Gov Sovereigns/Treasurys

Highlights The vaccine promises an eventual return to “normal” life – just as Americans voted to “return to normalcy.” Markets are cheering and hinting at an eventual rotation into value stocks. The contested US election can still cause volatility even though Trump is highly unlikely to change the result. The fiscal stimulus cliff is still a risk to the normalcy rally in the short run. But gridlock is the best political outcome over the coming 12-24 months. Stay strategically long global stocks over bonds. Tactically maintain safe-haven positions, add risk gradually, and stay short China/Taiwan. Feature The news of Pfizer’s success in developing a COVID-19 vaccine galvanized financial markets this week. America’s leading public health official Anthony Fauci also predicted that Moderna’s vaccine candidate would be similarly effective. It will take time to distribute these vaccines but the world can look toward economic recovery next year. Stocks rallied, bonds sold off, and value outperformed growth on the back of the news (Charts 1A and 1B). Chart 1ABiden: Return To Normalcy Biden: Return To Normalcy Biden: Return To Normalcy Chart 1BVaccine: Return To Normalcy Vaccine: Return To Normalcy Vaccine: Return To Normalcy The vaccine announcement super-charged the “return to normalcy” rally that followed the US election. The election’s likeliest policy outcome is that President Elect Joe Biden will not raise sweeping tariffs while Republican senators will not raise taxes next year, the best-case scenario for markets. This is genuinely positive news. The benefits are very clear over the next 12 months. But the risks are also very clear over the next three months: the virus will remain a problem until the vaccine is widely distributed, the US is in the midst of a contested election that could still cause negative surprises, the Republican senators are less likely to agree to fiscal relief, and President Trump will take aggressive actions to cement his legacy during the “lame duck” period of his last 68 days in office. The takeaway is that the US dollar will see a near-term, counter-trend rally and developed markets will outperform emerging markets for a while longer. We are only gradually adding risk to our strategic portfolio as we keep dry powder and maintain tactical safe-haven trades. Is The Election Over Or Not? Yes, most likely the election is over. But our definitive guide to contested US elections will teach any reader to be sensitive to the tail risks. The counting of ballots is not finished and the Electoral College does not vote until December 14. First, it is still possible that President Trump could pull off a victory in Georgia, which will now recount ballots by hand. Biden’s margin of victory of 14,045 votes is not so large there as to make it impossible that Trump would come back with a win (though history suggests recounts only change hundreds, not thousands, of votes). Trump is also narrowing the gap in Arizona, where counting continues, though the latest reports suggest he is still falling short of the roughly 60% share of late ballots that he needs to close the 11,635 vote gap and win the state. Second, there is a 50/50 chance that the Supreme Court will rule that Pennsylvania must stick to the statutory November 3 deadline, i.e. not accept mail-in ballots that arrived in the three days after that date. While the high court would prefer to let Pennsylvania settle its own affairs, this case is of the sort that the court could feel compelled to weigh in. The constitution is crystal clear that legislatures, not courts, decide how a state’s electors are chosen. Such a ruling probably would not reverse Biden’s projected victory in Pennsylvania. Trump is currently trailing Biden by 53,980 votes in this state. State officials say that the ballots that arrived late amount to only 7,800 and would not be able to change the outcome.1 This may be understating the risk but it is probably accurate in the main. Table 1 shows the share of mail-in votes that arrived late in this year’s primary elections. The share was 1.07% in Pennsylvania and up to 3% in other states. Applying the high water mark of 3% to the November 3 general election mail-in ballots, it is possible that 77,187 votes arrived late and would be excluded by a Supreme Court ruling. However, 85% of those ballots would have to have gone to Biden in order for Trump to come out the winner. This is far-fetched. Table 1Share Of Ballots Arriving Late In Primary Election Extrapolated To General Election The "Normalcy" Rally The "Normalcy" Rally It is also unlikely that Republican legislatures will take matters into their own hands and defy the election boards of their state by nominating their own slate of Republican electors – a scenario we entertained in our definitive guide. If Biden leads the statewide vote, then a state legislature would be politically suicidal to appoint the state’s electors to vote for Trump. It would invite a popular backlash. In the case of Pennsylvania, Republican leaders of the lower and upper chambers have explicitly denied any willingness or ability to choose electors other than those entailed by the popular vote. Thus the 1876 “Stolen Election” scenario is extremely unlikely in this critical state. It is just as unlikely in Arizona, Nevada, or Georgia.2 Nevertheless, if President Trump wins in Georgia or gets a favorable Supreme Court verdict, investors will have to increase the probability that the election result will be overturned, which currently stands at 16% (Chart 2). This will cause a bout of volatility even if it changes nothing in the end. If somehow Trump pulls off a Rutherford B. Hayes and overturn the result, markets should sell off. Yes, Trump is an exclusively commercial and reflationary president, but his election on a constitutional technicality would create nearly unprecedented social and political instability in the United States and it would presage major instability globally. Chinese, European, and Canadian assets would be hardest hit (Chart 3). Chart 2Trump’s Tiny Chance Of Reversing Election The "Normalcy" Rally The "Normalcy" Rally Otherwise Trump and the Republicans are trying to do four things with their litigation: (1) probing for weaknesses that can delay or change the Electoral College math (2) conducting due diligence in case fraud really did tip over one of the states (3) saving face for President Trump and his allies, who otherwise would be exposed as failures (4) keeping their base motivated for the showdown in Georgia on January 5, which will determine control of the Senate. Chart 3Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie In Georgia, opinion polls show Republican David Perdue slightly leading Democrat Jon Ossoff, in keeping with his superior showing on November 3. However, Republican Kelly Loeffler is trailing Democrat Raphael Warnock (Charts 4A and 4B). Last week we argued that the odds of Democrats winning both races stood around 20%. If anything this view is generous – given that Perdue already beat Ossoff, and Warnock will continue to suffer attacks for associating with Fidel Castro – but it is in line with online betting markets (Chart 5). Chart 4AVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 4BVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 5Democrats Have ~20% Chance To Win Senate The "Normalcy" Rally The "Normalcy" Rally Investors should plan on the US government being gridlocked unless something occurs that fundamentally changes the Georgia race. Gridlock is positive, so if Trump’s election disputes keep the Republican political base spirited for the Georgia runoffs, then Trump’s activities have an ironic upside for markets. That is, as long as he doesn’t succeed in overturning the election result and the flames of discontent do not break out into a significant violent incident. Other fears about the transition period are less concerning. Several clients have asked us what should happen if President Elect Biden came down with COVID-19 or were otherwise incapacitated. The answer is that Vice President Elect Kamala Harris would take his place, as she now has popular consent to do exactly that. Prior to the Electoral College voting on December 14, the Democratic National Committee would have to nominate a candidate to replace Biden, almost certainly Harris. After December 14, the regular succession would apply under the twentieth amendment and Harris would automatically fill Biden’s shoes. Harris is only slightly more negative for equities than Biden: her regulatory pen would be more anti-business, but like Biden her main policies depend entirely on control of the senate. Bottom Line: It ain’t over till it’s over. The big picture is positive for risk assets but a surprise from ongoing election disputes or the unusually rocky transition of power would trigger a new bout of volatility. Stay long Japanese yen and health stocks on a tactical time frame. Trump’s Lame Duck Risk An investor in the Wild West has often criticized us for arguing that Trump would become a “war president” as he became a political lame duck at home. This war president view did pay off with Iran in January 2020, but otherwise the criticism is valid (see Trump’s Abraham Accords). Now Trump is almost certainly a lame duck so we will find out what he intends to do when unshackled from election concerns. Stay long Japanese yen and health stocks on a tactical time frame.  Since losing the election, Trump has fired Defense Secretary Mark Esper, several defense officials have resigned, and CIA Director Gina Haspel is rumored to be next on the chopping block. Most of the officials to depart had broken with the president over the course of the election year, so he may just be dishing out punishment now that the campaign is over. But it is possible that Trump is planning a series of final actions to cement his legacy and that these officials were removed because they got in the way. Chart 6Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait First, there is no doubt that Trump is already tightening sanctions on China and Iran. China was the origin of the coronavirus pandemic and Trump has called for reparations, which could mean more tariff hikes. His outstanding legacy in US history will be his insistence that the US confront China. We are fully prepared for this outcome and remain short the renminbi and Taiwanese equities, despite their strong performance year-to-date (Chart 6). Trump could also raise tariffs on Europe. However, investors should be used to tariffs and sanctions by now. The impact would be fleeting and the next administration could reverse it. In the case of the renminbi, or any tariffs that weigh on the euro, investors should buy on the dips. By contrast, there are some conceivable actions – we are speculating – that would be extremely destabilizing and possibly irreversible. These would include: Extending diplomatic recognition to Taiwan, potentially provoking a war with China. Sending aircraft carriers into the Taiwan Strait, like Bill Clinton did during the Third Taiwan Strait Crisis, to shore up US deterrence. Launching surgical strikes against Iran’s ballistic missile and nuclear facilities or critical infrastructure. A prominent official has already denied that Trump intends anything of the sort. Launching surgical strikes against North Korea’s ballistic missile and nuclear facilities. No sign of this, but Kim Jong Un did enhance his capabilities after his meetings with Trump, thus embarrassing the president on a major foreign policy initiative ahead of the election. Providing intelligence and assistance to US allies like Israel who may seek to sabotage or attack Iran now or in future to prevent it from acquiring nuclear weapons. Withdrawing US troops from Germany or South Korea – which is much more consequential than hasty withdrawals from Afghanistan or Syria, which Trump clearly intends. War actions are largely infeasible. The bureaucracy would refuse to implement them. Assuming the Department of Defense would slow-walk any attempts to reduce troops in important regions like Germany or Korea, it would almost certainly avoid instigating a war. Withdrawing troops from Afghanistan or Syria is manageable, and fitting with Trump’s legacy, but it would not be disruptive for financial markets. A diplomatic upgrade or a show of force to demonstrate the American commitment to defend Taiwan is possible and highly disruptive for global financial markets. The critical risk may come from US allies or partners that are threatened by the impending Biden administration and have a window of opportunity to act with full American support while Trump still inhabits the Oval Office. The likeliest candidate would be Israel and Saudi Arabia on the Iranian nuclear program. Trump’s onetime national security advisor, H. R. McMaster, has already warned that Israel could act on the “Begin Doctrine,” which calls for targeted preventive strikes against hostile nuclear capabilities.3 Even here, Israel is unlikely to jeopardize its critical security relationship with the United States, so any actions would be limited, but they could still bring a major increase in regional tensions. Saudi Arabia can do little on its own but President Trump could willingly or unwilling encourage provocative actions. Chart 7Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Any number of incidents or provocations could occur in this risky interregnum between Trump and Biden. Some suggest Trump will release a treasure trove of documents to discredit Washington and the Deep State. If that is all that occurs, then investors will be able to give a sigh of relief, as revelations of government intrigue would have to be truly consequential for future events in order to cause a notable market impact. Last-minute executive orders on regulating domestic industries are just as likely to shock markets as any international moves. We speculate that Big Tech is in Trump’s sights for censoring his comments during the election. In the wake of the Supreme Court’s decision in Department of Homeland Security versus Regents of the University of California, the Trump administration is positively incentivized to issue a flurry of executive orders and write them in a way that makes them hard for the Biden administration to rescind them.4 Tech is priced for perfection, despite ruffles due to the vaccine this week, and investors expect Biden-Harris to maintain Obama’s alliance with Silicon Valley, not least because Biden has named executives from Facebook and Apple to his transition team and is considering putting former Google chief Eric Schmidt in charge of a Big Tech task force (Chart 7).5 Ultimately we have no idea what the Trump administration will do in its final two months. A lot of Trump’s attention will be focused on contesting the election. Drastic or reckless decisions will likely be obstructed by the bureaucracy. But the president still retains immense powers and there are executive orders that are legitimate and would benefit the US’s long-term interests even if disruptive for financial markets – and these would be harder for officials to disobey. Trump is an anti-establishment player who intends to shake up Washington, stay involved in politics, and cement his legacy. There is a reason for investors to take political risk seriously rather than to assume that the transition to a more market-friendly administration will be smooth. Bottom Line: Stay long gold on geopolitical risk, despite the potential for a counter-trend rise in the US dollar. We are neutral tech: polarization and fiscal risks are positive for tech shares but reopening and Trump lame duck risks are negative. Biden’s Cabinet Picks This “lame duck Trump” risk explains why we are not overly concerned about Biden’s cabinet picks. Insofar as Biden’s choices affect the market at all, they will confirm the “return to normalcy” theme and hence will be market-friendly. Take for example Biden’s just-announced chief of staff, Ronald Klain, who was chief of staff when Biden served as vice president from 2009- 16. The current transition is obstructed by election disputes, as occurred in November-December of 2000, but the cabinet picks are not likely to bring negative surprises. Already Biden has announced a coronavirus advisory board, a bipartisan transition team, and is pondering other picks, some of which will be known by Thanksgiving. None of the choices are in the least disruptive or radical – and most are acceptable to Wall Street. Biden will pick experts and technocrats who are known from his political career, the Obama administration, the Clinton administration, the Democratic Party, and academia. The market will invariably approve of establishment nominations after four years of anti-establishment picks and spontaneous firings. Since the Senate will remain in Republican hands, the cabinet members will have to be centrist enough to be confirmed. While Biden will inevitably nominate a few progressives, they will either fail in the Senate or take up marginal posts. Stay long gold on Trump “lame duck” geopolitical risks. Biden may have the opportunity to appoint three or even four members to the Federal Reserve’s board of governors. The Trump administration failed to fill two seats, while Fed Chair Jerome Powell’s term will expire in February 2022 (Diagram 1). If Biden appoints Lael Brainard to another post, such as Treasury Secretary, he will have a fourth space to fill. Diagram 1Biden Could Have Three-To-Four Fed Picks The "Normalcy" Rally The "Normalcy" Rally Chart 8Facing Gridlock, Biden Will Re-Regulate The "Normalcy" Rally The "Normalcy" Rally The implication will be a further entrenchment of dovish policy, with greater attention to new concerns that fall outside of traditional monetary policy such as climate change and racial inequality. The Fed has already committed to pursuing “maximum employment,” refraining from rate hikes till the end of 2023, and targeting average inflation – all a major boon to the Biden administration as it attempts to revive the economy. What is negative for markets is that Biden will re-regulate the economy – after Trump’s deregulatory shock – and that this will bring about political risks for small business and key industries like health, financials, and energy (Chart 8). Biden has little other option given that his legislative agenda will be largely stymied. Nevertheless, the sectors most likely to be heavily impacted are attractively valued and stand to benefit from economic normalization if not from Biden’s version of normalcy. Bottom Line: Stay long health and energy. Yes, Gridlock Is Best For Markets Some clients have asked us about our view that gridlocked government is truly the best for financial markets. Wouldn’t Democrats winning control of the Senate in Georgia be better, as it would usher in greater political certainty and larger fiscal spending? We have addressed this issue in previous reports so we will be brief. First, yes, gridlock has higher returns than single-party sweep governments on average over the past 120 years (Chart 9). Clearly the normalcy rally can go higher, but it is equally clear that it will get caught by surprise when the political reality hits home.  Second, however, the stock market’s annual returns are roughly average under single-party sweeps during this period (Chart 10). Chart 9Gridlock Best For Markets The "Normalcy" Rally The "Normalcy" Rally Chart 10Single-Party Sweeps Generate Average Annual Returns The "Normalcy" Rally The "Normalcy" Rally So while investors can cheer gridlock, it is not as if they should sell everything if Democrats do win control of the Senate on January 5. Chart 11Sweeps As Good As Gridlock Over 70 Years The "Normalcy" Rally The "Normalcy" Rally Indeed, looking at the period after World War II, sweep governments have witnessed average annual returns that are the same or slightly better than under gridlock (Chart 11). Whereas limiting the study to the post-Reagan era, gridlocks are clearly favored. If greater fiscal resources are needed then gridlock will quickly become a market risk rather than an opportunity. It is notable that over the past 120 years, there is not an example of a Democratic president presiding over a Republican senate and a Democratic House. There was only one case of the inverse – a Republican President, a Democratic senate, and a Republican House – which occurred in 2001-02 and coincided with a bear market. In fact, this episode should be classified as a Republican sweep, as in Table 2, since a sweep was the result of the 2000 election and the context of the key market-relevant legislation in 2001.6 Table 2Average Annual Equity Returns And Gridlock Government The "Normalcy" Rally The "Normalcy" Rally Chart 12Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 In 2020 the stock market clearly anticipated a gridlocked outcome – the market’s performance matches with the historical profile of divided government (Chart 12). We argued that this was the best case for the market because it meant neither right-wing populism nor left-wing socialism. But we also highlighted that any relief rally on election results (reduced uncertainty) would be cut short by the major near-term implication of gridlock: a delay of fiscal support for the economy in the near term. This was the only deflationary scenario on offer in this election. Hence bad news in winter 2020-21 would precede the good news over the entire 2020-22 period. This is still largely our view, but we admit that the vaccine announcement erodes near-term risk aversion even further. There is little substance to the discussion of whether Americans will take the vaccine or not. Evidence shows that Americans are no less likely to take vaccines than other developed country citizens – assuming they are demonstrated to be safe and effective (Chart 13). Chart 13Yes, Americans Take Vaccines The "Normalcy" Rally The "Normalcy" Rally So gridlock looks even better now than it did previously. Yet we still think the near-term fiscal risks will hit markets sometime soon. Senate Republicans have been emboldened by the fact that their relative hawkishness paid off in the election on November 3. If they would not capitulate to House Speaker Nancy Pelosi prior to the election, they are even less likely to do so after gaining seats in the House, retaining the Senate, and crying foul over the presidential election. McConnell could agree to a $500 billion deal before Christmas – or not. There is no clear basis for optimism. A government shutdown is even possible if the continuing resolution expires on December 12. If the economic data turns sour and/or markets sell off dramatically then the Republicans will be forced to agree to a bigger deal, but as things stand they are not forced to do anything. And that presents a downside risk to the normalcy rally. Investment Takeaways Today’s post-election environment is comparable to the period after 2010, when a new business cycle was beginning and a new President Barack Obama had to face down Republican fiscal hawks in the House of Representatives. Today’s GOP senators may prove somewhat more cooperative with President Elect Biden, but that remains to be seen. Given how tight the election was, Republicans have an incentive to obstruct, slow down the economic recovery, and contest the 2022 midterms and 2024 election on the back of another slow-burn recovery. It worked last time. The debt ceiling crises of 2011 and 2012-13 were different than the fiscal stimulus cliff that Washington faces today but the market implications are similar. At the climax of brinkmanship between the president and the senate, treasuries will rally, the dollar will rally, stocks will fall, and emerging markets will underperform (Charts 14A and 14B). Today there is a greater limit on how far the dollar will rise and how far treasury yields will fall, but a fiscal impasse will still drive flows into these assets. Chart 14AObama’s Debt Ceiling Crises… Obama's Debt Ceiling Crises... Obama's Debt Ceiling Crises... Chart 14B… Presage Biden’s Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ​​​​​​​This is what we expect over the next three months. The fact that President Trump could bring negative surprises only enhances this expectation. Therefore we are only gradually adding risk to our strategic portfolio and maintaining tactically defensive positions. Clearly the normalcy rally can go higher, but it is equally clear to us that it will get caught by surprise when the political reality hits home. Since this could be anytime over the next two months, we are only gradually adding new risk. We would not deny that the outlook is brighter over the 12-24-month periods due to the vaccine and election results.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Chris Matthews, "Alleging fraud, GOP seeks to overturn election results in Michigan, Pennsylvania," MarketWatch, November 10, 2020, marketwatch.com. 2 See Senator Jake Corman and Representative Kerry Benninghoff, "Pennsylvania lawmakers have no role to play in deciding the presidential election," Centre Daily, October 19, 2020, centredailly.com. As for the 1876 “Stolen Election,” the initial election results suggested that Democrat Samuel Tilden had won 184 electoral votes while Republican Rutherford B. Hayes had won 165. The amount needed for a majority in the Electoral College at the time was 185, so Tilden fell one vote short while Hayes fell 20 votes short. After partisan litigation, actions by state legislatures, an intervention by the US House of Representatives, and a grand political compromise, Hayes won with 185 votes. 3 See Charles Creitz, "McMaster warns Biden on Iran deal: Don't resurrect 'political disaster masquerading as a diplomatic triumph,’" Fox News, November 12, 2020, foxnews.com. 4 In this ruling, which was decided on a 5-4 split with Chief Justice John Roberts siding with liberal justices, the Supreme Court denied the Trump administration’s effort to overturn the Obama administration’s policy known as Deferred Action on Childhood Arrivals (DACA), which stopped the US from deporting illegal immigrants who came to the US as children. The majority opinion argued that the Trump administration had merely asserted, not demonstrated, that the Obama administration’s executive orders were unconstitutional. In doing so, it established a precedent by which the court can determine whether one president’s executive orders should overrule another’s. While future administrations may follow better procedures in attempting to revoke their predecessors’ orders, this decision likely incentivizes the Trump administration to try to issue decrees that will be difficult to revoke. See John Yoo, "How the Supreme Court’s DACA decision harms the Constitution, the presidency, Congress, and the country," American Enterprise Institute, June 22, 2020, aei.org. 5 See Kiran Stacey, “What can Silicon Valley expect from Joe Biden?” Financial Times, November 8, 2020, ft.com. 6 The election produced a Republican sweep, with a 50-50 balance in the Senate, that led to the Bush tax cuts in May 2001. The business cycle was ending, however. In June, Democrats took the senate majority when Republican Senator Jim Jeffords of Vermont became an independent and began caucusing with Democrats. In September terrorists attacked the World Trade Center causing a market collapse.

Highlights US Election & COVID-19: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Fixed Income Strategy: The big news announcements do not motivate us to change our fixed income investment recommendations. Stay below-benchmark on overall duration, and underweight the US in global bond portfolios. Stay overweight global inflation-linked bonds versus nominal government debt, particularly in the US and Italy. Maintain an overweight stance on global spread product, focused on US corporates (investment grade and Ba-rated high-yield) and emerging market US dollar denominated corporates. Feature Chart of the WeekUS Yields Leading The Way Higher US Yields Leading The Way Higher US Yields Leading The Way Higher Investors have digested two major pieces of news over the past few days – the projected election of Joe Biden as the 46th US President and the positive results of Pfizer’s COVID-19 vaccine trial. Both outcomes are bond-bearish, but the bigger response came after the news of a potential vaccine, with the 10-year US Treasury yield hitting an 8-month high of 0.96% yesterday. Yields in other countries rose by a lesser amount, continuing the recent trend of US Treasury underperformance (Chart of the Week). After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios.  The introduction of a successful vaccine would obviously be a game-changer for all financial markets, not just fixed income, as it would allow investors to see an end to the pandemic and a return to more normal economic activity. While we are heartened by the vaccine trial announcement, there are still many hurdles that need to be cleared before any vaccine is approved and distributed around the world. It is still too soon to adjust our bond investment strategy in anticipation of a post-COVID world. After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios. While a Biden victory combined with the Republicans likely keeping control of the US Senate was the least bond-bearish outcome - thus avoiding the big surge in government spending likely after a Democratic “blue wave” - there is clear upward momentum in US economic growth that suggests more upside for Treasury yields on both an absolute basis and relative to other countries. Cross-Country Divergences Are Starting To Appear Our recent decision to cut our recommended overall global duration stance to below-benchmark was motivated by our more bearish view on US Treasuries. However, a more defensive duration posture was justified by the rapid rebound in global growth seen since the depths of the COVID-19 recession. Our Global Duration Indicator, comprised of leading economic data, has been calling for a bottom in global bond yields toward the end of 2020 (Chart 2). The rise in global yields we are witnessing now appears to be right on cue. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. Chart 2Global Yields Are Bottoming Global Yields Are Bottoming Global Yields Are Bottoming Importantly, inflation expectations across the developed world have yet not risen by enough to force central banks to become less dovish. This suggests that global yield curves will have a steepening bias over at least the next six months, with longer-term yields rising more on the back of faster growth (and additional increases in inflation expectations) than shorter-maturity yields which are more sensitive to monetary policy shifts. Those trends will not be seen equally across all countries, though. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. For example, the October US manufacturing ISM and Payrolls data released last week showed robust strength, even in a month where new US COVID-19 cases rose sharply. Europe, on the other hand, has seen an even bigger surge in new cases, resulting in a wave of national lockdowns that has already begun to weigh on domestic economic activity. Thus, core European bond yields have remained stable, even with the euro area manufacturing PMI remaining elevated (Chart 3). We see similar divergences in other developed economies, with generally strong manufacturing PMIs and mixed responses from bond yields. When looking at the breakdown of nominal bond yields into the real yield and inflation expectations components, even more divergences are evident (Chart 4).1 Chart 3Mixed Responses To Rebounding Growth Mixed Responses To Rebounding Growth Mixed Responses To Rebounding Growth Chart 4Real Yield Trends Are Starting To Diverge Real Yield Trends Are Starting To Diverge Real Yield Trends Are Starting To Diverge Chart 5Discounting An Extended Period Of Negative Real Rates Discounting An Extended Period Of Negative Real Rates Discounting An Extended Period Of Negative Real Rates The real yields on benchmark 10-year inflation-linked bonds are slowly rising in the US and Canada, but remain stable in Germany, the UK and Australia. Market expectations for central bank policy rates, extracted from overnight index swap (OIS) curves, are currently priced for an extended period of low policy rates over the next few years. This is no surprise, as central banks have told the markets this would be the case via dovish forward guidance. Yet central banks are also projecting inflation rates to move higher between 2021 and 2023, even as they are signaling unchanged interest rates over that same period (Chart 5). Central banks are effectively telling markets that they want an extended period of negative real policy rates - a major reason why real bond yields are negative across the developed world. At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. Unemployment in the US and Canada has already declined sharply since spiking during the first wave of COVID-19 lockdowns. In the US, the unemployment rate has fallen from a peak of 14.7% to 6.9%; in Canada, the decline has been from 13.7% to 8.9% (Chart 6). This contrasts sharply to trends in Europe and Australia, where unemployment rates remain elevated. Chart 6Diverging Trends In Unemployment A Vaccine For Uncertainty A Vaccine For Uncertainty At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. With the Fed and Bank of Canada (BoC) projecting additional declines in unemployment over the next few years, markets are starting to discount a less dovish stance from both central banks. The US and Canadian OIS curves are now discounting one full 25bp policy rate hike by Aug 2023 and May 2023, respectively. This is a bit sooner than signaled by the forward guidance of the Fed and BoC. Thus, markets are now pricing in a less negative path for real policy rates – and, by association, real bond yields. Chart 7Markets Still Discounting Low Yields For Longer A Vaccine For Uncertainty A Vaccine For Uncertainty This contrasts to the euro area, Australia and the UK, where unemployment rates remain elevated. The recent surge in coronavirus cases across Europe means that the ECB and Bank of England will be under no pressure by markets to reconsider their current easy money policies. While in Australia, persistently weak inflation and, more recently, worries about an appreciating Australian dollar are keeping expectations for Reserve Bank of Australia (RBA) policy ultra-dovish. Given the likely hit to longer-term potential growth from the COVID-19 pandemic, coming at a time of elevated debt levels (both government and private), markets are justified in pricing in a structurally lower level of policy rates for longer (Chart 7). Yet even in such a world, there will be cyclical upswings in growth and inflation that will upward pressure on bond yields. At the moment, those pressures seem greatest in the developed world in the US and Canada. This suggests that global bond investors should underweight both the US and Canada. However, the Fed seems more willing to accept a period of rising bond yields than the BoC, which has been very aggressive in the expansion of its quantitative easing (QE) program, which leaves us to only consider the US as a recommended underweight. Bottom Line: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Recommended Fixed Income Strategy After A Busy Few Days Joe Biden’s election victory and the potential COVID-19 vaccine do not lead us to make any changes to our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On duration, we continue to recommend a moderate below-benchmark overall exposure. Our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On country allocation, we remain underweight the US, neutral Canada and Australia, and overweight the UK, core Europe, Italy, Spain and Japan. The country allocations are determined by each country’s sensitivity to changes in US Treasury yields, particularly during periods of rising yields. We are overweight the countries with a lower “yield beta” to changes in US yields. We view Italy and Spain as credit instruments, supported by large-scale ECB purchases and more fiscal cooperation within Europe. We are not recommending underweights to higher-beta Canada and Australia, however, with both the BoC and RBA being very aggressive with bond purchases (Chart 8). On credit, the backdrop remains very conducive to spread product outperformance versus government bonds, particularly with the monetary policy backdrop remaining highly accommodative (Chart 9). Chart 8Global QE Has Been Aggressive Global QE Has Been Aggressive Global QE Has Been Aggressive We expect some additional spread tightening for developed market corporate debt as well also emerging market US dollar denominated corporates. In terms of regions and credit tiers, we prefer US investment grade and Ba-rated high-yield to euro area credit. Chart 9Central Bank Liquidity Still Supportive For Global Credit Central Bank Liquidity Still Supportive For Global Credit Central Bank Liquidity Still Supportive For Global Credit Chart 10More Global QE Is Good For Inflation-Linked Bonds More Global QE Is Good For Inflation-Linked Bonds More Global QE Is Good For Inflation-Linked Bonds Finally, we continue to recommend overweight allocations to inflation-linked bods versus nominal government debt in the US, Italy and Canada. Central banks will continue to err on the side of maintaining stimulative monetary policy settings to keep financial conditions easy to support economic growth. That means no hawkish surprises on the interest rate front, while also continuing to buy bonds via quantitative easing (Chart 10) – reflationary policies that should help boost inflation expectations.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have deliberately left Japan out of this analysis, as the Bank of Japan’s Yield Curve Control policy has effectively short-circuited the link between Japanese economic growth, inflation and bond yields. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Vaccine For Uncertainty A Vaccine For Uncertainty Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Bond Yields Have Upside In A Blue Sweep Bond Yields Have Upside In A Blue Sweep Bond Yields Have Upside In A Blue Sweep Today’s US election has important implications for the near-term path of bond yields. In particular, a “blue sweep” outcome where the Democrats win control of the House, Senate and White House will probably cause yields to jump (Chart 1), as such an outcome virtually guarantees a large fiscal relief package early next year. Fiscal negotiations will be more contentious if the Republicans maintain control of the Senate, and yields could decline this evening if that occurs. However, no matter the election outcome, our 6-12 month below-benchmark portfolio duration recommendation will not change tomorrow. The economic recovery appears to be on track and some further fiscal stimulus is likely next year no matter who prevails tonight. The stimulus will just be smaller if a divided government necessitates compromise. In any case, bond investors should keep portfolio duration below-benchmark and stay overweight TIPS versus nominal Treasuries. They should also maintain positions in nominal and real yield curve steepeners and inflation curve flatteners. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 99 basis points in October, bringing year-to-date excess returns up to -300 bps. Corporate bonds are certainly not as cheap as they were back in March, but we still see acceptable value in the sector. The corporate index’s 12-month breakeven spread is at its 20th percentile since 1995 and the equivalent Baa spread is at its 28th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further tightening. Corporate bond issuance increased in September, though it remains well below the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have enough cash to cover their investment needs (bottom panel). This will keep issuance low in the coming months. At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,1  Healthcare and Energy bonds.2  We also advise underweight allocations to Technology3 and Pharmaceutical bonds.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Big Night For The Bond Market A Big Night For The Bond Market Table 3BCorporate Sector Risk Vs. Reward* A Big Night For The Bond Market A Big Night For The Bond Market High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 86 basis points in October, bringing year-to-date excess returns up to -373 bps. Ba-rated bonds outperformed lower-rated credits in October, and they remain the best performing corporate credit tier since the March 23 peak in spreads (See Appendix A). In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate cannot be ruled out completely, but it would necessitate a rapid pace of economic recovery. We are not yet confident enough in the recovery to position for such a fast drop-off in defaults, especially with Job Cut Announcements still well above pre-COVID levels (bottom panel). We therefore continue to recommend an overweight allocation to the Ba-rated credit tier – where access to the Fed’s emergency lending facilities is broadly available – and an underweight allocation to bonds rated B and below. At the sector level, we advise overweight allocations to high-yield Technology5 and Energy bonds.6 We are underweight the Healthcare and Pharmaceutical sectors.7   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to -39 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 11 bps on the month to land at 72 bps. This is now slightly below the 76 basis point spread offered by Aa-rated corporate bonds but well above the 62 bps offered by Agency CMBS and the 29 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we remain concerned that the elevated primary mortgage spread is a warning that refinancing risk is greater than what is currently being priced in the market (Chart 4). Yes, the mortgage spread has tightened during the past few months, but it remains 35 bps above its average 2019 level. This suggests that the mortgage rate could fall another 35 bps due to spread compression alone, even if Treasury yields are unchanged. Such a move would lead to a significant increase in prepayment losses. 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. 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 30 basis points in October, bringing year-to-date excess returns up to -284 bps. Sovereign debt outperformed duration-equivalent Treasuries by 151 bps on the month, bringing year-to-date excess returns up to -420 bps. Foreign Agencies outperformed the Treasury benchmark by 18 bps in October, bringing year-to-date excess returns up to -690 bps. Local Authority debt underperformed Treasuries by 21 bps in October, dragging year-to-date excess returns down to -362 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to -33 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -7 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, this year’s dollar weakness has been relative to other Developed Market currencies. In recent months, the dollar has actually strengthened versus EM currencies (Chart 5). Value also remains poor for EM Sovereigns, which continue to offer a lower spread than Baa-rated corporate debt (panel 4). We looked at EM Sovereign valuation on a country-by-country basis in a recent report.8 We concluded that Mexican and Russian bonds offer the most compelling risk/reward trade-offs relative to the US corporate sector. Of those two countries, Mexican debt offers the best opportunity as US politics remain a concern for the Russian currency. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 41 basis points in October, bringing year-to-date excess returns up to -464 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened in October, but value remains exceptional with most maturities trading at a positive before-tax spread. As we showed in a recent report, municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum.9 On a duration-matched basis, the Bloomberg Barclays General Obligation and Revenue Bond indexes trade at before-tax premiums relative to corporate bonds of the same credit rating, an extremely rare occurrence (Chart 6). 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. If the Democrats win the House, Senate and White House this evening – a fairly likely scenario – federal aid for state & local governments will be delivered in January. This would alleviate a lot of 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. 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 October, largely due to rising expectations of a “blue sweep” election outcome. The 2/10 and 5/30 Treasury slopes steepened 18 bps and 9 bps, respectively, to reach 74 bps and 127 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. More bear steepening is likely if the Democrats win the House, Senate and White House tonight, as this would mean that a large amount of fiscal stimulus is coming early next year. But we will stick with our curve steepening recommendation regardless of the election outcome. No matter who wins the election, some further fiscal stimulus is likely on a 6-12 month horizon. 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 valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 38 basis points in October, bringing year-to-date excess returns up to -93 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 7 bps and 5 bps on the month. They currently sit at 1.71% and 1.82%, respectively. Core CPI rose 0.19% in September and the year-over-year rate held steady at 1.73%. The 12-month trimmed mean CPI ticked down from 2.48% to 2.37%, so the gap between core and trimmed mean continued to narrow (Chart 8). We anticipate 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 no longer cheap according to our Adaptive Expectations Model (panel 2).10 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). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +72 bps. Aaa-rated ABS outperformed the Treasury benchmark by 6 bps on the month, bringing year-to-date excess returns up to +59 bps. Non-Aaa ABS outperformed by 29 bps, bringing year-to-date excess returns up to +157 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.11  We noted that stimulus received from the CARES act caused disposable income to increase significantly since February. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers 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. 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 9 basis points in October, bringing year-to-date excess returns up to -250 bps. Aaa Non-Agency CMBS underperformed Treasuries by 10 bps on the month, dragging year-to-date excess returns down to -73 bps. Non-Aaa Non-Agency CMBS outperformed by 72 bps, bringing year-to-date excess returns up to -738 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate (CRE) continues. Without Fed support, non-Aaa CMBS will struggle to deal with tightening CRE lending standards and falling demand (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 29 basis points in October, bringing year-to-date excess returns up to +17 bps. The average index spread tightened 6 bps on the month. It currently sits at 62 bps, well above typical historical levels (bottom panel). At its last meeting, the Fed decided to slow its pace of Agency CMBS purchases. It will no longer seek to increase its Agency CMBS holdings, but will instead purchase only 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. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities A Big Night For The Bond Market A Big Night For The Bond Market 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 October 30TH, 2020) A Big Night For The Bond Market A Big Night For The Bond Market 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 October 30TH, 2020) A Big Night For The Bond Market A Big Night For The Bond Market 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 63 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 63 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) A Big Night For The Bond Market A Big Night For The Bond Market 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 October 30TH, 2020) A Big Night For The Bond Market A Big Night For The Bond Market   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 9 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 10 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 11 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Your feedback is important to us. Please take our client survey today. Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals November 2020 November 2020 According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).6 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus November 2020 November 2020 According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift 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

Your feedback is important to us. Please take our client survey today. Highlights Duration: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Monetary Policy: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Economy: Weekly claims data are consistent with a continued decline in the unemployment rate, due mostly to fewer temporarily unemployed workers. All in all, the US economy is recovering, but it remains very far from full employment. Feature Chart 1Real Yields Have Troughed Real Yields Have Troughed Real Yields Have Troughed After having advocated “at benchmark” portfolio duration since March, we officially lowered our recommended duration stance to “below benchmark” in last week’s Special Report.1 Two main catalysts led us to this decision. First, there was the Fed’s late-August adoption of an Average Inflation Target. This was an important bond-bearish catalyst because it signaled that the Fed’s reaction function has reached its maximum dovishness. Treasury yields stayed low throughout the summer even as the economy recovered because the Fed was simultaneously guiding the market toward a more dovish reaction function. As evidence for this dynamic, notice that between March and August the uptrend in the cost of inflation compensation was completely offset by falling real yields (Chart 1). But now, the Fed has officially adopted its new Average Inflation Targeting framework. In addition, it has promised not to lift rates at all until inflation is above its 2% target and is expected to overshoot that target for some time. To get more dovish from here, the Fed would probably need to actually increase its long-run inflation target from 2% to 3%, a step it is not prepared to take. For this reason, we expect that the Fed has exhausted its ability to push real yields lower as the economy recovers. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. Such a shock would cause investors to anticipate a slower return of inflation and thus push bond yields down, even if the market’s assessment of the Fed’s willingness to respond to inflationary pressures (aka its reaction function) remains constant. The failure of Congress to deliver additional fiscal stimulus after the expiry of the CARES act’s main income-supporting provisions is the sort of thing that could cause such a shock. However, September’s market action made it clear that investors are willing to look past the failure to deliver a bill if they can look forward to a larger fiscal stimulus in January. As we wrote last week, the most likely election outcome of the Democrats winning the House, Senate and White House would certainly deliver on that promise. Bottom Line: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Will  The Fed Use Its Balance Sheet To Keep Bond Yields Low? Chart 2Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time One possible counterargument to our bond-bearish view is that, even if the Fed’s interest rate guidance is as dovish as it will get, the central bank will simply ramp up asset purchases to prevent any significant rise in long-maturity bond yields. Certainly, the Fed has not shied away from transacting in the Treasury market this year (Chart 2). In fact, the Fed took down more than 100% of gross note and bond issuance in the second quarter (Chart 3) and its current stated policy is to purchase at least $80 billion of Treasury securities per month. At present, the Fed holds more than 35% of all outstanding Treasuries with more than 10 years to maturity and about one quarter of the outstanding supply for all other maturities (Chart 4). This is a significant presence in the Treasury market, but not so large that the Fed would think twice about increasing its pace of Treasury purchases if such a policy was deemed necessary. But what would actually make the Fed increase its pace of asset purchases? Would a modest bear-steepening of the Treasury curve (our base case outlook) be enough? We doubt it. Chart 3Fed Purchases Peaked In Q2 Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 4Fed Owns A Good Chunk ##br##Of The Market Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 5Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative The Fed would be concerned if broad measures of financial conditions started to tighten, as that would indicate a looming period of slower economic growth. But that’s very different from long-maturity Treasury yields moving somewhat higher in response to an improving economic outlook. In fact, to get a meaningful tightening in broad measures of financial conditions, we would need to see significant credit spread widening and weaker equity prices (Chart 5). A bear-steepening Treasury curve, even if long-dated yields move 40-50 bps higher, will not prompt a selloff in credit markets or equities as long as the market believes that the Fed is committed to maintaining an accommodative monetary policy stance. Bottom Line: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Can  The Fed Use It’s Balance Sheet To Keep Bond Yields Low? Chart 6Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Of course, in the extreme, the Fed could decide to set a cap on the 10-year Treasury yield and promise to purchase as many securities as necessary to maintain that cap. This sort of Yield Curve Control would effectively prevent long-maturity Treasury yields from rising, even as the economy recovered. As discussed above, we think the economic situation would have to turn quite dire for the Fed to pursue such a policy. A more relevant question is whether, in the absence of a stated yield cap, the Fed’s current pace of $80 billion of Treasury purchases per month (or even $100 billion per month) will prevent Treasury yields from rising. Our sense is that, without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. In fact, we see very little evidence to support the notion that changes in Fed Treasury purchases influence the trend in bond yields, beyond what the purchase announcements signal to markets about the Fed’s intentions with regards to interest rate policy. Consider Chart 6, which shows the 10-year Treasury yield alongside the Global Manufacturing PMI and two different measures of Fed Treasury purchases. At first blush, between 2010 and 2012, there is a fairly strong relationship between a falling 10-year Treasury yield and an increase in Fed Treasury holdings greater than five years. However, the correlation between the 10-year Treasury yield and the Global Manufacturing PMI during this period is even stronger. This suggests an alternative explanation where the decline in bond yields is driven by the market shifting its rate hike expectations out into the future in response to slowing economic growth. Greater Fed purchases only served to reinforce the Fed’s increasingly dovish interest rate guidance during this time. Without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. The key point from Chart 6 is that it is difficult to identify periods when the Fed’s balance sheet policy and interest rate guidance suggest opposite outcomes for bond yields. Typically, when the Fed is ramping up asset purchases it is also signaling to the market that it will shift toward a more dovish interest rate policy. Similarly, when the Fed is reducing its asset purchases, it tends to also be preparing the market for eventual rate hikes. This makes it impossible to say conclusively whether a given move in bond yields is driven by interest rate guidance or balance sheet actions. In our minds, this casts a lot of doubt on the notion that the Fed could maintain its current interest rate guidance during the next 6-12 months while also preventing a rise in Treasury yields by increasing asset purchases. The policy of increasing asset purchases would appear incoherent if it wasn’t also paired with increasingly dovish forward rate guidance, guidance that the Fed is likely unwilling to deliver. Bottom Line: Even if the Fed modestly increases its monthly pace of Treasury purchases, or shifts some purchases further out the curve as some FOMC participants have suggested, the impact on long-dated Treasury yields will be negligible without a concurrent shift in interest rate guidance. The Hedging Effectiveness of Treasuries Is Diminished, But Not Gone Completely One topic that has come up a lot recently in our client interactions is the idea that Treasury securities are no longer an effective hedge for equity portfolios. There are two possible reasons why this could be true. The first is that with Treasury yields so close to the zero-lower-bound there is very little scope for capital appreciation in bonds. The second is that Treasury yields may not respond to falling equity prices by declining, as they have in the past. We don’t currently see much evidence for the second reason. The only way that bond yields wouldn’t decline alongside a major equity sell-off is if that sell-off was driven by high and rising inflation and expectations that the Fed would aggressively hike rates to combat higher prices. Inflation is nowhere near high enough for this to be a concern. The first reason, however, could hold some water. To test it, we first looked at this year’s COVID-driven 34% drop in the S&P 500 that occurred between February 19th and March 23rd (Table 1). If an investor purchased a 5-year Treasury note on February 19th and sold it on March 23rd, they would have earned 5.21% on that trade, offsetting some portion of the equity decline. The same trade in a 30-year T-bond would have earned 16.65%. Long-maturity Treasuries still perform their role as hedging instruments for equity portfolios. But with starting bond yields much lower today, Treasuries may not offer the same protection. Table 2 shows how much an investor would earn if they bought a Treasury security today, held it for six months, and during that timeframe the entire spot yield curve fell to zero. We also show what returns would be earned if the yield curve shifted in the same way it did during the Feb 19th – Mar 23rd equity selloff, except we don’t let any yields fall into negative territory.2 Table 1Total Returns From Stock Market Peak (Feb. 19th) To Stock Market Through (Mar. 23rd) Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Table 2Treasury Total Returns Over A Hypothetical 6-Month Period Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Notice that projected returns for shorter maturities in Table 2 are significantly lower than the returns earned during the Feb 19th – Mar 23rd episode. A 5-year Treasury note will earn only 1.90% during the next six months if the entire yield curve falls to zero, this is well below the 5.21% earned in February and March. However, for maturities beyond 10 years, returns are similar between Table 1 and Table 2. This makes sense because, unlike the short-end, those long-dated yields are still fairly far from the zero bound. Bottom Line: Treasuries still perform their role as hedging instruments for equity portfolios, but investors now have to move further out the curve, and thus take more interest rate risk, to get the same protection they received from less-risky shorter-maturity notes in the past. US Economy: Digging Into Claims Chart 7Labor Market Update Labor Market Update Labor Market Update Initial unemployment claims spooked some investors when the weekly number jumped to +898k two weeks ago, even as the consensus was calling for a small decline.3 But that spike was completely reversed last week, and a good chunk of it was actually revised out of the data. A delay in California’s reporting was one reason for the big swing. The state had failed to report claims data for two consecutive weeks at the beginning of the month. This meant that the national claims number was based on an assumed figure for the state. California resumed reporting last week and the result was a big drop in overall claims, back down to +787k. Stepping back from the large swings of the past two weeks, a good portion of which are statistical artifacts stemming from California’s reporting delay, we see that overall employment trends haven’t changed much. Initial claims have flattened-off since late-August, but continuing claims are still falling rapidly (Chart 7). This suggests that the unemployment rate will drop again next week when October’s employment report is released. The big question in next week’s employment report will be whether the decline in the unemployment rate is once again driven by falling temporary unemployment, or whether the number of permanently unemployed workers will reverse its uptrend (Chart 7, bottom panel). All in all, the labor market data continue to paint a picture of an economy that is recovering but that still has a very large output gap. In other words, the economy is a long way from generating meaningful inflationary pressure. 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 3Performance Since March 23 Announcement Of Emergency Fed Facilities Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Blank cells in Table 2 mean that returns are the same as in the “Spot Curve Falls To 0%” scenario. 3 Please see BCA Daily Insights, “Slowing US Labor Market Momentum: Investors Should Not Have Been Surprised”, dated October 15, 2020, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Duration: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Country Allocation: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. Treasury-Bund Spread: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures. Feature In a Special Report jointly published last week with our colleagues at BCA Research US Bond Strategy, we laid out the case for why US Treasury yields have bottomed and should now begin to drift higher.1 We reached that conclusion for two reasons: 1) there will be a major US fiscal stimulus after the upcoming US election, especially so if Joe Biden becomes president and the Democrats take the Senate; and 2) the Fed’s shift to Average Inflation Targeting in late August represented the point of maximum Fed dovishness. The investment conclusions were to reduce duration exposure, while also downgrading our recommended allocation to US government bonds to underweight. We also advised cutting exposure to non-US government bond markets with relatively higher sensitivity to changes in US bond yields, while increasing allocations to countries with a lower “yield beta” to US Treasuries (Table 1). Table 1Updated GFIS Model Bond Portfolio Recommended Positioning The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields In this follow-up report, we will further discuss the implications of our changed view on US yields for non-US developed market government bonds. This includes specific adjustments to the recommended country allocations in our model bond portfolio, as well as a new tactical trade to profit from a move higher in US yields that will not to be matched in Europe. Our Recommended Overall Duration Stance: Now Below-Benchmark The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound at very low levels across the developed economies. Our Global Duration Indicator, comprised of economic sentiment measures and leading economic indicators, bottomed back in March and has soared sharply since then (Chart of the Week). Given the usual lead time between peaks and troughs of the Indicator and global bond yields - around nine months, on average – that suggests yields should bottom out sometime before year-end. Chart of the WeekA Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields Chart 2UST Yields About To Break Out? UST Yields About To Break Out? UST Yields About To Break Out? In the US, we now think we are past that point, as we discussed last week. The 10-year US Treasury yield has been drifting higher during the month of October and is now bumping up against its 200-day moving average of 0.83% (Chart 2). This is only the first such attempt at a trend breakout in yields, and such a move is unlikely prior to US Election Day - or, more accurately, “US Election Is Decided Day” which may not be November 3! The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound. Outside the US, however, momentum of bond yields and potential trend breakouts paint a more mixed picture. German and French bond yields remain stable and generally trendless, with Italian and Spanish yields continuing to grind lower. At the same time, yields in the UK, Canada and Australia have started to perk up but remain just below their 200-day moving averages. Bond yields have not responded to the sharp cyclical rebound across the developed world, with large gaps between elevated manufacturing PMIs and stagnant bond yields (Chart 3). Low inflation, ample spare economic capacity and dovish monetary policies are all playing a role, with bond markets not expecting an imminent inflation surge that could drive up yields and fuel expectations of tighter monetary policy. By way of contrast, China - where domestic services sectors have improved at a rapid pace from the COVID-19 recession and where the central bank is not running an overly accommodative monetary policy – has seen a more typical positive correlation between government bond yields and the rising manufacturing PMI over the past several months (Chart 4). This suggests that developed market bond yields can begin to normalize if the domestic services side of those economies emerges more forcefully from the lockdown-induced downturn. Chart 3A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields Chart 4Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? The news on that front is more optimistic in the US compared in Europe. The Markit services PMIs for the euro area and UK have all weakened over the past few months, with headline inflation rates flirting with deflation (Chart 5). Similar data in the US has trended in the opposite direction, with stronger US services activity with rising inflation. Chart 5Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US The pickup in new COVID-19 cases, and the degree of the response by governments to contain it, has been far stronger in Europe and the UK than in the US on a population-adjusted basis (Chart 6). Lockdowns have become more widespread across Europe to contain the second larger wave of the virus. The recent softer services PMI data in the euro area and UK are a reflection of those greater economic restrictions and weaker confidence. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates.  In the US, governments have been far less willing to implement politically unpopular restrictions in an election year, while lockdown-weary consumers have been more willing to go about their lives rather than stay sheltered at home. The result is a healthier tone to the US data compared to other countries, even with the number of new US cases on the rise again. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates. As we discussed in last week’s Special Report, both the Biden and Trump platforms are calling for major fiscal stimulus – between $5-6 trillion over the next decade, including tax changes – although the Biden plan has much more front-loaded direct government spending, only partially offset by tax increases, if fully implemented. This is the “Blue Sweep” scenario, with a Biden victory and Democratic Party control of the US Congress, that is most bearish for US Treasuries, as the outcome would eventually help reduce the expected 2021 US fiscal drag of -7.2% of GDP as estimated by the latest IMF Fiscal Monitor (Chart 7). Even a re-elected Trump, however, would also mean more US fiscal stimulus, although with a mix of tax cuts and spending increases. Chart 6The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder Combined with an improving services sector and rising inflation, this puts the US in a much different economic position than the major economies of Europe. Chart 7Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag There, the IMF is also projecting some fiscal drag in 2021, but now with a much less healthy domestic economy due to the COVID-19 surge and where inflation is already near 0%. Our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. There will likely be another round of fiscal measures to help combat virus-stricken economies in Europe and elsewhere, but the US election is bringing the issue to the forefront more quickly. In other words, the US will get a more bond-bearish fiscal stimulus before Europe does. Bottom Line: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Our Recommended Country Allocation: Downgrade US, Upgrade Lower-Beta Countries Net-net, our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. This also has implications for our recommend country allocation in our model bond portfolio. First, are downgrading our recommended US Treasury allocation to underweight. We are also increasing our desired weighting in countries where government bond yields are less sensitive to changes in US Treasury yields – especially during periods when the latter are rising. We call this “upside yield beta”. The countries that have the highest such beta to US Treasuries are Canada, Australia and New Zealand, making them downgrade candidates (Chart 8). Similarly, lower upside beta countries like Germany, France, Japan and the UK are upgrade possibilities. Chart 8Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Already, we are seeing the widening of yield spreads between US Treasuries and non-US government markets – with more to come as US Treasuries grind higher over the next 6-12 months. We see the greatest upside for spreads between the US and the low upside yield beta countries – that means wider spreads for US-Germany, US-France, US-Japan and US-UK (Chart 9). Chart 9Expect More Underperformance From USTs Expect More Underperformance From USTs Expect More Underperformance From USTs Chart 10Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Thus, this week are making significant changes to our strategic government bond country allocations (see page 15), as well as the country weightings in our model bond portfolio (see pages 13-14), based on our new view on US bond yields and non-US yield betas. Specifically, we are not only cutting our recommended US weighting to underweight, but we are also downgrading Canada and Australia from overweight to neutral. On the other side, we are upgrading UK Gilts to overweight from neutral, while also upgrading Germany, France and Japan to overweight. Importantly, we are maintaining our overweight stance on Italian and Spanish sovereign debt, as those markets are supported by greater European fiscal policy integration in the world of COVID-19 and, just as importantly, large-scale ECB asset purchases. More generally, the relative “aggressiveness” of central bank quantitative easing (QE) does play a role in our recommended country allocation. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. This means less expected QE buying of Treasuries by the Fed. Conversely, given how aggressive the Reserve Bank of Australia and Bank of Canada have been with expanding their balance sheet via QE (Chart 10), this makes us reluctant to shift to the underweight stance on those countries implied by their high beta to rising US Treasury yields. Therefore, we are only downgrading those two countries to neutral. Bottom Line: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. A New Tactical Trade: A UST-Bund Spread Widener Using Futures This week, we are also introducing a new recommended trade in our Tactical Overlay portfolio on page 16 to take advantage of our view on US bond yields: a 10-year US-Germany spread widening trade using government bond futures. Chart 11A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread This trade makes sense for several reasons: Germany has one of the lowest yield betas to US Treasuries during periods when the latter is rising, as shown earlier. Our US Treasury-German Bund fundamental fair value spread model – which uses relative policy interest rates, unemployment and inflation between the US and the euro area as inputs - suggests that the spread is now far too tight after the massive rally in US Treasuries in 2020 (Chart 11). The main reason why the spread looks so “expensive” is that the underlying fair value has risen with US inflation rising and euro area inflation falling (Chart 12, bottom panel). The UST-Bund yield differential is not stretched from a technical perspective, when looking at deviations of the spread from its 200-day moving average or the 26-week change in the spread; both measures suggest room for additional spread widening before reaching historical extremes (Chart 13). Also, duration positioning by US fixed income investors is only around neutral, according to the JP Morgan duration survey, suggesting scope to push yields higher if bond investors become more defensive. Chart 12Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Chart 13Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread As a reference, we are initiating this trade with the cash bond 10-year US-Germany spread at +138bps, with a target range of +170-190bps over the 0-6 month horizon we maintain for our Tactical Overlay positions. Bottom Line: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift 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

Highlights Does it still make sense to use historical yield betas for fixed income country allocation? Yes, favoring countries with higher government bond yield betas when global yields are falling, and vice versa, is still an appropriate way to manage fixed income risk – although betas do vary between global bond bull and bear markets. Can inflation breakevens and real yields continue moving in opposite directions? Yes, but that negative correlation will become less intense, especially in the US, with rising inflation expectations eventually becoming the more dominant influence on nominal bond yields. Will inflation breakevens continue to have a strong positive correlation with oil prices? Yes, but only for as long as non-energy inflation remains low and stable, which has made energy prices the only source of inflation variability in most developed countries. Feature Sleepy bond markets got a bit of a jolt over the past couple of weeks, with longer-maturity government bond yields moving higher across the developed markets, led by the US where the 30-year Treasury yield is now back to levels last seen in June. The move higher in US Treasury yields may be a sign that investors are taking the US election polling numbers – which now signal not only a Joe Biden victory on November 3, but also a swing of the US Senate to Democratic Party control – seriously. A so-called “Blue Sweep”, resulting in the full implementation of the Biden policy platform including a massive fiscal stimulus, is potentially bond bearish, and not only for US Treasuries, given the close correlation of US yields to other bond markets. There is a strong correlation between the level of bond yields, and the yield beta, for the major developed market countries. This brief burst of global bond market volatility, stemming from developments in the US, is a reminder that investors should always be aware of the importance of cross-market correlations when making trading and portfolio construction decisions. With that in mind, this week we ask some important questions about the critical correlations across global government bond markets that support our current investment recommendations – and under what conditions they could possibly change. Does It Still Make Sense To Use Historical Yield Betas For Fixed Income Country Allocation? Chart 1Developed Bond Yields Relative To The 'Global' Bond Yield Developed Bond Yields Relative To The 'Global' Bond Yield Developed Bond Yields Relative To The 'Global' Bond Yield One of the key elements underlying our bond country allocation recommendations is the concept of “yield beta”. Simply put, this is a measure of the sensitivity of changes in individual country bond yields to changes in the overall level of global bond yields. The way we measure yield betas is by using a regression (over a three-year rolling window) of monthly changes for an individual country’s 10-year bond yield on the monthly change of the Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket (as the proxy for the “global” 10-year yield). The regression coefficient on the individual country yield change is the yield beta. There is a strong correlation between the level of bond yields, and the yield beta, for the major developed market countries. Currently, the list of “high-yielders” – with 10-year government bond yields above the benchmark index yield – includes the US, Italy, Canada, Australia and New Zealand (Chart 1). The low-yielders, with 10-year yields below the benchmark index yield, are Germany, France, Spain, the UK and Japan. When we look at the yield betas for that same list of countries, we can also break up the list into high-beta and low-beta bond markets. When we rank the ten countries by their rolling three-year yield betas, the five highest betas belong to the same five countries with the highest yields, and vice versa (Chart 2). This is an intuitive correlation, as countries with higher yield betas are, by definition, more volatile and should require higher yields from investors to compensate for that additional volatility. Chart 2The Higher-Yielding Countries Also Have Higher Yield Betas The Higher-Yielding Countries Also Have Higher Yield Betas The Higher-Yielding Countries Also Have Higher Yield Betas The yield betas are not stable over time for all countries, however. The US has consistently remained the highest beta market, and Japan the lowest beta market, over the past twenty years. Other countries have seen their yield betas evolve over time. For example, France, Spain and, more recently, the UK have seen their yield betas decline in recent years, while Italy has gone from being low-beta to one of the higher-beta markets. In our view, the evolution of yield betas relates to the “activism” of policymakers in each country. Higher-beta, higher-yield countries also have central banks that move interest rates higher and lower with more frequency compared to the low-beta, low-yield countries. In our view, the evolution of yield betas relates to the “activism” of policymakers in each country. That high-beta group includes bond markets linked to the Federal Reserve, the Bank of Canada, the Reserve Bank of Australia and the Reserve Bank of New Zealand – all central banks that are not shy about aggressively cutting or hiking interest rates. The low-beta markets have central banks that move rates very infrequently, like the European Central Bank and the Bank of Japan. Table 1Yield Betas For The Major Developed Markets Some Important Questions Regarding Bond Yield Correlations Some Important Questions Regarding Bond Yield Correlations One other interesting point on yield betas is that they do vary depending on the overall direction of global bond yields. As a way to show this, we estimated “upside” and “downside” yield betas for the same ten countries shown earlier. Those betas were calculated by sorting the monthly yield changes for all countries by months when the benchmark global bond index yield was rising or falling. Thus, upside yield beta comes from a regression of monthly yield changes for individual countries on changes in overall global bond yields, but only using data for months when global yields increased. The opposite is true for downside beta, where only data from months when the global benchmark index yield declined are used. The individual yield betas – for the overall sample and the upside and downside groupings – are presented in Table 1. One conclusion that comes from breaking up the data this way is that countries that were in the low-beta group when looking at the full set of data have relatively high yield betas during periods of rising global yields, like France and the UK (Chart 3). In addition, when looking at downside betas, US Treasuries have the highest beta, by far, when global yields are falling – with yields for euro area countries having relatively lower betas (Chart 4). Chart 3Yield Betas During Periods Of Rising Global Yields Yield Betas During Periods Of Rising Global Yields Yield Betas During Periods Of Rising Global Yields Chart 4Yield Betas During Periods Of Falling Global Yields Yield Betas During Periods Of Falling Global Yields Yield Betas During Periods Of Falling Global Yields Our conclusion from this analysis is that yield betas do have a useful role in making country allocation decisions for global fixed income investors. Specifically, adjusting allocations based on a view on the overall direction of global bond yields should help better manage portfolio risk and, potentially, improve returns. Chart 5Italy Has Become High-Beta As Spreads Have Narrowed Italy Has Become High-Beta As Spreads Have Narrowed Italy Has Become High-Beta As Spreads Have Narrowed A final point on Italy – the reason Italy has had such a high yield beta over the past few years is because Italian government bond yields have been driven more by the reduction of Italian sovereign credit risk – including the redenomination risk from a potential Italian exit from the euro (Chart 5). As Italian credit spreads have melted away from the levels reached during the 2011/12 European Debt Crisis, yields have fallen faster than others during periods of falling global yields, and vice versa. Looking ahead, with the ECB continuing to be an aggressive buyer of Italian bonds in its various asset purchase programs, and with the COVID-19 pandemic forcing the European Union into a deeper level of economic co-operation – which now includes grants to Italy – the sovereign risk premium on Italian government debt should continue to narrow. That means Italy will continue to trade as a high-beta market when global yields are falling, and a low-beta market when yields are rising, making Italy an ideal overweight candidate in global bond portfolios. Bottom Line: Favoring countries with higher government bond yield betas when global yields are falling, and vice versa, is still an appropriate way to manage fixed income risk – although betas do vary between global bond bull and bear markets. Can Inflation Breakevens And Real Yields Continue Moving In Opposite Directions? The behavior of real bond yields over the past few months garnered a lot of attention in 2020, particularly the sharp fall in US TIPS yields into deeply negative territory. This has occurred at the same time as a widening of inflation breakevens, which exhibited a deeply negative correlation with real yields. The result: narrow trading ranges for nominal government bond yields in most developed countries, with moves in real yields and inflation breakevens largely offsetting each other. Adjusting allocations based on a view on the overall direction of global bond yields should help better manage portfolio risk and, potentially, improve returns. Looking at the history of real yields and inflation breakevens, periods of a negative correlation between the two are not unusual. In Chart 6, we show the range of historic correlations between 10-year inflation-linked bond yields, and 10-year inflation breakevens, for the US, UK, Germany, France, Italy, Australia, Canada and Japan since 2010. The dark bars represent the range of rolling correlations over a three-year period, while the red diamonds are a more recent correlation over the past thirteen weeks. All countries shown have seen periods of negative correlation, with only Australia and France having the most recent correlation be far lower than the historic experience. Chart 6Negative Real Yield/Breakevens Correlations Are Not Unprecedented Some Important Questions Regarding Bond Yield Correlations Some Important Questions Regarding Bond Yield Correlations So if a negative real yield/inflation breakeven correlation is not that unusual, then what is the cause of it? We see two drivers: the amount of spare capacity in an economy and the central bank policy response to it. We can see this by looking at the data from the countries with the two largest inflation-linked bond markets, the US and UK. In the US, real TIPS yields and inflation breakevens have generally been positively correlated only during Fed tightening cycles, specifically after the Fed has raised the fed funds rate above the rate of realized core inflation (Chart 7). This was the case in the tightening cycles of the mid-2000s and 2016-18. During those episodes, the Fed pushed the real funds rate steadily higher, which also had the effect of pushing real TIPS bond yields higher, even as inflation expectations were stable-to-rising. Looking at the history of real yields and inflation breakevens, periods of a negative correlation between the two are not unusual. The opposite held true during Fed easing cycles since the advent of the TIPS market in the late 1990s, when the Fed always lowered the funds rate below realized inflation. The result was a period of a falling real funds rate, leading to lower real TIPS yields and eventually triggering an increase in inflation breakevens. In other words, the correlation between breakevens and real yields became negative. In the UK, the negative correlation between real index-linked Gilt yields and inflation breakevens has been consistently negative since the 2008 financial crisis (Chart 8). The Bank of England has barely moved policy rates since that crisis, while keeping nominal policy rates below 1% - a level that was consistently below core UK inflation. Thus, the Bank of England has maintained negative real policy rates for the past twelve years, with real Gilt yields declining steadily and inflation breakevens rising – a negative correlation - over that period. Chart 7Fed Policy Influences The US Real Yield/Breakevens Correlation Fed Policy Influences The US Real Yield/Breakevens Correlation Fed Policy Influences The US Real Yield/Breakevens Correlation Chart 8A Persistently Negative Correlation Of UK Real Yields & Breakevens A Persistently Negative Correlation Of UK Real Yields & Breakevens A Persistently Negative Correlation Of UK Real Yields & Breakevens   For both the US (Chart 9) and UK (Chart 10), the rolling 3-year correlation between real yields and breakevens has itself been correlated to the unemployment gap, or the difference between the unemployment rate and the full-employment NAIRU rate, over the past two decades. This suggests that the ebbs and flows of labor market slack, and how the Fed and Bank of England have responded to them by easing or tightening monetary policy, also play a role in determining the real yield/breakevens correlation. Chart 9Real Yield/Breakevens Correlation Will Stay Negative In The US Real Yield/Breakevens Correlation Will Stay Negative In The US Real Yield/Breakevens Correlation Will Stay Negative In The US Chart 10Real Yield/Breakevens Correlation Will Stay Negative In The UK Real Yield/Breakevens Correlation Will Stay Negative In The UK Real Yield/Breakevens Correlation Will Stay Negative In The UK   In the case of the US, a more extended UK-like period of negative real policy rates and real bond yields is likely if the Fed is to be taken at their word that they will keep rates low to engineer a US inflation overshoot. We suspect that the correlation will not be perfectly negative, as has occurred at times this year, with inflation expectations rising alongside stable-to-falling real TIPS yields as the US economy recovers from the COVID-19 shock – especially if there is a major boost from fiscal stimulus after next month’s elections. Bottom Line: We continue to see a case for inflation breakevens and real yields to stay negatively correlated in the developed economies over at least the next few years, as the labor market slack created by the 2020 COVID-19 global recession is slowly absorbed. That negative correlation will become less intense, especially in the US, with rising inflation expectations eventually becoming the more dominant influence on nominal bond yields. Will Inflation Breakevens Continue To Have A Strong Positive Correlation With Oil Prices? While the negative correlation between real inflation-linked bond yields and real yields has gotten attention this year, the positive correlation between breakevens and oil prices has become familiar to investors over the past several years. That correlation has been persistently high and positive across all developed economies since the 2008 financial crisis. Prior to that, oil prices and inflation breakevens moved together less frequently and, at times, were even uncorrelated (Chart 11). In both the US and euro area, the lack of non-energy inflation is the main reason why breakevens and oil are so correlated. In our view, the reason why breakevens and oil became strongly correlated is relatively straightforward. Since the 2008 crisis and ensuing Great Recession, swings in oil prices have been the main driver of changes in realized inflation, with ex-energy inflation rates staying very low and stable. We can see that in the US, where ex-energy CPI inflation has been broadly stable around 2% for the past decade, even as headline CPI inflation has seen more variability and has even approached 0% after the collapse in oil prices in 2014/15 and 2020 (Chart 12). Chart 11A Persistent Strong Correlation Of Global Breakevens To Oil Real Yield/Breakevens Correlation Will Stay Negative In The UK Real Yield/Breakevens Correlation Will Stay Negative In The UK Chart 12Strong Oil/Breakevens Correlation While US Ex-Energy Inflation Is Low Strong Oil/Breakevens Correlation While US Ex-Energy Inflation Is Low Strong Oil/Breakevens Correlation While US Ex-Energy Inflation Is Low Chart 13Energy Has Become The Only Source Of Euro Area Inflation Energy Has Become The Only Source Of Euro Area Inflation Energy Has Become The Only Source Of Euro Area Inflation The same dynamics, only more intense, exist in the euro area. Ex-energy inflation has struggled to stay above 1% over the past decade, leaving changes in energy prices as an even greater determinant of realized headline inflation than in the US (Chart 13). In both the US and euro area, the lack of non-energy inflation is the main reason why breakevens and oil are so correlated. Until there is evidence of a more broad-based move higher in inflation rates outside of oil - which will almost certainly require an extended period of above-trend global growth and accommodative global fiscal and monetary policies - trading inflation breakevens off oil will still be a successful strategy. Bottom Line: Global inflation breakevens will maintain a strong positive correlation to oil prices, but only for as long as non-energy inflation remains low and stable, which has made energy prices the only source of inflation variability in most developed countries Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes   Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Market Implications Of A Blue Wave Market Implications Of A Blue Wave Chart 2.... As Do Betting Markets Market Implications Of A Blue Wave Market Implications Of A Blue Wave   Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures.  Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin Market Implications Of A Blue Wave Market Implications Of A Blue Wave At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Trump Victory Was Followed By Rising Interest Rates Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Market Implications Of A Blue Wave Market Implications Of A Blue Wave Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Market Implications Of A Blue Wave Market Implications Of A Blue Wave Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters Market Implications Of A Blue Wave Market Implications Of A Blue Wave In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Market Implications Of A Blue Wave Market Implications Of A Blue Wave Chart 7Democratic Districts Have Fared Better Over The Past Decade Market Implications Of A Blue Wave Market Implications Of A Blue Wave Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3   As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4  There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers.  What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix Market Implications Of A Blue Wave Market Implications Of A Blue Wave Current MacroQuant Model Scores Market Implications Of A Blue Wave Market Implications Of A Blue Wave

Highlights Q3/2020 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark by +19bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +10bps, led by overweights in US (+13bps), Canada (+2bps) and Italy (+4bps) that favored allocations to inflation-linked government bonds out of nominals. Spread product generated a similar-sized outperformance (+9bps), led by overweights to US investment grade corporates (+8bps). Portfolio Positioning For The Next Six Months: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar. Feature As we enter the final quarter of 2020, global financial markets are dealing with many near-term uncertainties related to the upcoming US presidential election, potential next moves in global policy stimulus and, perhaps most worrying, a second wave of coronavirus infections in Europe and the US. That means the “easy money” has been made in global fixed income from the unwind of the blowout in credit spreads, and collapse of government bond yields, seen following the COVID-19 related market turbulence of February and March. Investors should expect substantially lower fixed income returns in the coming months. Relative performance between countries and sectors will be the more dominant influence on bond portfolio returns in the absence of big directional moves in yields or spreads. Alternatively put, expect alpha to win out over beta. This week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2020 Model Portfolio Performance Breakdown: Another Positive Quarter, Led By Linkers & Corporates Chart of the WeekQ3/2020 Performance: Gains From Both Sides Of The Portfolio Q3/2020 Performance: Gains From Both Sides Of The Portfolio Q3/2020 Performance: Gains From Both Sides Of The Portfolio The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was 3.14%, modestly outperforming the custom benchmark index by +19bps (Chart of the Week).1 This is the second consecutive positive quarter, lifting the year-to-date outperformance into positive territory (+12bps) – an impressive accomplishment given the sharp drawdown that occurred during the market volatility of February and March. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +10bps of outperformance versus our custom benchmark index while the latter outperformed by +9bps. That government bond return includes a substantial gain (+17bps) from inflation-linked bonds, which we added as a new asset class in our model portfolio framework back on June 23.2 In a world of very low bond yields (Table 2), our preference for the relatively higher-yielding government bond markets in the US, Canada and Italy was an important source of outperformance, delivering a combined excess return of +19bps (including inflation-linked bonds). This was only partially offset by the negative active returns from underweights in low-yielding countries such as Germany, France, and Japan (a combined drag of -9bps). Table 2GFIS Model Bond Portfolio Q3/2020 Overall Return Attribution GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation In spread product, our overweights in US investment grade corporates (+8bps), UK investment grade corporates (+3bps) and US Agency CMBS (+4bps) were the main sources of outperformance, while the negative active return from underweighting Euro Area high yield (-2bps) was minimal. Our preference to favor higher-rated US high-yield relative to lower-rated US junk bonds, even as riskier credit rallied, did little damage to portfolio performance, with a combined excess return across all three US junk credit tiers of just -2bps. The moderate outperformance of the model bond portfolio versus the benchmark in Q3 is in line with our cautious recommended stance on what are always the largest drivers of the portfolio returns: overall duration exposure and the relative allocation between government debt and spread product. We have stuck close to benchmark exposures on both, eschewing big directional bets on bond yields or credit spreads while focusing more on relative opportunities between countries and sectors – particularly in sectors most strongly supported by central bank easing actions, like US investment grade corporates. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q3/2020 Government Bond Performance Attribution GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 3GFIS Model Bond Portfolio Q3/2020 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Biggest Outperformers: Long US TIPS (+12bps) Overweight US investment grade industrials (+5bps) Overweight US Agency CMBS (+4bps) Overweight UK investment grade corporates (+3bps) Overweight US high-yield Ba-rated corporates (+3bps) Biggest Underperformers: Underweight French government bonds with maturity greater than 10 years (-4bps) Underweight US high-yield B-rated corporates (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2020. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q3/2020 (red for underweight, dark green for overweight, gray for neutral).3 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q3/2020 GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation The top performing sectors within our model bond portfolio universe in Q3 were well distributed among government bonds and spread products: Italian government bonds (relative index return of +3.8), New Zealand government bonds (+3.0%), EM USD-denominated sovereign (+2.6%), US high-yield corporates (2.4%), Spanish government bonds (+2.3%), and investment grade corporates in the UK (+2%) and US (1.9%). Importantly, we were overweight or neutral all of those markets during the quarter, driven by our main investment themes of “buying what the central banks are buying” and “yield chasing.”4 On the other side, we had limited exposure to the worst performing sectors during Q3, with underweights to government bonds in Germany and Japan, US Agency MBS and euro area high-yield. Cutting our long-standing overweight on UK Gilts to neutral in early August also benefitted the portfolio performance, with Gilts being the worst performer in our model bond universe by far in Q3. Bottom Line: Our model bond portfolio modestly outperformed its benchmark index in the second quarter of the year by +19bps – a positive result driven by our relative positioning that favored higher yielding government debt and spread product sectors directly supported by central bank purchases. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. This is in line with the current strategic investment recommendations of the BCA Research fixed income services. Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. The overall duration of the portfolio is in line with that of the custom benchmark index (Chart 5), consistent with our strategic investment recommendation to be neutral on exposure to changes in interest rates. With central banks actively seeking to keep policy rates as low as possible until inflation returns – i.e. aiming to push real rates even lower - we expect the negative correlation seen between global inflation breakevens and real bond yields to persist over at least the next 6-12 months. Offsetting moves in both will continue to dampen the volatility of nominal bond yields, as has been the case over the past six months (Chart 6). Chart 5Overall Portfolio Duration Exposure: At Benchmark Overall Portfolio Duration Exposure: At Benchmark Overall Portfolio Duration Exposure: At Benchmark Central banks aiming for an inflation overshoot and negative real rates will also continue to boost the relative performance of inflation-linked bonds versus nominal equivalents. Chart 6Within Governments, Continue Overweighting Linkers Vs Nominals The Strategic Case For Inflation-Linked Bond Outperformance The Strategic Case For Inflation-Linked Bond Outperformance We see this as a similar environment to the years following the 2008 financial crisis, with central banks keeping rates at 0% while rapidly expanding their balance sheets via quantitative easing and cheap liquidity provision for banks. The result was a multi-year period where linkers outperformed nominal government bonds (Chart 7). Thus, we are maintaining a large core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy and Canada. Chart 7The Strategic Case For Inflation-Linked Bond Outperformance Within Governments, Continue Overweighting Linkers Vs Nominals Within Governments, Continue Overweighting Linkers Vs Nominals Chart 8Overall Portfolio Allocation: Moderately Overweight Credit Vs Governments GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation In terms of country allocations on the government bond side of the portfolio, we continue to favor overweights in higher-yielding markets with overall global yield volatility likely to remain subdued. Chart 9Global QE Continues To Support Credit Markets Global QE Continues To Support Credit Markets Global QE Continues To Support Credit Markets That means overweighting the US, Canada, Australia, Italy and Spain, while underweighting Germany, France and Japan. The UK belongs in that latter list, but we are maintaining a neutral stance on the UK, for now, given the near-term uncertainty surrounding final Brexit negotiations and the surge in new UK COVID-19 cases. Turning to spread product, we are maintaining only a moderate aggregate overweight allocation versus government bonds, equal to 4% of the portfolio (Chart 8). The same aggressive easing of global monetary policy and expansion of central bank balance sheets that is good for relative inflation-linked bond performance also benefits global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has proven to be an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 9). With the combined balance sheet now expanding at a 40% pace, corporate bonds are likely to continue to outperform government debt over the next 6-12 months. Thus, our allocation to inflation-linked bonds and corporate credit, both out of nominal government bonds, are both motivated by the same factor – monetary policy reflation. The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. At the same time, we continue to maintain a cautious stance on allocations to countries and sectors within that overall overweight tilt towards spread product in the model bond portfolio. We prefer to stay relatively up-in-quality within global corporate debt, even with high-yield bonds in the US and Europe offering relatively high spreads using our 12-month breakeven spread metric (Chart 10).5 Chart 10US & European HY Offer Relatively Wide Breakeven Spreads GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 11US & European HY Offer No Spread Cushion Against Rising Defaults US & European HY Offer No Spread Cushion Against Rising Defaults US & European HY Offer No Spread Cushion Against Rising Defaults The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. Our measure of the default-adjusted spread, calculated by taking the option-adjusted spread of the Bloomberg Barclays high-yield index and subtracting default losses, shows that high-yield spreads on both sides of the Atlantic will be dwarfed by expected default losses over the next year, assuming a typical pattern of defaults after recessions (Chart 11). We continue to prefer staying up-in-quality within our recommended corporate allocations, favoring Ba-rated US high-yield over B-rated and Caa-rated credit while also underweighting euro area high-yield relative to euro area investment grade corporates. This strategy lowers the yield of the model portfolio, which is currently in line with that of the custom benchmark index (Chart 12), at the expense of stretching for yields in riskier credit that may not be sustainable over the medium-term. Chart 12Overall Portfolio Yield: At Benchmark Overall Portfolio Yield: At Benchmark Overall Portfolio Yield: At Benchmark Chart 13Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate At the same time, our measured stance on relative corporate exposure also acts to reduce portfolio risk – a useful outcome as we are targeting a relatively moderate tracking error (relative portfolio volatility versus that of the benchmark) within the model portfolio (Chart 13). Given the near-term uncertainties over the US elections and the potential second wave of COVID-19 in the US and Europe, staying relatively cautious on the usage of the “risk budget” of the portfolio seems prudent. Scenario Analysis & Return Forecasts In past quarterly reviews of our model bond portfolio, we have presented forecasts for the performance of the overall portfolio based off scenario analysis and some simple quantitative model-based predictions of various fixed income sectors. Given the unprecedented nature of the COVID-19 shock, we chose to avoid such model driven forecasts based on historical coefficients and correlations that may not be applicable. As it turns out, we may have been too cautious in that decision. The “risk-factor” models that we have used to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A) - have actually done a reasonable job of predicting yield changes over the past year. This can be seen in the charts shown in the Appendix on pages 18-20. Only in the case of US Caa-rated high-yield and EM USD-denominated corporates – two sectors where we are underweight given our concerns about valuation - have yields fallen by a far greater amount than implied by our models. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. For the government bond side, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those into changes in non-US bond yields by applying a historical yield beta (Table 2B). Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 14Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs (Chart 14): Base Case: The US election result is initially uncertain, but a clear winner is determined within a few days. COVID cases continue to increase, but with less severe economic restrictions than during the first wave. Global growth continues to show steady improvement. There will be some additional global fiscal stimulus, with central banks keeping foot on monetary accelerator. There is mild bear steepening of the US Treasury curve with moderate widening of US inflation breakevens. The VIX reaches 25, the USD dollar depreciates by -5%, oil prices climb 10% and the fed funds rate remains at 0%. Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. Optimistic Scenario: The US election goes smoothly and a clear winner is declared on election night. The current uptick in global COVID cases does not turn into a full-blown second wave requiring severe economic restrictions. Global growth continues to steadily improve, with additional global fiscal stimulus and central banks staying highly dovish. The US Treasury curve bear steepens as US inflation expectations steadily increase. The VIX falls to 20, the USD dollar depreciates by -7%, oil prices climb 20%, and the fed funds rate stays at 0%. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Chart 15US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis Pessimistic Scenario: There is a contested US election result taking weeks to resolve, leading to major US social unrest. A full-blown second COVID-19 wave hits the world and severe economic restrictions are implemented. Governments become more worried about debt/deficits and deliver underwhelming stimulus. Central banks do not provide enough additional stimulus to offset the shocks. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX soars to 35, the USD dollar rise by 5%, oil prices fall -20%, while the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B and Chart 15). The model bond portfolio is expected to deliver an excess return over the next six months of +17bps in the base case and +27bps in the optimistic scenario, but is only projected to underperform by -1bp in the pessimistic scenario. Bottom Line: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of lobal Inflation Expectations", dated June 23 2020, available at gfis.bcaresearch.com. 3 Note that sectors where we made changes to our recommended weightings during Q3/2020 will have multiple colors in the respective bars in Chart 4. 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 The 12-month breakeven spread measures the amount of spread widening that must take place for a credit product to have the same return over a one-year horizon as a duration-matched position in government bonds. We compare those breakeven spreads to their own history in a percentile ranking to determine the relative attractiveness of a credit product strictly from a spread and spread volatility perspective. Appen dix Appendix Chart 1US Investment Grade Sectors US Investment Grade Sectors US Investment Grade Sectors Appendix Chart 2US High-Yield Credit Tiers US High-Yield Credit Tiers US High-Yield Credit Tiers Appendix Chart 3US MBS & CMBS US MBS & CMBS US MBS & CMBS Appendix Chart 4Euro Area And UK Credit Euro Area and UK Credit Euro Area and UK Credit Appendix Chart 5Emerging Markets USD-Denominated Debt Emerging Markets USD-Denominated Debt Emerging Markets USD-Denominated Debt Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation GFIS Model Bond Portfolio Q3/2020 Performance Review & Current Allocations: The Power Of Reflation Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns