2 Gone For Good? Given the Fed’s stated desire for the facilities to continue and the fact that a new Treasury Secretary – presumably one that will show greater deference to the Fed – will take over in January. It’s conceivable that the facilities could be quickly re-started. If the Treasury had simply not authorized an extension of the facilities without taking its money back, this would be as simple as flicking a switch. The fact that the Fed will return the money makes the process slightly more complicated, but by no means impossible. The facilities in question are all structured as Special Purpose Vehicles (SPVs) to which the Treasury Department supplies some amount of equity financing. The Fed then loans money to the SPVs, levering them up dramatically in the process. Crucially, there is no statutory limit on the amount of leverage the Fed can provide to the SPVs. This means that the Fed could ramp them back up, even if it gets only a small injection of capital from the Treasury. A new Treasury Department could easily find enough money in the Exchange Stabilization Fund for the Fed to re-start the facilities in January, without seeking Congressional approval. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. In our view, Secretary Mnuchin has a point when he writes that markets are functioning well enough on their own. Simply look at how little the emergency facilities have been used (Table 2). The Fed has purchased only $13 billion of corporate bonds in the SMCCF. TALF has only been tapped for $3.75 billion and both the MSLF and MLF are operating at less than 1% of their maximum capacities. The PMCCF, which the Fed can use to purchase new issuance in the corporate bond market, has never been accessed! Table 2Usage Of The 2020 Federal Reserve Emergency Lending Facilities Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? Even the SMCCF, the facility through which the Fed buys corporate bonds and corporate bond ETFs in the secondary market, has significantly scaled back its purchases during the past few months. It also hasn’t purchased an ETF since August (Chart 5). Chart 5The Fed Is Not Very Active In The Corporate Bond Market Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? At a certain point, if the facilities aren’t being used, it is entirely reasonable to ask whether they are still necessary. They would no doubt prove useful if we hit another crisis – like in March – where spreads widen sharply and primary markets shut down. But that seems like a relatively low-risk tail event at this stage of the recovery. Finally, Secretary Mnuchin made the case in his letter that the returned funds from the Fed could be re-deployed as fiscal stimulus by Congress. This argument doesn’t make a lot of sense economically. When it scored the CARES act, the Congressional Budget Office assumed that the Treasury would take no losses on the money used to finance the Fed’s emergency lending facilities, so clawing those funds back has no impact on the deficit. But this may not matter. What matters is whether Senate Republicans can use the Treasury’s maneuver as political cover to justify voting for more fiscal relief. We think they might be able to do so, and we therefore see the Treasury’s move as increasing the odds of getting another fiscal relief bill through Congress. Investment Implications Chart 6MLF And TALF Aren't Pushing Yields Lower MLF And TALF Aren't Pushing Yields Lower MLF And TALF Aren't Pushing Yields Lower This development does not immediately influence our recommended investment strategy. On corporate bonds, we can’t definitively rule out the possibility that the expiry of the facilities will cause spreads to widen in the near-term. But if that does occur, we will view it as an opportunity to quickly increase exposure. For municipal bonds, the MLF allows municipal governments to place new debt with the Fed at a rate that varies depending on the municipality’s credit rating. At present, that MLF rate is well above municipal bond yields for all credit ratings (Chart 6), meaning that it would only become important in the event of a crisis that caused municipal yields to rise sharply. Similarly, TALF allows participants to take out loans from the Fed using Aaa-rated securitizations as collateral. But the current yields on Aaa-rated consumer ABS and Aaa-rated non-agency CMBS are 91 bps and 33 bps below this rate, respectively (Chart 6, bottom panel). In other words, spreads would need to widen fairly sharply for TALF to be relevant for investors. The expiry of TALF is more concerning for CMBS than consumer ABS. Commercial real estate is structurally challenged by the current crisis, while consumer balance sheets are in good shape. We recommend overweighting consumer ABS across the entire credit spectrum but would limit non-agency CMBS exposure to the Aaa credit tier. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Preparing For A Dark Winter … But Do Markets Care? Preparing For A Dark Winter … But Do Markets Care? Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The second section of this report (titled “Treasury – Fed Disaccord”) examines the specific market implications of the Treasury Department’s decision to not authorize an extension of the Fed’s emergency lending facilities. 2  For details on how these facilities are structured and what they are designed to do please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020 and US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge Markets Reacting Calmly To This COVID-19 Surge Markets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 A Huge Second Wave of COVID-19 A Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Economic Restrictions Weighing On European Growth Vs US Economic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine Nobody Wants A Stronger Currency Nobody Wants A Stronger Currency So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations COVID-19 Surge Weighing On Global Growth Expectations COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Global Interest Rate Expectations Have Bottomed Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment Bullish Equity Sentiment, Bearish USD Sentiment Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A New Leg Of USD Weakness On The Horizon? A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD An Inflationary Impulse From A Weaker USD An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Currency Impact On Inflation Greater In Some Countries Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Biggest Currency Impact On Financial Conditions Outside The US Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Relative QE Matters Less For Currencies Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads Relative QE Matters More For Bond Yield Spreads Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance More Non-US QE Will Support Non-US Bond Outperformance More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending Central Banks Are Increasingly 'Funding' Government Spending Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Nobody Wants A Stronger Currency Nobody Wants A Stronger Currency Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns