High-Yield

Highlights Chart 1Stick With Steepeners Stick With Steepeners Stick With Steepeners The new year promises to be one of Fed tightening. The minutes from the December FOMC meeting reinforced the notion that rate hikes will begin as early as March and the market is now priced for 85 bps of rate increases (between 3 and 4 hikes) by the end of 2022. The long-end of the curve has responded to the hawkishness with the 10-year Treasury yield moving above its previous post-pandemic high of 1.74%. Just as interesting, however, is that the 5-year/5-year forward Treasury yield has only just climbed back to the lower-end of the range of neutral fed funds rate estimates (Chart 1). This has implications for our preferred yield curve positioning. With the 5-year/5-year forward yield still below our target, it makes sense to position for a bear-steepening of the Treasury curve. A shift from steepeners to flatteners will be warranted once the 5-year/5-year is more consistent with survey estimates of the neutral rate. For now, we recommend keeping portfolio duration low and owning 2/10 Treasury curve steepeners (long 2-year, short cash/10 barbell). Feature Table 1Recommended Portfolio Specification Prepare For Liftoff Prepare For Liftoff Table 2Fixed Income Sector Performance Prepare For Liftoff Prepare For Liftoff Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in December and by 162 bps in 2021. The index option-adjusted spread tightened 7 bps on the month and our quality-adjusted 12-month breakeven spread ticked down to its 6th percentile since 1995 (Chart 2). This indicates that corporate bonds remain expensive, despite the Fed’s pivot toward tightening. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable holding corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 bps to 50 bps.1 The 3-year/10-year Treasury slope recently bounced off the 50 bps level and it currently sits at 59 bps. However, our fair value estimates for the 3/10 slope suggest that it won’t stay above 50 bps for long (bottom panel). The three scenarios we consider all suggest that the 3/10 slope will break below 50 bps within the next six months.2 We will turn more defensive on corporate bonds once that occurs. Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 216 bps in December and by 669 bps in 2021. The index option-adjusted spread tightened 54 bps on the month, ending the year at 283 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also fell back to 3.3% (Chart 3). The odds are good that defaults will come in below 3.3% in 2021, which should coincide with the outperformance of high-yield bonds versus duration-matched Treasuries. For context, the high-yield default rate came in at 1.8% for the 12 months ending in November and we showed in a recent report that corporate balance sheets are in excellent shape.3 Specifically, we noted that the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We recommend that investors favor high-yield over investment grade corporate bonds. While, as noted on page 3, we will turn more defensive on credit risk (including high-yield) once the 3/10 Treasury slope moves sustainably below 50 bps, we will likely retain a preference for high-yield over investment grade based on relative valuations.      MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in December but lagged by 69 bps in 2021. The zero-volatility spread for conventional 30-year agency MBS tightened 6 bps on the month, evenly split between 3 bps of option-adjusted spread (OAS) tightening and a 3 bps drop in the compensation for prepayment risk (option cost) (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021, despite the back-up in yields.4 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refinancings to remain stubbornly high in 2022. This will put upward pressure on MBS spreads. We recommend an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel). Government-Related: Overweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 34 basis points in December and by 68 bps in 2021. Sovereign debt outperformed duration-equivalent Treasuries by 216 bps in December but lagged by 10 bps in 2021. Foreign Agencies outperformed the Treasury benchmark by 6 bps on the month and by 41 bps in 2021. Local Authority bonds underperformed by 37 bps in December but beat duration-matched Treasuries by 368 bps in 2021. Domestic Agency bonds underperformed by 1 bp in December and were flat versus Treasuries on the year. Supranationals outperformed Treasuries by 2 bps in December and by 20 bps in 2021. The investment grade Emerging Market Sovereign bond index outperformed the duration-equivalent US corporate bond index by 109 bps in December. The Emerging Market Corporate & Quasi-Sovereign index outperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.5  Within EM sovereigns, attractive countries include: Philippines, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in December and by 416 bps in 2021 (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuations.6 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 19% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 25% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in December but reversed some of that flattening in the first week of January. All in all, the 2-year/10-year Treasury slope has flattened 2 bps since the end of November, bringing it to 89 bps. As noted on the front page of this report, the 5-year/5-year forward Treasury yield is rising but it is still only at the low-end of survey estimates of the long-run neutral fed funds rate. This argues for continuing to hold curve steepeners in the near term. It will make sense to shift into flatteners once the 5-year/5-year forward yield rises to the middle of the range of survey estimates. We also observe that the 2/5/10 butterfly spread is extremely high, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that a 2/10 curve steepening position (long 5-year bullet, short 2/10 barbell) is incredibly cheap. Indeed, the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4) and the Fed has still not raised rates off the zero bound. A trade long the 5-year bullet and short a duration-matched 2/10 barbell looks attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen. For that reason, we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. We recommend buying the 2-year bullet versus a duration-matched cash/10 barbell. We also advise investors to own a position long the 20-year bond versus a duration-matched 10/30 barbell. This latter position offers a very attractive duration-neutral yield advantage of 20 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 85 basis points in December and by 830 bps in 2021. The 10-year TIPS breakeven inflation rate rose 8 bps on the month while the 2-year TIPS breakeven inflation rate fell by 2 bps. The 10-year and 2-year rates currently sit at 2.52% and 3.17%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month. It currently sits at 2.19%, somewhat below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in December and by 31 bps in 2021. Aaa-rated ABS outperformed by 4 bps in December and by 17 bps in 2021. Non-Aaa ABS outperformed Treasuries by 9 bps in December and by 103 bps in 2021. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth is starting to rebound, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.       Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in December and by 180 bps in 2021. Aaa Non-Agency CMBS outperformed Treasuries by 17 bps in December and by 80 bps in 2021. Non-Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in December and by 513 bps in 2021 (Chart 10). Though returns have been strong and spreads remain relatively high, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in December and by 70 bps in 2021. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 36 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet.   Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31st, 2021) Prepare For Liftoff Prepare For Liftoff Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31st, 2021) Prepare For Liftoff Prepare For Liftoff 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 -58 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 58 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) Prepare For Liftoff Prepare For Liftoff Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  We consider three scenarios for the fed funds rate. (1) March liftoff, 100 bps per year hike pace, 2.08% terminal rate. (2) March liftoff, 75 bps per year hike pace, 2.08% terminal rate. (3) March liftoff, 75 bps per year hike pace, 2.33% terminal rate. 3  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 5  Please see US Bond Strategy Special Report, “2022 Key Views: US Fixed Income”, dated December 14, 2021. 6  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.  

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

Highlights Chart 1Curve Flattening Is Overdone Curve Flattening Is Overdone Curve Flattening Is Overdone Fed Chair Jay Powell made big news last month. During Senate testimony, Powell not only signaled that the Fed is likely to accelerate the pace of asset purchase tapering when it meets in December, he also suggested that the Fed won’t necessarily wait until “maximum employment” is achieved before lifting rates. Powell’s comments suggest that the first Fed rate hike could come as early as June 2022 and as late as December 2022, and the exact timing will depend on how inflation and inflation expectations move during the next few months. The front-end of the Treasury curve is fairly priced for either scenario. The 2-year Treasury yield is currently 0.60%. If we assume that the Fed eventually lifts rates at a pace of 100 bps per year until reaching a 2.08% terminal rate, we calculate a fair value range for the 2-year yield of 0.39% to 0.74%, depending on whether Fed liftoff occurs in June or December. In contrast, the same assumptions give us a fair value range of 1.69% to 1.79% for the 10-year Treasury yield, well above its current level of 1.40% (Chart 1). The investment implications are clear. Investors should maintain below-benchmark portfolio duration and put on Treasury curve steepeners, overweight the 2-year note and underweight the 10-year. Feature Table 1Recommended Portfolio Specification Powell’s Pivot Powell’s Pivot Table 2Fixed Income Sector Performance Powell’s Pivot Powell’s Pivot Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 89 basis points in November, dragging year-to-date excess returns down to +102 bps. The index option-adjusted spread widened 12 bps on the month and our quality-adjusted 12-month breakeven spread is now at its 7th percentile since 1995. This indicates that valuations remain stretched even after the recent widening (Chart 2). The back-up in spreads was driven by the combination of the Fed’s shift toward a more hawkish policy stance and concerns about the new omicron COVID variant. This led to a large flattening of the yield curve in addition to wider corporate bond spreads. The slope of the yield curve is a critical indicator for our corporate bond call. We are very comfortable owning corporate bonds when the 3-year/10-year Treasury slope is above 50 bps, but our work suggests that returns to credit risk take a significant step down once the slope flattens into a range of 0 – 50 bps.1  The 3-year/10-year Treasury slope currently sits at 49 bps, just below our 50 bps threshold. However, our range of fair value estimates suggests that the 3/10 slope should be between 63 bps and 86 bps today, and that it should only break below 50 bps between March and September of next year (bottom panel). All in all, we expect the pace of Treasury curve flattening to abate during the next couple of months and this will allow spreads to tighten back to their recent lows. We will turn more cyclically defensive on corporate bonds next year when the break below 50 bps in the 3/10 slope is confirmed by our fair value readings. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Powell’s Pivot Powell’s Pivot Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 121 basis points in November, dragging year-to-date excess returns down to +444 bps. The index option-adjusted spread widened 50 bps on the month, leading to a significant rise in the spread-implied default rate. The spread-implied default rate is the 12-month default rate that is priced into the junk index, assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps. At present, the spread-implied default rate sits at 3.8% (Chart 3). For context, defaults have come in at an annualized rate of 1.6% so far this year and we showed in a recent report that corporate balance sheets are in excellent shape.2  Specifically, the ratio of total debt to net worth for the nonfinancial corporate sector has fallen to 41%, the lowest ratio since 2010 (bottom panel). We conclude that the default rate will be comfortably below 3.8% during the next 12 months, allowing high-yield bonds to outperform duration-matched Treasuries. We recommend that investors favor high-yield over investment grade corporate bonds, and we expect that last month’s spread widening will reverse in relatively short order. However, as noted on page 3, we will turn more defensive on credit risk (including high-yield bonds) next year once we are confident that the 3/10 Treasury curve has sustainably moved into a flatter regime (0 – 50 bps). MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 46 basis points in November, dragging year-to-date excess returns down to -90 bps. The zero-volatility spread for conventional 30-year agency MBS widened 13 bps on the month, driven by an 11 bps widening of the option-adjusted spread and a 2 bps increase in the compensation for prepayment risk (option cost) (Chart 4). We wrote in last week’s report that MBS’ recent poor performance is attributable to an option cost that is too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index has been slow to fall this year despite the back-up in yields.3 The robust pace of home price appreciation has been an important factor boosting refis, as homeowners have been increasingly incentivized to tap the equity in their homes. With no indication that cash-out refi activity is about to slow, we expect refi activity will remain sticky going forward. This will put upward pressure on MBS spreads. We recommend adopting an up-in-coupon bias within an overall underweight allocation to MBS. Higher coupon MBS exhibit more attractive option-adjusted spreads and higher convexity than lower coupon MBS. This makes high-coupon MBS (4%, 4.5%) more likely to outperform low-coupon MBS (2%, 2.5%, 3%) in an environment where bond yields are flat or rising (bottom panel).  Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-neutral Treasury index by 35 basis points in November, dragging year-to-date excess returns down to +33 bps. Sovereign debt underperformed duration-equivalent Treasuries by 157 basis points in November, dragging year-to-date excess returns down to -220 bps. Foreign Agencies underperformed the Treasury benchmark by 9 bps on the month, dragging year-to-date excess returns down to +36 bps. Local Authority bonds underperformed by 16 bps in November, dragging year-to-date excess returns down to +406 bps. Supranationals outperformed by 2 bps, bringing year-to-date excess returns up to +18 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 42 bps in November. The Emerging Market Corporate & Quasi-Sovereign index underperformed duration-matched US corporates by 16 bps (Chart 5). Both EM indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.4 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Maximum  Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in November, bringing year-to-date excess returns up to +371 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will support state & local government coffers for some time. A recent report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.5 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity bonds are especially compelling. We calculate that 12-17 year maturity Revenue Munis offer a breakeven tax rate of 14% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 22% versus corporates (panel 2). High-yield muni spreads are reasonably attractive compared to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve flattened dramatically in November. Increasingly hawkish rhetoric from the Fed pushed front-end yields higher as news about the omicron COVID strain pressured long-dated yields lower. The 2-year/10-year Treasury slope flattened 16 bps on the month, it currently sits at 75 bps. The 5-year/30-year Treasury slope flattened 11 bps on the month, it currently sits at 56 bps. As noted on the front page, long-dated Treasury yields have fallen to well below levels consistent with a reasonable Fed rate hike cycle. This drop in long-maturity yields has pushed the 2/5/10 butterfly spread to extremely high levels, both in absolute terms and relative to our model’s fair value (Chart 7). This signals that 2/10 yield curve steepeners are incredibly cheap. Indeed, we observe that the 2/10 slope has already flattened to below the levels that were witnessed on the last two Fed liftoff dates in 2015 and 2004 (panel 4). A trade long the 5-year bullet and short a duration-matched 2/10 barbell does indeed look attractive in this environment. However, we note that the 2/5 Treasury slope has also flattened to below levels seen on the prior two Fed liftoff dates (bottom panel). In other words, the 2/5 slope also has room to steepen during the next 6-12 months, and we prefer to focus our long positions on the 2-year Treasury note rather than the 5-year. This leads us to recommend a position long the 2-year note and short a duration-matched barbell consisting of cash and the 10-year note. We also advise investors to own a position long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This latter position offers a very attractive duration-neutral yield advantage of 24 bps. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in November, leaving year-to-date excess returns unchanged at +739 bps. The 10-year TIPS breakeven inflation rate fell 8 bps on the month while the 2-year TIPS breakeven inflation rate rose 17 bps. The 10-year and 2-year rates currently sit at 2.44% and 3.24%, respectively. The Fed’s preferred 5-year/5-year forward TIPS breakeven inflation rate rose 8 bps on the month. It currently sits at 2.16%, below the Fed’s 2.3% - 2.5% target range. Our valuation indicator shows that 10-year TIPS are slightly expensive compared to 10-year nominal Treasuries (Chart 8), and we retain a neutral allocation to TIPS versus nominals at the long-end of the curve. We acknowledge the risk that a prolonged period of high inflation could lead to a break-out in long-dated TIPS breakevens, but this now looks less likely given the Fed’s increasing hawkishness. We see better trading opportunities at the front-end of the TIPS curve, where the 2-year TIPS breakeven inflation rate remains well above the Fed’s target range (panel 4). Short-maturity breakevens are more sensitive to swings in CPI than those at the long-end. Therefore, the 2-year TIPS breakeven inflation rate has considerable downside during the next 6-12 months, assuming inflation moderates as we expect it will. We recommend an underweight allocation to TIPS versus nominals at the front-end of the curve. Given our view that CPI inflation will be lower in 6-12 months, we recommend shorting 2-year TIPS outright, positioning in 2/10 TIPS breakeven inflation curve steepeners (bottom panel) and 2/10 TIPS (real) yield curve flatteners. All three trades will profit from falling short-maturity inflation expectations. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 9 basis points in November, dragging year-to-date excess returns down to +26 bps. Aaa-rated ABS underperformed by 11 bps on the month, dragging year-to-date excess returns down to +13 bps. Non-Aaa ABS performed in line with Treasuries in November, keeping year-to-date excess returns steady at +93 bps. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). The result is that the collateral quality backing consumer ABS is exceptionally high. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in November, dragging year-to-date excess returns down to +155 bps. Aaa Non-Agency CMBS underperformed Treasuries by 30 bps in November, dragging year-to-date excess returns down to +63 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 70 bps, dragging year-to-date excess returns down to +469 bps (Chart 10). Though returns have been strong this year and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 47 basis points in November, dragging year-to-date excess returns down to +58 bps. The average index option-adjusted spread widened 9 bps on the month. It currently sits at 40 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.     Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -62 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 62 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 30th, 2021) Powell’s Pivot Powell’s Pivot Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 30th, 2021) Powell’s Pivot Powell’s Pivot Table 6Discounted Slope Change During Next 6 Months (BPs) Powell’s Pivot Powell’s Pivot Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11 Footnotes 1   Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 3  Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. 4  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 5  Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021.

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

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (November 16 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET and November 17 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Highlights Chart 1Buy The 2-Year, Sell The 10-Year Buy The 2-Year, Sell The 10-Year Buy The 2-Year, Sell The 10-Year Treasury yields have been volatile of late, but the biggest move has been a flattening of the yield curve led by a sell-off at the front-end. Our recommended yield curve positioning (short the 5-year bullet / long a duration-matched 2/10 barbell) was well suited to profit from this move but has now run its course. The solid lines in the bottom panel of Chart 1 show the paths discounted in the forward curve for the 2-year and 10-year yields. The dashed lines show the fair value paths for each yield in a scenario where the Fed starts hiking in December 2022 and proceeds at a pace of 100 bps per year until reaching a 2.08% terminal rate. We can see that the 2-year yield looks a bit too high relative to fair value and the 10-year looks too low. Taken together, our fair value estimates show that the 2/10 Treasury slope should flatten during the next 12 months, but not by as much as is currently discounted in the forward curve (Chart 1, top panel). Investors should maintain below-benchmark portfolio duration but should shift out of 2/10 flatteners and into steepeners. Specifically, we close our prior yield curve trade and open a new one: Long the 2-year note, short a duration-matched barbell consisting of cash and the 10-year note.   Feature Table 1Recommended Portfolio Specification Curve Flatteners Are Too Expensive Curve Flatteners Are Too Expensive Table 2Fixed Income Sector Performance Curve Flatteners Are Too Expensive Curve Flatteners Are Too Expensive Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds performed in line with the duration-equivalent Treasury index in October, leaving year-to-date excess returns unchanged at +193 bps (Chart 2). The combination of above-trend economic growth and accommodative monetary policy continues to support positive excess returns for spread product versus Treasuries. The recent flattening of the yield curve is a strong reminder that the window of outperformance for corporate bonds will eventually close, but the curve will need to be a lot flatter before we start to worry. Specifically, we are targeting a level of 50 bps for the 3-year/10-year Treasury slope as a level where we will turn more cautious on spread product relative to Treasuries. This slope currently sits at 80 bps and the pace of flattening should moderate during the next few months. A recent report presented the results of a scenario analysis for investment grade corporate bond returns during the next 12 months.1 We concluded that investment grade corporate bond total returns will be close to zero or negative during the next 12 months and that excess returns versus duration-matched Treasuries are capped at 85 bps. With that in mind, we advise investors to seek out higher returns in junk bonds, municipal bonds and USD-denominated Emerging Market sovereign and corporate bonds. We also recommend favoring long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in October, bringing year-to-date excess returns up to +572 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.1% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first nine months of the year, well below the estimate generated by our model. Another recent report considered different plausible scenarios for junk bond returns during the next 12 months.4 We concluded that junk bond total returns will fall into a range of -0.29% to +1.80% during the next 12 months and that excess returns versus duration-matched Treasuries will be between +0.94% and +1.84%.     MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in October, dragging year-to-date excess returns down to -44 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 16 bps in October. The spread looks tight relative to levels seen during the past year and relative to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) tightened 3 bps in October to reach 29 bps (panel 3). This is only just above the 28 bps offered by Aaa-rated consumer ABS but below the 54 bps offered by Aa-rated corporate bonds and the 30 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS.  Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index performed in-line with the duration-equivalent Treasury index in October, leaving year-to-date excess returns unchanged at 68 bps. Sovereign debt outperformed duration-equivalent Treasuries by 23 basis points October, bringing year-to-date excess returns up to -65 bps. Foreign Agencies underperformed the Treasury benchmark by 5 bps on the month, dragging year-to-date excess returns down to +44 bps. Local Authority bonds outperformed by 16 bps in October, bringing year-to-date excess returns up to +423 bps. Domestic Agency bonds underperformed by 15 bps, dragging year-to-date excess returns down to +9 bps. Supranationals underperformed by 11 bps, dragging year-to-date excess returns down to +16 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 35 bps in October. The Emerging Market Corporate & Quasi-Sovereign index delivered 8 bps of outperformance versus duration-matched US corporates (Chart 5). Despite this outperformance, both indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.6 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 48 basis points in October, bringing year-to-date excess returns up to +341 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and individual tax hikes will only increase the attractiveness of tax-exempt munis if they are included in the upcoming reconciliation bill. Last week’s report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.7 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity municipal bonds are especially compelling. We calculate that 17-year+ maturity General Obligation Munis offer a before-tax yield pick-up relative to credit rating and duration-matched corporate credit. The same goes for 17-year+ Revenue bonds. High-yield muni spreads are reasonably attractive relative to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened dramatically in October. The 2-year/10-year Treasury slope flattened 17 bps to end the month at 107 bps. The 5-year/30-year slope flattened 35 bps to end the month at 75 bps. As is mentioned on the first page of this report, the large flattening of the yield curve has led us to take profits on our prior 2/10 flattener (short 5-year bullet versus 2/10 barbell) and to initiate a 2/10 curve steepener (long 2-year bullet versus cash/10 barbell). We also noted on the front page that we still expect the 2/10 slope to flatten during the next 12 months, just not by as much as what is currently priced into the forward curve. The 2/5/10 butterfly spread has risen a lot during the past few weeks and it now looks extremely high, both in absolute terms and relative to our fair value model (Chart 7). The 2/5/10 butterfly spread can rise because of either 2/5 steepening or 5/10 flattening. We contend that the current elevated 2/5/10 butterfly is mostly the result of a 5/10 slope that is too flat, not a 2/5 slope that is too steep. The bottom two panels of Chart 7 show the 2/5 and 5/10 slopes along with dashed lines indicating where those slopes were on prior Fed liftoff dates in 2015 and 2004. We see that the 2/5 slope is not unusually steep compared to those prior liftoff dates, but the 5/10 slope is unusually flat. For this reason, we want long exposure to the 2-year note and short exposure to the 10-year note between now and Fed liftoff in late-2022. The best way to achieve this exposure is to buy the 2-year note and short a duration-matched barbell consisting of the 10-year note and cash. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 106 basis points in October, bringing year-to-date excess returns up to +740 bps. The 10-year TIPS breakeven inflation rate rose 15 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate fell 10 bps. At 2.54%, the 10-year TIPS breakeven inflation rate is now slightly above the 2.3% to 2.5% range that is consistent with inflation expectations being well-anchored around the Fed’s target (Chart 8). Meanwhile, at 2.14%, the 5-year/5-year forward TIPS breakeven inflation rate has dipped below the Fed’s target range (panel 3). The divergence between 10-year and 5-year/5-year breakeven rates underscores the flatness of the inflation curve (bottom panel). Near-term inflation expectations are extremely high, but they decline sharply further out the curve. Our view is that inflationary pressures will wane during the next 6-12 months and this will lead to a steep decline in short-maturity TIPS breakeven inflation rates.8 Breakeven rates at the long-end should remain relatively close to the Fed’s target range. We recommend positioning for this outcome by entering inflation curve steepeners or real yield curve (aka TIPS curve) flatteners. We also advise entering an outright short position in 2-year TIPS. The 2-year TIPS yield has a lot of room to rise as the cost of 2-year inflation compensation falls and the 2-year nominal yield remains close to its fair value. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to +35 bps. Aaa-rated ABS underperformed by 8 bps on the month, dragging year-to-date excess returns down to +25 bps. Non-Aaa ABS underperformed by 5 bps, dragging year-to-date excess returns down to +93 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     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 1 basis point in October, bringing year-to-date excess returns up to +196 bps. Aaa Non-Agency CMBS underperformed Treasuries by 3 bps in October, dragging year-to-date excess returns down to +93 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 17 bps, bringing year-to-date excess returns up to +543 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to +105 bps. The average index option-adjusted spread tightened 3 bps on the month. It currently sits at 30 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 29th, 2021) Curve Flatteners Are Too Expensive Curve Flatteners Are Too Expensive 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 29th, 2021) Curve Flatteners Are Too Expensive Curve Flatteners Are Too Expensive 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 -60 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 flattens by less than 60 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) Curve Flatteners Are Too Expensive Curve Flatteners Are Too Expensive Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 For more details please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 7 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 8 Please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021.

Highlights The market pricing of the ECB is too aggressive. More so than in the US, temporary factors explain the European inflation surge. Energy, taxes, and base effects account for the bulk of the price increases. In contrast to supply shortages, European labor shortages are small and slack will limit wage growth. Despite the lack of near-term inflation risks, European growth prospects are significantly stronger than last decade. As a result, European inflation will settle at a higher level than in the 2010s and will increase durably in the second half of the 2020s. The inflation curve will steepen, as will the yield curve. Banks will continue to outperform, especially compared to the insurance sector. A tactical opportunity to buy European high-yield corporates has emerged. In France, Macron remains the favorite for the 2022 presidential election. Feature Last week’s ECB meeting did nothing to curb the impression among traders that the ECB will start removing monetary accommodation in 2022. The implied policy rate stands at -0.25% one year from now and -0.08% in two years. Meanwhile, Italian 10-year spreads over Germany have increased to 127bps, their highest level since November 2020. This market action rests on the perception that inflationary pressures in the Euro Area are durable. While this line of reasoning may have credence in the US, it is weaker across the Atlantic where the economy shows fewer signs of genuine inflationary pressure. Moreover, the deterioration in peripheral financial conditions further limits the ability of the ECB to withdraw accommodation without a financial accident. Meanwhile, the NGEU program has created a climate where the likelihood of a premature and excessive fiscal tightening is low. Thus, the weak European growth of the past decade will not be repeated. When considering these inflationary and fiscal views, it becomes apparent that the European yield curve has room to steepen further. Consequently, European banks remain attractive and should be bought on dips, especially relative to insurance companies. The EONIA Curve Is Too Aggressive The sudden increase in interest rate hikes priced in the EONIA curve is a consequence of the rapid acceleration in European realized inflation and CPI swaps. Neither are durable. Headline HICP has surged to 4.1% and core CPI towers at 2.1%, their highest reading in 13 and 19 years, respectively. These surges are the reflection of transitory factors: Chart 1The Energy Path-Through The Energy Path-Through The Energy Path-Through Energy prices are lifting HICP and are sipping through to core CPI. Inflation for electricity, gas, and fuel has reached 14.7% and the energy CPI is at 23.5%. Both are moving in line with headline and core CPI (Chart 1). Now that Brent oil and natural gas have increased four and twenty folds since Q2 2020, respectively, their ability to contribute as much to overall inflation has decreased because they are unlikely to appreciate as much again. While oil prices may rise again here, European natural gas will decline meaningfully in the coming months. Tax increases are another important driver of core CPI. Core inflation with constant taxes stand at 1.37%, which is 0.67% below core CPI. In other words, while core CPI is high by the standard of the past decade, once we adjust for tax increases, it stands at normal levels (Chart 2). Base-effects are another dominant ingredient of the surge in European core CPI. The annualized two-year rate of change of the Eurozone’s core CPI stands at 1.11%, which is within the norm of the past seven years and below the rates experienced prior to 2014. In comparison, the annualized two-year core inflation in the US is 2.87%, well outside the range of the past decade (Chart 3). Chart 2Death And Taxes Death And Taxes Death And Taxes Chart 3Controlling For The Base Effect Controlling For The Base Effect Controlling For The Base Effect Inflation remains narrowly based. The Euro Area trimmed-mean CPI stands at 0.22%, or 1.82% below core CPI. Meanwhile, in the US, trimmed-mean CPI has reached 3.5% or 0.5% below core CPI (Chart 4). These figures confirm that the Eurozone inflation increase is more muted and narrower than that of the US. Wages are not experiencing any meaningful shock so far. Negotiated wages are growing at a 1.7% annual rate; meanwhile, the Atlanta Fed Wage Tracker is expanding at 3.6% and is rising even more steadily for low-skill jobs (Chart 5). Chart 4Much More Narrow Than In The US Much More Narrow Than In The US Much More Narrow Than In The US Chart 5Limited Wage Pressures Limited Wage Pressures Limited Wage Pressures Continental Europe’s more limited inflationary pressures compared to the US are a consequence of policy decisions during the crisis. The Euro Area fiscal stimulus in 2020 and 2021 amounted to 11% of 2019 GDP, but output declined by 15% in Q2 2020 and suffered a second dip in Q1 2021. Meanwhile, US fiscal packages amounted to 25% of 2019 GDP, while GDP declined by 10% in Q2 2020. Consequently, the Eurozone’s output gap is -4.1% of GDP, while that of the US has essentially closed. The contrasting nature of the stimuli accentuated the different outcomes created by their respective size. In Europe, governmental support focused on keeping people at work, which left aggregate supply unchanged. In the US, public programs allowed jobs to disappear, but they placed money directly in the pockets of consumers, which caused aggregate demand to rise relative to aggregate supply. In this context, a wage-price spiral is unlikely to develop in Europe as long as the energy crisis does not continue through 2022. Chart 6 First, the labor shortage problems are less acute in the Eurozone than in the US or the UK. Chart 6 highlights the factors limiting production in various industries. In the industrial sector, the “labor shortages” category has grown, but pale compared to the role of “material and equipment shortages” as a problem. In the services sector, the “weak demand” and “other” categories are greater obstacles to production than the “labor” factor, which remains at Q1 2020 levels (Chart 6, middle panel). Only in the construction sector are “labor shortages” the chief problem, but they still hurt production less than “insufficient demand” did in February 2021, when real estate prices were already strong (Chart 6, bottom panel). Second, labor market slack remains comparable to 2011 levels, when the ECB erroneously increased interest rates to fight energy-driven inflation (Chart 7). Additionally, the rise in persons available to work but not currently seeking employment represent 75% of the increase in labor market slack since Q4 2019. At the crisis peak in Q2 2020, this category accounted for 105% of the increase in labor market slack. This suggests that, as the vaccination campaign continues to progress across the continent; as households use up their savings; and as government supports ebb across Europe, a large share of those who are a part of the labor market slack will start looking for jobs again, which will increase the supply of workers and limit wage pressures. If traders are overly worried about realized inflation remaining high in Europe, they are also over-emphasizing some CPI swap measures that trade above 2%. CPI swaps only tell one part of the inflation expectations story, because they are one and the same as energy prices. Elevated energy prices sap spending power in the rest of the economy, if other inflation expectation measures remain well anchored; thus, rising energy inflation rarely translates into broad-based pricing pressure. For now, our Common Inflation Expectation measure for the Eurozone, based on the New York Fed’s method for the US, is still toward the low-end of its distribution, even though it includes CPI swaps (Chart 8). This confirms that the energy crisis remains a relative-price shock and that it is unlikely to lead to a generalized inflation outburst in the Euro Area. Chart 7 Chart 8Different Inflation Expectations Different Inflation Expectations Different Inflation Expectations Bottom Line: Markets expect a first 10bps ECB rate hike by June 2022 and the deposit rate to be 25bps higher by September 2023. However, unlike in the US, there are few signs that European inflation reflects anything more than higher energy prices, rising taxes, and base effects. Moreover, the stories in the press of labor shortages are exaggerated, while broad-based inflation expectations are not unmoored. In this context, we lean against the EONIA pricing and expect the ECB to increase rates in 2024, at the earliest. Fiscal Policy Unlike Last Decade The 2010s were a lost decade for Europe. GDP only overtook its 2008 peak in 2015. Today, GDP is recovering much faster from the recession than it did twelve years ago, and it is unlikely to relapse as it did back then. Chart 9A Lost Decade A Lost Decade A Lost Decade The European economic underperformance last decade was rooted in fiscal policy. As the top panel of Chart 9 highlights, the fiscal thrust during the GFC was minimal, at 1.3% of GDP, and was rapidly followed by a negative fiscal thrust. Moreover, the ECB unduly tightened policy in 2011 and left peripheral spreads fester at elevated levels between 2011 and 2014. This combination substantially hurt demand, especially in the European periphery. Capex proved particularly vulnerable. It is derived demand and therefore adds considerable variance to GDP. Faced with strong policy headwinds, its share of GDP plunged for most of the decade, which greatly contributed to the European economic malaise (Chart 9, bottom panel). According to the IMF, the Eurozone fiscal thrust will not exert the same drag as it did last decade; hence, capex is also unlikely to repeat its mediocre performance. Instead, the poorer Eastern and Central European economies as well as the weaker peripheral nations will receive a significant fillip from the NGEU program (Chart 10). When the NGEU grants and loans as well as the EU’s Multiannual Financial Framework funds are aggregated together, the EU will provide EUR1.9 trillion funding (adjusted for inflation) to member states over the next five years (Table 1). These sums will prevent any meaningful fiscal retrenchment from taking place. Chart 10 Table 1Bigger Spending To Hike Or Not To Hike? To Hike Or Not To Hike? The NGEU funds will be particularly supportive for capex. The Recovery and Resilience Facility (RRF), which will be the main instrument to deliver funds across Europe, is heavily weighted toward green transition, reskilling, and digital transformation (Chart 11, top panel). Practically, this spending focuses on electrical, power, water, and broadband infrastructures, as well as renovation and modernization projects (Chart 11, bottom panel). This reinforces the notion that capex is unlikely to follow the same trajectory it did last decade. Chart 11 The implication of more accommodative fiscal policy and more robust capex is that the European output gap will close much faster than it did after the GFC. Hence, even if we expect the current inflation spike to pass next year, inflation will ultimately settle higher than it did last decade. Moreover, in the second half of the 2020s, European inflation will trend higher as full employment will be achieved. Bottom Line: The Euro Area is unlikely to experience another lost decade like the previous one. European trend growth remains low, but fiscal policy will not be as tight. Consequently, capex will not be as depressed, especially because the NGEU grants will greatly incentivize investments in certain sectors of the economy. As a result, the output gap will close much faster than it did in the 2010s. Moreover, once the current pandemic-driven inflation surge passes, CPI will settle at a higher level than it did last decade and will trend higher durably in the second half of the 2020s. Investment Implications Three main conclusions can be derived from our expectation on European inflation and growth dynamics over the coming decade. First, the inflation yield curve will steepen meaningfully. Today, near-term CPI swaps are lifted by energy markets and 2-year CPI swaps are 20bps above 20-year CPI swaps (Chart 12). From 2012 to 2020, 20-year CPI swaps stood between 30 bps and 150 bps above short maturity ones. Second, a steeper inflation curve, along with greater inflation risk toward the end of the decade will cause the European term premium to normalize from its -1.21% level. This will allow German 10-year yields to rise and the European yield curve to steepen (Chart 13). Chart 12Long-Term Inflation Expectations Have Upside Long-Term Inflation Expectations Have Upside Long-Term Inflation Expectations Have Upside Chart 13A Steeper German Yield Curve A Steeper German Yield Curve A Steeper German Yield Curve Third, higher German yields and a steeper curve will greatly benefit European banks (Chart 14, top panel). This pattern will be especially evident against insurance firms, which have massively outperformed deposit-taking institutions over the past seven years as yields fell (Chart 14, bottom panel). Additionally, banks’ balance sheets have become more robust than they once were and NPLs are unlikely to rise meaningfully as a result of government guarantees and easy fiscal policy (Chart 15). Investors should go long bank/short insurance on a cyclical basis. Chart 14Long Bank / Short Insurance Long Bank / Short Insurance Long Bank / Short Insurance Chart 15Imporving Balance Sheets Imporving Balance Sheets Imporving Balance Sheets A Tactical Buying Opportunity In European High-Yield Corporate Bond Market Chart 16Tactical Buying Opportunity Tactical Buying Opportunity Tactical Buying Opportunity The 40 basis points widening in European high-yield spreads has created a tactical buying opportunity. Inflation fears spurred by rising energy prices and by input prices are the likely culprit behind the recent spread widening (Chart 16). Although US junk spreads have already narrowed significantly, European high-yield corporate bond spreads are still 40 bps wider than at the beginning of September.     The 12-month breakeven spread, which measures the degree of spread widening required over a 12-month period for corporate bond returns to break even with a duration-matched position in government bond securities, now ranks at its 20th percentile, from 10th (Chart 16, second panel). Spreads will narrow back to near post-crisis lows before year-end on both an absolute and breakeven basis: First, monetary and fiscal policy remain very accommodative. Importantly, Spain and Italy will receive large shares of the NGEU funds until 2026. Second, growth will remain above trend despite recent inflation worries. Third, the European default rate is still falling, leaving the worst of the default cycle behind (Chart 16, third panel). Finally, our bottom-up Corporate Health Monitor signals improving corporate health, which historically coincides with narrowing spreads (Chart 16, bottom panel). Bottom Line: The recent widening in European high-yield spreads represents a short window of opportunity to buy the dip. Beyond this timeframe, a more cautious approach toward European credit is appropriate, as the ECB will become less active in the bond market. A French Update Chart 17 Last month, French President Emmanuel Macron unveiled a EUR30 billion investment plan aimed at supporting and fostering industrial and tech “champions of the future.” This new plan comes on top of the EUR100 billion recovery package that was announced in September 2020 to face the pandemic. While these investments will be made across many sectors of the French economy, the focus will be the French tech and energy sectors (Chart 17, top panel). This announcement comes six months before the next presidential election and amid the emergence of Eric Zemmour as a potential far-right candidate. However, Zemmour’s candidacy is unlikely to alter our expectation that Macron will be re-elected in 2022. Recent polls that include Zemmour as a potential candidate in the first-round show that he is appealing to Marine Le Pen’s voter base (Chart 17, bottom panel). Meanwhile, former Prime Minister Edouard Philippe—who would have made a formidable opponent to Macron had he decided to run—announced the creation of his own party with the objective of supporting Macron’s re-election campaign. Chart 18Recent Developments Support These Trades Recent Developments Support These Trades Recent Developments Support These Trades These political developments come as the French health and economic picture keeps improving. Although the vaccination pace has slowed in France, 68% of the population is fully vaccinated and 76% of the population has received at least one dose. Thus, the healthcare system continues to weather well recent COVID waves. Moreover, business confidence remains robust and reached its highest reading since July 2007, despite supply issues holding back production. The French jobs market is also recovering, with the unemployment rate expected to fall to 7.6% in Q3 from 8% in Q2. The introduction of a new investment plan, the emergence of a far-right candidate and Edouard Philippe’s newfound support, and the COVID-19 and economic developments bode well for President Macron’s chances at re-election. This implies additional French reforms over the next five years that aim to suppress unit labor costs and to make French exports more competitive vis-à-vis their main competitor, Germany. As a result, investors should overweight French industrial stocks relative to German ones (Chart 18, top panel). Meantime, additional investment in the French tech is bullish for a sector that is inexpensive relative to its European peers. Overweight French tech equities relative to European ones (Chart 18, panel 2 and 3).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations To Hike Or Not To Hike? To Hike Or Not To Hike? Cyclical Recommendations To Hike Or Not To Hike? To Hike Or Not To Hike? Structural Recommendations To Hike Or Not To Hike? To Hike Or Not To Hike? Closed Trades Image Currency Performance Fixed Income Performance Equity Performance

Highlights Energy Prices & Bond Yields: Surging energy prices are lifting inflation expectations in the US and Europe, while at the same time dampening consumer confidence amid diminished perceptions of real purchasing power. These conflicting trends are putting central banks in a tricky spot in the near-term, but tightening labor markets will force a more enduring need for dialing back global monetary accommodation in 2022, led by the Fed and the Bank of England. Stay below-benchmark on global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. High-Yield: Trans-Atlantic junk bond performance has diverged of late, with euro area spreads widening versus the US. This is a temporary distortion created by the pop in oil prices, with the Energy sector that benefits from higher oil prices representing a far greater share of the high-yield universe in the US compared to Europe. Maintain an overweight stance on European high-yield corporates. Feature Chart of the WeekGlobal Bond Yield Breakout? Global Bond Yield Breakout? Global Bond Yield Breakout? It is not easy being an inflation-targeting central bank these days. Soaring energy prices, with the Brent crude benchmark price climbing to a 3-year high of $86/bbl last week and natural gas prices up nearly four-fold year-to-date in Europe. These moves are adding upward pressure to inflation rates already elevated because of disrupted supply chains and rising labor costs. Government bond yields in the developed markets are moving higher in response, driven by rising inflation breakevens and increasing central bank hawkishness that is causing a stir in negative real yields (Chart of the Week). Among the three most important developed economy central banks - the Fed, the ECB and the Bank of England (BoE) – the most forceful signaling of a need for tighter policy is surprisingly coming from Threadneedle Street in London, home to one of the most dovish central banks since the 2008 crisis. Numerous BoE officials, including Governor Andrew Bailey, have strongly hinted that UK rate hikes could begin as soon as next month’s policy meeting. Fed officials have suggested a similar timetable for the start of the QE taper. By contrast, members of the ECB Governing Council have paid lip service to the recent sharp pickup in euro area inflation but, for the most part, have stuck to the view that it will not last long enough to justify a policy response. The relative hawkishness among “The Big Three” central banks fits with our current recommended strategy on global duration exposure, staying below-benchmark, and country allocation, with the largest underweights to US Treasuries and UK Gilts. Should Central Banks Focus More On Inflation Or Growth? Monetary policymakers are in a difficult spot at the moment. Rising energy prices have breathed new life into inflation, and inflation expectations, even as global growth momentum has cooled off somewhat. Given the magnitude and breadth of the global energy price surge – even coal prices in China have shot up 120% since late August - it will be difficult for central bankers to “see through” the inflationary implications and worry more about growth (Chart 2). Rising energy prices are likely to extend the current global inflation upturn that has already gone on for longer than expected because of supply-chain disruptions. This raises the risk that consumers could turn more cautious on spending behavior if they have to devote more of their incomes just to fuel their cars or heat their homes. In the US, this dynamic already appears to be playing out. The acceleration of inflation has broadened out, with the Cleveland Fed’s trimmed mean CPI inflation measure (which removes the most volatile components of the CPI) rising to 3.5% in September (Chart 3, top panel). With US consumers seeing higher prices on a wider range of goods and services, they have raised their inflation expectations. The preliminary October University of Michigan US consumer confidence survey showed that 1-year-ahead inflation expectations rose to a 13-year high of 4.8% (middle panel). Chart 2Pouring Gas On Global Inflation Pouring Gas On Global Inflation Pouring Gas On Global Inflation The New York Fed’s consumer survey showed a similar 1-year-ahead inflation forecast (5.3%), which is well above the forecast for income growth in 2022 (2.9%). Combining those two measures shows that US consumers implicitly see a contraction in their real incomes over the next 12 months. Chart 3US Consumers Expect A Sharp Decline In Real Purchasing Power US Consumers Expect A Sharp Decline In Real Purchasing Power US Consumers Expect A Sharp Decline In Real Purchasing Power This has likely played a big role in the sharp fall in the University of Michigan consumer confidence index since the peak back in June (bottom panel), despite favorable US labor market conditions. US consumer perceptions of inflation appear much greater than the reality of inflation evident in the official price indices. The New York Fed survey also asks US consumers what their 1-year-ahead expectations are for major spending categories, like food or rent (Chart 4). Consumers expect somewhat slower inflation for food (7.0%) and gasoline (5.9%) over the next year, yet they also expect much higher medical care costs (9.4%) and rent (9.7%). For the latter two, those are considerably higher than the latest actual inflation rates seen in the US CPI (2.4% for rent, 0.4% for medical care) or PCE deflator (2.1% for rent, 2.4% for medical care). Taking these survey results at face value, it is likely that US consumers are overestimating how much their real incomes will suffer next year from higher inflation. This is especially true as US household income growth will likely surpass the 2.9% estimate seen in the New York Fed survey. Yet that does not preclude the Fed from starting to turn more hawkish. Central bankers are always on the lookout for signs that higher realized inflation is feeding through into rising inflation expectations, which could require a policy tightening response to prevent an overshoot of inflation targets. The Fed has given itself a bit more leeway in that regard by altering their policy framework to allow temporary deviations of inflation from the central bank targets. The BoE, however, has not given itself the same sort of flexibility, which is why it is now signaling an imminent rate hike in response to survey-based inflation expectations, and breakeven inflation rates on longer-dated index-linked Gilts, climbing to close to 4% (Chart 5). Yet even the Fed, with its Average Inflation Targeting framework, has signaled that a tapering of its bond purchases will likely begin by year-end. Chart 4US Consumer Inflation Expectations Well Above Actual Inflation US Consumer Inflation Expectations Well Above Actual Inflation US Consumer Inflation Expectations Well Above Actual Inflation Markets are looking at the persistence of high inflation and have priced in a more hawkish trajectory for interest rates in the US, UK and even Europe over the next 12-24 months (Chart 6, bottom panel). Chart 5Inflation Weighing On UK & European Consumer Confidence Inflation Weighing On UK & European Consumer Confidence Inflation Weighing On UK & European Consumer Confidence Real bond yields in those regions are also starting to move higher in response to rising rate expectations (third panel) - a bond-bearish dynamic that we have discussed at length in recent reports.1 Between those three, the BoE’s hawkish turn has hammered the Gilt market the hardest. Yet there has definitely been a spillover into rate expectations and bond yields in other countries on the back of the BoE guidance. We have already seen rate hikes from smaller developed market central banks, Norway and New Zealand, over the past month. If a major central bank like the BoE soon follows suit because of overshooting inflation expectations, then markets are justified in thinking that the Fed or even the ECB could be next. Of those “Big 3” central banks, we see the ECB as being the least likely to respond to the current inflation upturn with rate hikes in 2022. There is simply not enough evidence suggesting that the energy/supply-chain driven inflation in the euro area is broadening out into other parts of the economy on a sustainable basis. Furthermore, there is already some degree of monetary tightening “scheduled” in 2022 when the ECB’s pandemic bond purchase program expires in March. The ECB will not want to compound that by moving into rate hiking mode soon after. On the other hand, the Fed will likely see enough further tightening of US labor market conditions to begin hiking rates in the fourth quarter of 2022 (Chart 7). In the UK, After next month’s likely rate hike, the BoE will need to deliver at least another 50-75bps of additional hikes in 2022 and likely more in 2023 with real policy rates already well below neutral before the latest spike in energy prices. Chart 6Expect Higher Real Yields As Central Banks Turn More Hawkish Expect Higher Real Yields As Central Banks Turn More Hawkish Expect Higher Real Yields As Central Banks Turn More Hawkish Chart 7Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 Labor Markets, Not Commodities, Will Dictate Monetary Policy In 2022 With the Fed and BoE set to be far more hawkish than the ECB next year, we see greater risks of government bond yields rising faster, and higher than current forward rates, in the US and UK compared to the euro area (Chart 8). This justifies an overall cautious strategic stance on duration exposure in global bond portfolios. With regards to inflation-linked bonds, however, we recommend only a neutral overall stance. Elevated inflation breakevens have converged to, or even above, central bank inflation targets in all developed market economies (excluding Japan). 10-year UK breakevens, in particular, look very expensive on our fair value model (Chart 9). Chart 8Our Recommended "Big 3" Country Allocations Our Recommended 'Big 3' Country Allocations Our Recommended 'Big 3' Country Allocations Chart 9Maintain An Overall Neutral Stance On Inflation-Linked Bonds Maintain An Overall Neutral Stance On Inflation-Linked Bonds Maintain An Overall Neutral Stance On Inflation-Linked Bonds Bottom Line: Our view on the policy decisions of the Big 3 central banks in 2022 informs our strategic (6-18 months) investment strategy within those markets. Stay below-benchmark on overall global duration exposure, favoring euro area government debt over US Treasuries and UK Gilts. Fade The Recent Backup In European High Yield Spreads Chart 10A Slight Pickup In European Junk Spreads A Slight Pickup In European Junk Spreads A Slight Pickup In European Junk Spreads Corporate credit markets in the US and Europe have calmed down since the July/August “Delta fueled” selloff with one notable exception – European high-yield (HY). The Bloomberg European HY index spread now sits 39bps above the September low, noticeably diverging from the US HY index spread (Chart 10). We view those wider spreads as a tactical buying opportunity for European junk bonds, both in absolute terms and versus US junk bonds. The recent underperformance appears rooted in soaring European energy prices. The spread widening has been concentrated in European consumer sectors (both cyclicals and non-cyclicals) that would be more exposed to the drain on real incomes from booming natural gas prices. Energy is also a smaller part of the European high-yield index (2%) compared to the US HY index (13%), which helps explain the performance gap with the US – the US index is more exposed to companies that benefit from higher energy prices (Chart 11). Chart 11Sectoral Breakdown Of US & Euro Area High-Yield Indices Central Banks Backed Into A Corner Central Banks Backed Into A Corner Over a more medium-term perspective, there is little reason why there should be a meaningful performance difference between US and European HY. The path of spreads and excess returns (versus duration-matched government debt) for the two markets have been highly correlated in recent years (Chart 12). When adjusting European HY returns to allow a proper apples-to-apples comparison to US HY – by hedging European returns into US dollars and controlling for duration differences between the two markets – there has been little sustained difference in returns dating back to 2018. Chart 12Euro Area HY Has Closed The Gap Vs. The US Euro Area HY Has Closed The Gap Vs. The US Euro Area HY Has Closed The Gap Vs. The US Chart 13Junk Default Rates Will Stay Low In 2022 Central Banks Backed Into A Corner Central Banks Backed Into A Corner More fundamentally, there is little difference in default rates that would justify a major divergence of HY spreads on both sides of the Atlantic. Moody’s is forecasting a HY default rate for a rate of 2% in both the US and Europe for 2022 (Chart 13). Such similar default rate expectations make sense with economic growth likely to remain well above trend in 2022 in both the US and Europe. Higher inflation will also boost nominal GDP growth, helping lift corporate revenues and the ability to service debt. From a valuation perspective, there is also little to choose from between European and US HY: The default-adjusted spread, which takes the current HY index spread and subtracts expected default losses over the next twelve months, is 196bps in Europe and 166bps in the US (Chart 14). While those spreads are below the post-2000 mean in both markets, they are still above past valuation extremes. The percentile ranking of 12-month breakeven spreads (the amount of spread widening over one year that would eliminate the yield advantage of HY over duration-matched government bonds) are also similar, 25% for European HY and 26% for US HY (Chart 15). These suggest HY spreads are not particularly “cheap”, from a historical perspective, in either market, but they could move lower to reach previous historical extremes. Chart 14Low Expected Default Losses Supporting HY Valuations Low Expected Default Losses Supporting HY Valuations Low Expected Default Losses Supporting HY Valuations Chart 15Overall HY Spreads Are Tight In The US & Europe Overall HY Spreads Are Tight In The US & Europe Overall HY Spreads Are Tight In The US & Europe Chart 16Euro Area Ba-Rated HY Spreads Look More Attractive Central Banks Backed Into A Corner Central Banks Backed Into A Corner Summing it all up, there is no discernable reason why European HY should trade at a sustainably wider spread to US HY, outside of the compositional issue related to the weight of the Energy sector in both markets. When breaking down the two markets by credit rating buckets, European Ba-rated corporates even look more attractive versus similarly-rated US corporates, based on 12-month breakeven spread percentile rankings (Chart 16). Bottom Line: Maintain a strategic overweight stance on European high-yield corporates, and tactically position for some relatively better performance of European junk bonds versus US equivalents.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "What If Higher Inflation Is Not Transitory?", dated September 23, 2021, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning   Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Central Banks Backed Into A Corner Central Banks Backed Into A Corner The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Spread Product: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market & Fed: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. The Treasury curve will bear-flatten as that outcome is priced in. Duration: Investors should maintain below-benchmark portfolio duration with an expectation that the 10-year Treasury yield will reach a range of 2%-2.25% by the time of Fed liftoff in December 2022. Feature Chart 1A December Debt Ceiling Debate A December Debt Ceiling Debate A December Debt Ceiling Debate The creditors of the United States government can breathe a little easier, at least for a couple of months, as Congress reached an agreement last week to punt debt ceiling negotiations until December. T-bills maturing this month reacted sharply to price-out the risk of technical default, though December bill yields have already started to push higher in anticipation of more turmoil (Chart 1). Of course, the political incentives to lift the debt ceiling will be the same in December as they are today, and Congress will ultimately act to avert economic disaster.1 Financial markets seem to realize this, and Treasury note and bond yields have been unphased by the drama. Instead, Treasury yields have moved higher in recent weeks alongside other indicators of optimism surrounding economic reflation and re-opening (Chart 2). However, there is one troubling signal from financial markets that warrants further investigation. Corporate bonds (both investment grade and high-yield) have underperformed duration-matched Treasuries so far in October, even as Treasury yields have moved higher (Chart 3). Typically, Treasury yields and corporate bond spreads are negatively correlated – spreads tighten as Treasury yields rise, and vice-versa – so it is notable when the correlation flips. Chart 2The Reflation Trade Is Back The Reflation Trade Is Back The Reflation Trade Is Back Chart 3Bad Times For Bonds Bad Times For Bonds Bad Times For Bonds   The next section of this report explores the economic drivers of the yield/spread correlation and considers whether the flip to a positive yield/spread correlation signals anything about future corporate bond performance. An Examination Of The Yield/Spread Correlation The simple economic explanation for the negative yield/spread correlation is that an improved economic outlook leads to both a better environment for credit risk (i.e. tighter corporate bond spreads) and the expectation that higher interest rates will be needed to cool the economy in the future (i.e. higher Treasury yields). With that in mind, when spreads and yields both rise at the same time it usually means that the Fed is “over-tightening”. That is, tightening monetary policy so much that the near-term credit environment is deteriorating. This could be because the Fed is making a policy mistake – tightening into an economic slowdown – or because inflation is high enough that the Fed is deliberately slowing growth in an effort to bring down prices. A Technical Examination Looking at the history of monthly changes in Treasury index yields and High-Yield index spreads since 1994, we see that it is quite unusual for yields and spreads to both rise in the same month (Chart 4). In fact, monthly yield and spread changes are negatively correlated 65% of the time and have only risen together in 15% of the months since 1994. Chart 4Monthly Junk Spread Changes Versus Monthly Treasury Yield Changes Since 1994 An Early Warning Sign For Spreads An Early Warning Sign For Spreads Second, we observe in Chart 4 that almost all months of large spread widening or tightening occur against the back-drop of a negative yield/spread correlation. This shouldn’t be too surprising. The worst months for corporate bond performance occur during economic recessions when the Fed is cutting interest rates. Conversely, the best months for corporate bond performance occur just after the recession-peak in spreads when the Fed has finished cutting rates and the economic recovery is starting up. Tables 1A and 1B delve deeper into the return numbers. Table 1A shows average High-Yield excess returns over different investment horizons following a signal from the yield/spread correlation. For example, the second row shows that after a month when both Treasury yields and junk spreads rise, high-yield bonds deliver average excess returns of 24 bps during the following 3 months, 116 bps during the following 6 months and 75 bps during the following 12 months. Table 1B provides even more detail by showing 90% confidence intervals for each number. Table 1AAverage High-Yield Excess Returns After A Signal From Yield/Spread Correlation An Early Warning Sign For Spreads An Early Warning Sign For Spreads Table 1BHigh-Yield Excess Returns After A Signal From Yield/Spread Correlation: 90% Confidence Intervals An Early Warning Sign For Spreads An Early Warning Sign For Spreads We draw two conclusions from this analysis. First, a month when spreads widen and yields fall sends the worst signal for near-term (3-month) corporate bond performance, though a month where both yields and spreads rise is a close second. Second, and most relevant for the current market, a month when yields and spreads rise together sends the worst signal for junk bond performance over the following 12 months. In fact, it is the only signal where the 90% confidence interval shows the chance of negative excess returns during the following 12 months. This second conclusion aligns with our intuition. A period of both rising Treasury yields and junk spreads likely signals that the market is pricing-in some move toward a tighter monetary policy stance, though not a severe enough move to send long-maturity Treasury yields down. This is most likely to occur in the very early stages of a monetary tightening cycle, when monetary conditions are still accommodative but recent shifts in Fed policy suggest that they will become more restrictive down the road. A Historical Examination A look back through history confirms our analysis of when yields and spreads tend to rise concurrently. The solid line in the third panel of Chart 5 shows the number of months when both junk spreads and Treasury yields rose out of the most recent trailing 12-month period. The dashed line shows the same measure over the trailing 3-month period, multiplied by 4 to put it on the same scale as the solid line. A spike in these lines indicates that Treasury yields and junk spreads were rising at the same time. Chart 5Rising Yields And Spreads Is A Warning Signal For Monetary Tightening Rising Yields And Spreads Is A Warning Signal For Monetary Tightening Rising Yields And Spreads Is A Warning Signal For Monetary Tightening We identify four relevant historical periods. First, yields and spreads rose concurrently during the 1999/2000 Fed tightening cycle. Specifically, yields and spreads rose together in the early stages of the tightening cycle, then spreads continued to widen as yields fell during the 2001 recession. Second, our indicator showed a couple blips higher during the 2004/06 tightening cycle, though corporate bond returns were solid during this period, at least until after the tightening cycle ended and the recession began. Third, the 2013 taper tantrum coincided with a temporary increase in both yields and spreads as investors worried that the Fed was moving too quickly toward rate hikes. Fourth, yields and spreads both moved higher in 2015 as the Fed was heading toward a December 2015 rate hike against a back-drop of slowing economic growth. Turning to today, we view the recent jump in our indicator as similar to the jump seen during the 2013 taper tantrum. Not only is the Fed once again about to taper asset purchases, but the tapering of asset purchases suggests that the Fed’s next move will be a rate hike at some point down the road. We view this as an early warning sign for corporate bond spreads. While the monetary environment remains supportive for positive corporate bond returns for now, this may not be true by this time next year when the Fed is that much closer to liftoff. Bottom Line: Investors should stay overweight spread product versus Treasuries for now (with a preference for high-yield corporates over investment grade). But recent shifts in the yield/spread correlation suggest that the credit cycle is getting a bit long in the tooth. We will be quick to recommend a reduction in spread product exposure once the monetary tightening cycle is more advanced and the 3-year/10-year Treasury slope flattens to below 50 bps. We expect this could occur in the first half of 2022. Labor Market Update: Still On Track For November Taper And December 2022 Liftoff Chart 6Employment Growth Slowed in September Employment Growth Slowed in September Employment Growth Slowed in September September’s employment report delivered a disappointing headline number, with nonfarm payrolls growing only 194 thousand on the month compared to a consensus estimate of 500k (Chart 6). The details of the report were slightly better: August’s nonfarm payroll growth number was revised higher, our measure of the unemployment rate adjusted for distortions in the number of people employed but absent from work fell from 5.5% to 4.9% (Chart A1) and average hourly earnings rose at an annualized monthly rate of 7.7% (Chart 6, bottom panel). Expect A November Taper For bond investors, the most pressing question is whether the report is bad enough to delay the Fed’s tapering announcement past November. We doubt it. The Fed’s test for when to taper asset purchases, that it gave itself last December, is “substantial further progress” back to pre-COVID levels of employment. Since December 2020, total nonfarm payroll employment is 50% of the way back to its February 2020 level (Chart 7) and there are several good reasons to believe that employment growth will be much stronger in October and November. First, the delta wave of COVID cases clearly weighed on employment growth in September, much like it did in August. The Leisure & Hospitality sector only added 74 thousand jobs in September, compared to an average monthly pace of 349 thousand jobs between February and July of this year before the delta wave struck. With a shortfall of almost 1.6 million Leisure & Hospitality jobs compared to pre-COVID levels (Table 2), job growth in this sector will bounce back sharply during the next few months now that new COVID cases are receding (Chart 8). Chart 7"Substantial Further Progress" Has Been Made "Substantial Further Progress" Has Been Made "Substantial Further Progress" Has Been Made Chart 8Delta Wave Has Crested Delta Wave Has Crested Delta Wave Has Crested   Second, the last column of Table 2 shows that the government sector accounted for net job loss of 123 thousand in September. This negative number was driven by state & local government education jobs and is almost certainly a statistical artifact. According to the Bureau of Labor Statistics’ release notes: Recent employment changes [in state & local government education] are challenging to interpret, as pandemic-related staffing fluctuations in public and private education have distorted the normal seasonal hiring and layoff patterns. Table 2Employment By Industry An Early Warning Sign For Spreads An Early Warning Sign For Spreads Expect December 2022 Liftoff As for what this labor market report means for when the Fed will start lifting rates, we believe that we are still on track for liftoff in December 2022. The Appendix to this report updates our scenarios that show the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and labor force participation rates by specific future dates. If we use the median assumption from the New York Fed’s Survey of Market Participants that the Fed will lift rates when the unemployment rate is 3.5% and the participation rate is 63%, we calculate that average monthly nonfarm payroll growth of +453k is required to reach those targets by the end of 2022. We see that threshold as eminently achievable.2 Bottom Line: September’s employment report likely doesn’t alter the Fed’s timeline. The Fed is still on track to announce a tapering of its asset purchases next month and we expect employment growth will be sufficiently strong for the Fed to start hiking rates in December 2022. Investors should maintain below-benchmark portfolio duration and hold Treasury curve flatteners in anticipation of that outcome. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.8% and a participation rate of 62.8%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +453k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date An Early Warning Sign For Spreads An Early Warning Sign For Spreads Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date An Early Warning Sign For Spreads An Early Warning Sign For Spreads Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date An Early Warning Sign For Spreads An Early Warning Sign For Spreads Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents An Early Warning Sign For Spreads An Early Warning Sign For Spreads Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Footnotes 1 For more details on the politics of the debt ceiling please see US Political Strategy Weekly Report, “The House Ways And Means Tax Plan”, dated September 15, 2021. 2 For a discussion about what unemployment and participation rate targets to use in this analysis please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

  Highlights Chart 1Bond Yields Still Track The "Re-Opening" Trade Bond Yields Still Track The "Re-Opening" Trade Bond Yields Still Track The "Re-Opening" Trade Bond yields rose notably in September, with the bulk of the move coming in the days after the Fed teased an upcoming tapering of its asset purchases and revealed slightly hawkish revisions to its interest rate projections. Interestingly, some of the details of the bond market move don’t mesh nicely with the mildly hawkish policy surprise that the Fed delivered. For example, the Treasury curve steepened on the month and long-maturity TIPS breakeven inflation rates rose. Our sense is that September’s market moves were less driven by the Fed and more by a revival of the reflation (or re-opening) trade from earlier this year. The daily new US COVID case count ticked down and, while overall S&P 500 returns were negative on the month, a basket of equities designed to profit from the end of the pandemic soundly beat a basket of “COVID winners” (Chart 1). With the delta COVID wave receding, we remain confident that economic growth will be sufficiently strong for the Fed to launch a new rate hike cycle in December 2022. The Treasury curve will bear-flatten as that outcome gets priced in.   Feature Table 1Recommended Portfolio Specification A Bout Of Reflation A Bout Of Reflation Table 2Fixed Income Sector Performance A Bout Of Reflation A Bout Of Reflation Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to +193 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 99 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report presented the results of a scenario analysis for investment grade corporate bond returns during the next 12 months.1 We concluded that investment grade corporate bond total returns will be close to zero or negative during the next 12 months and that excess returns versus duration-matched Treasuries are capped at 85 bps. With that in mind, we advise investors to seek out higher returns in junk bonds, municipal bonds and USD-denominated Emerging Market sovereign and corporate bonds. We also recommend favoring long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Bout Of Reflation A Bout Of Reflation Table 3BCorporate Sector Risk Vs. Reward* A Bout Of Reflation A Bout Of Reflation High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 53 basis points in September, bringing year-to-date excess returns up to 558 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first eight months of the year, well below the estimate generated by our macro model. Another recent report considered different plausible scenarios for junk bond returns during the next 12 months.4 We concluded that junk bond total returns will fall into a range of -0.29% to +1.80% during the next 12 months and that excess returns versus duration-matched Treasuries will be between +0.94% and +1.84%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in September, bringing year-to-date excess returns up to -43 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 19 bps in September. The spread is wide compared to recent history, but it remains tight compared to the recent pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) tightened 6 bps in September to reach 31 bps (panel 3). This is above the 22 bps offered by Aaa-rated consumer ABS but below the 52 bps offered by Aa-rated corporate bonds and the 33 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 15 basis points in September, dragging year-to-date excess returns down to +69 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 95 bps in September, dragging year-to-date excess returns down to -87 bps. Foreign Agencies outperformed the Treasury benchmark by 5 bps on the month, bringing year-to-date excess returns up to +49 bps. Local Authority bonds outperformed by 24 bps in September, bringing year-to-date excess returns up to +406 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to +24 bps. Supranationals underperformed by 4 bps, dragging year-to-date excess returns down to +27 bps. Last week’s report looked at performance and valuation trends for Emerging Market sovereign and corporate bonds relative to US corporates.6 The recent underperformance of EM bonds versus US corporates has led to attractive relative valuations in the sector. We see investment grade EM sovereign and corporate bonds both outperforming investment grade US corporates during the next 12 months. The outperformance will be the result of better starting valuations and an acceleration of EM growth in 2022. The bonds of Colombia, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar look particularly attractive within the USD-denominated EM sovereign space. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in September, bringing year-to-date excess returns up to +292 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 Both General Obligation (GO) and Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporate bonds with the same credit rating and duration (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in September, with yields moving sharply higher – especially in the 5-10 year maturity space. The 2-year/10-year Treasury slope steepened 14 bps to end the month at 124 bps. The 5-year/30-year slope flattened 5 bps to end the month at 110 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 2.08%, the 5-year/5-year forward Treasury yield is already within our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.30% in one year’s time and 1.62% in five years (Chart 7). The latter rate has 131 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 256 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in September, bringing year-to-date excess returns up to +627 bps. The 10-year TIPS breakeven inflation rate rose 3 bps on the month, while the 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps. At 2.41%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to a steepening of the inflation curve (bottom panel). We recommend that investors position for a steeper 2/10 inflation curve, or alternatively for a flatter 2/10 real Treasury curve. We noted in last week’s report that the combination of nominal curve flattening and inflation curve steepening will lead to a large flattening of the 2/10 real curve during the next 6-12 months.9The 2-year TIPS yield, in particular, has a lot of upside.                         ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent nominal Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +43 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +32 bps. Non-Aaa ABS outperformed by 7 bps, bringing year-to-date excess returns up to +99 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum.     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 2 basis points in September, bringing year-to-date excess returns up to +195 bps. Aaa Non-Agency CMBS outperformed Treasuries by 4 bps in September, bringing year-to-date excess returns up to +96 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 4 bps on the month, dragging year-to-date excess returns down to +525 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +94 bps. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 33 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -17 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 flattens by less than 17 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 Bout Of Reflation A Bout Of Reflation Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of September 30th, 2021) A Bout Of Reflation A Bout Of Reflation Footnotes 1  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2  Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3  Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5  Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 7  Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8  Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 9  Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021.