Inflation Protected

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum ​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates ​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) ​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit ​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe ​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure ​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense

Highlights Chart 1Are Expectations Too Dovish? Are Expectations Too Dovish? Are Expectations Too Dovish? The dominant market narrative has clearly shifted in the last few days. The primary concern among investors used to be that the Fed had fallen behind the curve on inflation. Now, asset prices are telling us that investors are more worried about an overly hawkish Fed and an increased risk of recession. The shift is evident in bond market prices. The yield curve is now priced for only 176 basis points of rate hikes over the next 12 months and only 90 bps of tightening over the next 24 months (Chart 1). What’s more, long-dated market-based inflation expectations have plunged to below the Fed’s target range (bottom panel). We recommend keeping portfolio duration close to benchmark for now, as bond yields could still have some downside during the next few months as both inflation and economic growth slow. That said, we suspect that the market is now pricing-in an overly dovish Fed tightening path for the next couple of years, a change that may soon warrant a shift back to below-benchmark portfolio duration. Stay tuned. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance A Narrative Shift A Narrative Shift Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 168 basis points in June, dragging year-to-date excess returns down to -379 bps. The average index option-adjusted spread widened 28 bps on the month and it currently sits at 158 bps. Similarly, our quality-adjusted 12-month breakeven spread moved up to its 61st percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve is very flat, signaling that we are in the mid-to-late stages of the credit cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Despite our underweight 6-12 month investment stance, there’s a good chance that spreads will narrow during the next few months as inflation falls. That said, the persistent removal of monetary accommodation and flatness of the yield curve will limit how much spreads can compress. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* A Narrative Shift A Narrative Shift High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 591 basis points in June, dragging year-to-date excess returns down to -889 bps. The average index option-adjusted spread widened 172 bps on the month to reach 578 bps, 209 bps above the 2017-19 average and 41 bps above the 2018 peak. 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 – moved higher in June. It currently sits at 8% (Chart 3). As is the case with investment grade, there’s a good chance that high-yield spreads will stage a relief rally in the back half of this year as inflation falls. But due to the flatness of the yield curve, we think it will be difficult for spreads to move below the average seen during the last tightening cycle (2017-19). But even a move back to average 2017-19 levels would equate to roughly 11% of excess return for the junk index if it is realized over a six month period. This potential return is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we would be inclined to downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to 4%.3  MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 63 basis points in June, dragging year-to-date excess returns down to -171 bps. We discussed the outlook for Agency MBS in a recent report.4 We noted that MBS’s poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates (panel 4). The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (bottom panel). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. Given that we see some potential for yields to fall during the next six months, we recommend favoring low-coupon MBS (1.5%-2.5%) within an overall underweight allocation to the sector. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 182 basis points in June, dragging year-to-date excess returns down to -737 bps. EM Sovereigns underperformed the Treasury benchmark by 280 bps on the month, dragging year-to-date excess returns down to -925 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 122 bps, dragging year-to-date excess returns down to -617 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 99 bps in June. The yield differential between EM sovereigns and duration-matched US corporates remains negative. Further, the relative performance of EM sovereigns versus US corporates has been tracking the performance of EM currencies versus the dollar and our Emerging Markets Strategy service sees further headwinds for EM currencies in the near term (Chart 5).5  The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 1 bp in June. The index continues to offer a significant yield advantage versus duration-matched US corporates (bottom panel), and as such, we continue to recommend a neutral (3 out of 5) allocation to the sector.   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 89 basis points in June, dragging year-to-date excess returns down to -167 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong and yet governments have also been slow to hire.6  The result is that net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete these coffers even as economic growth slows and federal fiscal thrust turns to drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni / Treasury yield ratio is currently 94%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched US corporates is 92%. The same measure for 17-year+ Revenue bonds stands at 97%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2-year/10-year Treasury slope flattened 26 bps on the month and the 5-year/30-year slope flattened 13 bps. The 2/10 and 5/30 slopes now stand at 4 bps and 23 bps, respectively. In a recent Special Report we noted the unusually large divergence between flat slopes at the long end of the curve and steep slopes at the front end.7 This divergence has narrowed in recent weeks, but it remains wide by historical standards. For example, the 5-year/10-year Treasury slope is currently 0 bps while the 3-month/5-year slope is 122 bps. The divergence is happening because the market moved quickly to price-in a rapid near-term pace of rate hikes, but the Fed has only delivered 150 bps of tightening so far and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. The 5 over 2/10 butterfly spread has narrowed during the past month, but the trade continues to look attractive on our model (Chart 7). We also continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade.  TIPS: Underweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 246 basis points in June, dragging year-to-date excess returns down to -14 bps. The 10-year TIPS breakeven inflation rate fell 31 bps on the month, landing back inside the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Consistently, our TIPS Breakeven Valuation Indicator is drifting toward neutral territory, signaling that TIPS are becoming less expensive (panel 2). At the front-end of the yield curve, the 2-year TIPS breakeven inflation rate fell 57 bps in June – from 3.86% to 3.29% - and the 2-year TIPS yield rose 96 bps – from -1.33% to -0.37% (bottom 2 panels). The large drop in short-maturity breakevens is the result of increasing investor conviction that inflation has indeed peaked. In a recent report we made the case that core CPI inflation can fall to a range of 4%-5% (from its current 6.0% rate) without the Fed needing to cause a recession. We also argued that a recession will be required to push inflation from 4% back down to 2%.8 The upshot for bond investors is that TIPS breakeven inflation rates will drop further as core inflation rolls over. This will be particularly true at the front-end of the yield curve. We also noted in last week’s report that Fed policymakers have increasingly indicated a desire for positive real yields across the entire curve.9 This tells us that investors should continue to short 2-year TIPS, targeting a positive real 2-year yield.   ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 21 basis points in June, bringing year-to-date excess returns up to -42 bps. Aaa-rated ABS outperformed by 25 bps on the month, bringing year-to-date excess returns up to -33 bps. Non-Aaa ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to -93 bps. During the past two years, substantial federal government support for household incomes caused US households to build up an extremely large buffer of excess savings. Nowhere is this more evident than in the steep drop in the amount of outstanding credit card debt that was witnessed in 2020 and 2021 (Chart 9). In 2022, consumers have started to re-lever. The personal savings rate was just 5.4% in May and the amount of outstanding credit card debt has recovered to its pre-COVID level (bottom panel). But while household balance sheets are starting to deteriorate, they remain exceptionally strong in level terms. In other words, it will be some time before we see enough deterioration to cause a meaningful uptick in consumer credit delinquencies. 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: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in June, dragging year-to-date excess returns down to -194 bps. Aaa Non-Agency CMBS outperformed Treasuries by 12 bps on the month, bringing year-to-date excess returns up to -141 bps. Non-Aaa Non-Agency CMBS underperformed by 52 bps on the month, dragging year-to-date excess returns down to -340 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently slightly above their historic averages (Chart 10). Meanwhile, weak commercial real estate (CRE) investment continues to drive strong CRE price appreciation (panel 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 32 basis points in June, bringing year-to-date excess returns up to 9 bps. The average index option-adjusted spread tightened 3 bps on the month. It currently sits at 47 bps, close to its long-term average (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight.  Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 176 basis points of rate hikes during the next 12 months. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. A Narrative Shift A Narrative Shift Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of June 30, 2022) A Narrative Shift A Narrative Shift 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 June 30, 2022) A Narrative Shift A Narrative Shift 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 -9 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 9 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 Narrative Shift A Narrative Shift Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of June 30, 2022) A Narrative Shift A Narrative Shift Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2  Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3 For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 Please see Emerging Markets Strategy Charts That Matter, “Beware Of Another Downleg In Risk Assets”, dated June 30, 2022. 6 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 7 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. 8 Please see US Bond Strategy Weekly Report, “No End In Sight For Fed Tightening”, dated June 21, 2022. 9 Please see US Bond Strategy Weekly Report, “When Dual Mandates Clash”, dated June 28, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary An Optimal Control Policy An Optimal Control Policy An Optimal Control Policy We could see some modest near-term downside in Treasury yields as inflation rolls over during the next few months, but we caution against turning overly bullish on bonds even if you anticipate a recession. An optimal control approach to monetary policy tells us that the Fed should be willing to accept a significant increase in the unemployment rate to tame inflation. The implication is that the next recession may not be met with the dramatic easing of monetary policy we have become accustomed to. Short-maturity real yields remain deeply negative, but they will move into positive territory before the end of the economic cycle. Indicators of corporate balance sheet health are not flashing red, but they are moving in the wrong direction.   Bottom Line: Investors should keep portfolio duration close to benchmark, maintain a defensive posture on corporate bonds and short 2-year TIPS.   The Return Of Optimal Control Bonds rallied into the close last week and, as of Monday morning, their gains have only been partially unwound. The 2-year Treasury yield is down to 3.07% from its recent high of 3.45% and the 10-year yield is down to 3.16% from its recent high of 3.49% (Chart 1). The 2-year/10-year Treasury slope remains close to inversion at 9 bps (Chart 1, bottom panel). Increasingly, the message from the Treasury market is that the Fed is no longer playing catch-up to runaway inflation. Rather, the dominant market narrative is that the Fed may have to moderate its hiking pace to avoid an economic recession. With the unemployment rate at 3.6% and nonfarm payroll growth averaging +408k during the past three months, the US economy is clearly not in a recession today. That said, leading indicators are pointing to increased risk of a downturn within the next 12 months. For example, the S&P Global Manufacturing PMI fell sharply last week from 57.0 to 52.4 (Chart 2). The more widely tracked ISM Manufacturing PMI remains elevated at 56.1, but regional Fed surveys and trends in financial conditions suggest that the ISM could dip into contractionary territory during the next few months (Chart 2, bottom 2 panels). Chart 1Treasury Yields Treasury Yields Treasury Yields Chart 2Recession Risk Is Rising Recession Risk Is Rising Recession Risk Is Rising This is obviously a tricky situation for the Fed as there is a risk that its two mandates of price stability and maximum employment could come into conflict. Not surprisingly, the Fed has a playbook for these sorts of situations, one that was described by Janet Yellen as “optimal control” in a 2012 speech.1 Under an optimal control approach to policymaking the Fed specifies a loss function that is based on deviations of inflation from its 2% target and of the unemployment rate from its estimated full employment level. Understanding that it will be impossible to perfectly achieve both of its objectives, the Fed attempts to set policy so that the output of the loss function is minimized. One example of a simple loss function was given by St. Louis Fed President James Bullard in a speech from 2014.2 That function is as follows: Distance From Goals = (π – π*)2 + (μ - μ*)2 Where: π = inflation π* = The Fed’s target inflation rate μ = the unemployment rate μ* = The Fed’s estimate of the unemployment rate consistent with full employment Chart 3An Optimal Control Policy An Optimal Control Policy An Optimal Control Policy Let’s apply Bullard’s loss function to the present-day economic situation. The top panel of Chart 3 shows the square root of the function’s output. The Fed’s goal, of course, is to get that line as close to zero as possible. First, let’s see what happens if we input the median FOMC member’s forecast for core PCE inflation and the unemployment rate. That forecast has core PCE inflation falling to 4.3% by the end of this year and it has the unemployment rate edging up to 3.7%. Not surprisingly, this scenario leads to a modest improvement in Bullard’s loss function. Now let’s examine an alternative scenario where core PCE inflation falls to 4% by the end of the year but we set the loss function to remain at its current level. That outcome can be achieved even with the unemployment rate rising to 6.68%. This scenario is instructive. It tells us that, from an optimal control perspective, the Fed would be willing to tolerate an increase in the unemployment rate all the way up to 6.68% if it meant that inflation would fall back down to 4%. Why is this example important? It’s important because it gives us some perspective on what sort of labor market pain the Fed may be willing to tolerate to tame inflation. More specifically, there is a growing sense among some market participants that the US economy will soon fall into recession and that recessions are usually accompanied by Fed rate cuts. However, the magnitude of the increase in the unemployment rate that is shown in our alternative scenario would almost certainly be classified as a recession, but an optimal control perspective tells us that the Fed shouldn’t back away from tightening if that were to occur. The bottom line is that while we could see some modest near-term downside in Treasury yields as inflation rolls over during the next few months, we caution against turning overly bullish on bonds even if you anticipate a recession within the next 6-12 months. Given where inflation is today, there are strong odds that the Fed would respond to a rising unemployment rate by simply tempering its pace of rate hikes or perhaps temporarily pausing. Optimal control tells us that we would need to see an extremely large employment shock for the Fed to consider reversing course and cutting rates. Investors should stick with ‘at benchmark’ portfolio duration for the time being. A Quick Note On Real Yields   Chart 4Short 2-Year TIPS Short 2-Year TIPS Short 2-Year TIPS The 2-year real yield has risen to -0.70% from a 2021 low of -3.05%, but we have high conviction that it has further to run (Chart 4). At the press conference following the June FOMC meeting, Fed Chair Powell hinted that he viewed positive real yields across the entire Treasury curve as a reasonable intermediate-term goal. He then made similar claims when testifying before the Senate last week: It’s really only the very short end of the curve where our rates are still in negative territory from a real perspective. If you look further out, real rates are positive right across the curve and that’s really what you’re trying to achieve in a situation like this where we have 40 year highs in inflation.3 One way or another, we think it is highly likely that the Fed will achieve its goal of positive real yields across the entire curve. This could happen in a benign scenario where falling inflation expectations push short-maturity real yields higher. Or, it could happen in a more dramatic fashion where inflation expectations remain elevated but that only quickens the pace of Fed tightening. In that scenario, rising short-maturity nominal yields would drag real yields with them. Either way, investors should continue to hold outright short positions in 2-year TIPS. Corporate Health Check-Up In prior reports we noted the extremely good condition of corporate balance sheets, while also suggesting that balance sheet health would deteriorate going forward.4  An updated read on the status of corporate balance sheets suggests that conditions are still favorable, but much less so than even a few months ago. We begin with our Corporate Health Monitor (CHM), a composite indicator of six financial ratios calculated from the US National Accounts data for the nonfinancial corporate sector. This indicator was deep in “improving health” territory at the end of 2021, but it moved close to neutral in 2022 Q1 (Chart 5). Ratings trends, meanwhile, send a similar message. Through the end of May, upgrades continued to dramatically outpace downgrades in the investment grade space (Chart 5, panel 2), but the rate of net upgrades slowed somewhat in high-yield (Chart 5, bottom panel). Digging deeper, we find that the main culprit behind the CHM’s recent jump is a large drop in the ratio of Free Cash Flow to Total Debt (Chart 6). This drop occurred because after-tax cash flows held roughly flat in Q1 but capital expenditures surged, causing free cash flow to dip (Chart 6, panel 2). Chart 5Corporate Health Monitor Corporate Health Monitor Corporate Health Monitor Chart 6Capex Surged In Q1 Capex Surged In Q1 Capex Surged In Q1 This trend is confirmed by another important indicator of corporate balance sheet health, the financing gap. The financing gap is the difference between capital expenditures and retained earnings. A positive financing gap means that retained earnings are insufficient to cover capital expenditures and firms therefore have an incentive to tap debt markets. We see that the financing gap jumped sharply in Q1, from deeply negative into positive territory (Chart 7). Chart 7The Financing Gap Is Positive The Financing Gap Is Positive The Financing Gap Is Positive A positive financing gap on its own does not send a negative signal for corporate defaults. However, when a positive financing gap coincides with tightening lending standards, then an increase in the default rate becomes likely. For now, lending standards are close to unchanged (Chart 7, bottom panel), but there is a strong chance that continued Fed hiking will push them into ‘net tightening’ territory in the months ahead. Investment Implications Chart 8Attractive Value In HY Attractive Value In HY Attractive Value In HY Corporate balance sheet health isn’t quite flashing red, but it is certainly trending in the wrong direction. With continued Fed tightening likely to weigh on lending standards and interest coverage going forward, a defensive posture toward corporate bonds is warranted. We continue to recommend an underweight allocation (2 out of 5) to investment grade corporate bonds in US fixed income portfolios. We maintain a somewhat higher neutral (3 out of 5) allocation to high-yield bonds for the time being. This is because high-yield valuation is quite attractive, and we see potential for some near-term spread tightening as inflation rolls over (Chart 8). That said, the sector’s long-term return prospects are not good, and we will consider turning more defensive should the average high-yield spread narrow to its 2017-19 average or should core inflation move closer to our 4% target.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  https://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm 2 https://www.stlouisfed.org/from-the-president/-/media/project/frbstl/stlouisfed/files/pdfs/bullard/remarks/bullardowensborokychamberofcommerce17july2014final.pdf   3 https://www.c-span.org/video/?521106-1/federal-reserve-chair-jerome-powell-testifies-inflation-economy 4 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Calculating Trend Inflation Calculating Trend Inflation Calculating Trend Inflation Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition should occur later this year. Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession will eventually be required to push inflation from 4% down to the Fed’s 2% target. Economic growth will slow going forward, but we won’t see enough weakness for the Fed to abandon its tightening cycle within the next 6-12 months.       Bottom Line: US bond investors should keep portfolio duration close to benchmark, underweight TIPS versus nominal Treasuries and maintain a defensive posture on corporate bond spreads (underweight IG and neutral HY). The Fed Goes Big Chart 1Inflation Expectations Inflation Expectations Inflation Expectations The US Federal Reserve continued to prove its inflation-fighting mettle last week with a 75 basis point rate hike, the largest single-meeting increase since 1994. Chair Powell had initially telegraphed 50 basis point rate increases for both the June and July FOMC meetings, but he made it clear during last week’s press conference that the committee was spooked by May’s surprisingly high CPI number and by the recent jump in 5-10 year household inflation expectations (Chart 1). Alongside the 75 basis point rate hike, committee members revised up their fed funds rate forecasts. The median FOMC member now expects the funds rate to reach a range of 3.25% to 3.5% by the end of 2022. That is consistent with three more 50 basis point rate hikes and one more 25 basis point hike at this year’s four remaining FOMC meetings. Looking further out, the median committee member anticipates 25-50 bps additional upside in the fed funds rate in 2023 but is then forecasting a modest reduction in 2024. Critically, the fed funds rate is still expected to be above estimates of long-run neutral by the end of 2024. Chart 2 shows how current market expectations compare to the Fed’s forecasts. We see that, even after the Fed’s upward forecast revisions, the market still anticipates a somewhat faster pace of tightening this year. The market is also priced for rate cuts in 2023, likely due to the increasingly widespread expectation that a recession is coming within the next 12 months. Chart 2Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed Rate Expectations: Market Versus Fed The Fed’s Near-Term Plan As for what we can expect going forward, we found two comments from Chair Powell’s press conference particularly enlightening. First, he called last week’s 75 basis point rate increase “unusually large” and said that he “doesn’t expect moves of that size to be common.” Second, Powell said that the Committee will need to see “convincing” and “compelling” evidence of falling inflation before it starts to moderate its tightening pace.1 From these statements we deduce the following near-term plan: 1. The Fed’s baseline expectation is to lift rates by 50 bps at each meeting. 2.  A significant upside surprise in either the monthly core CPI data or long-dated inflation expectations would cause the Fed to lift by 75 bps instead of 50 bps. 3.  The Fed will not reduce the pace of tightening to 25 bps per meeting until there is clear and convincing evidence that inflation is trending down. Bottom Line: Investors should anticipate 50 basis point rate hikes at each FOMC meeting, eventually transitioning to 25 bps per meeting once inflation shows clear and convincing evidence of trending down. This transition from 50 bps per meeting to 25 bps per meeting should occur later this year, meaning that the Fed will tighten no more quickly than what is already priced into the yield curve for the remainder of 2022. Inflation: All Clear To 4%, 2% Will Be More Challenging It’s evident from the above discussion that inflation remains the critical input for both monetary policy and US bond yields. In particular, the key questions are: 1. Will inflation trend down, and if so, how quickly? 2. Is an economic recession required to curtail inflation? Our answer to these questions is that core US inflation should fall naturally to a trend rate of roughly 4-5%, even in the absence of recession. However, an economic recession and its associated labor market weakness are likely required to move inflation from 4% back to the Fed’s 2% target. Chart 3Calculating Trend Inflation Calculating Trend Inflation Calculating Trend Inflation To arrive at these conclusions, we seek out different ways of estimating inflation’s underlying trend (Chart 3). The first method we consider is the Atlanta Fed’s decomposition of core inflation into “flexible” and “sticky” components. As defined by the Atlanta Fed, “flexible” items tend to change price more frequently compared to “sticky” items. Items like hotels and new & used vehicles fall into the flexible index, while rent and medical care fall into the sticky index.2 As of May, 12-month core flexible inflation is running at a rate of 12.3%. Meanwhile, core sticky inflation is running at 5.0% (Chart 3, top panel). Second, we consider the New York Fed’s Underlying Inflation Gauge (UIG). The UIG uses a dynamic factor model to derive a measure of trend inflation from a broad set of data.3 In total, the measure uses 346 data series encompassing price measures and other nominal, real and financial variables. The New York Fed has demonstrated that the UIG provides better forecasts of CPI inflation than other measures of core and trimmed mean inflation. At present, the UIG is running at 4.9% (Chart 3, panel 2). A second “prices only” UIG measure that includes only price data and no other economic or financial variables is running hotter at 6.0%. Finally, we can assess inflation’s underlying trend by looking at wage growth. Specifically, we can look at unit labor costs, a measure of wages relative to productivity. Unit labor costs are volatile, but they tend to track core inflation over long periods of time. Unit labor costs grew at an extremely high rate of 8.2% in the four quarters ending in Q1, but this is partly due to huge post-pandemic swings in productivity growth. If we create a more stable measure of underlying wage pressure by subtracting annualized 5-year productivity growth from the 12-month growth rate in average hourly earnings, we see that this trend inflation measure is running at only 3.8% (Chart 3, bottom panel). Chart 4Auto Inflation Will Slow Auto Inflation Will Slow Auto Inflation Will Slow We conclude from our analysis that 12-month core CPI inflation will fall from its current 6.0% back down to its trend level of roughly 4-5% without the Fed needing to slam the brakes on economic growth. This will occur because we will finally see the normalization of some prices that were pushed dramatically higher during the pandemic. Auto price inflation, for example, shot up above 20% last year because the pandemic and the fiscal response to the pandemic conspired to cause a surge in auto sales at the same time as a slump in production (Chart 4). Now, for reasons that have nothing to do with monetary policy but everything to do with the waning impact of the pandemic, we see auto sales rolling over as production ramps up. This will push prices lower in the second half of this year. All that said, once core inflation reaches its 4-5% trend level, more economic pain will be required to push it lower. Shelter, for example, carries a huge weight in the Atlanta Fed’s core sticky CPI and it is highly correlated with the economic cycle. A rising unemployment rate, and an economic recession, will eventually be required to push shelter inflation down. Bottom Line: Core inflation has peaked for the year and it can fall to a range of 4-5% even in the absence of an economic recession or meaningful labor market weakness. A recession and a rising unemployment rate will eventually be required to push inflation from 4% down to the Fed’s 2% target. The Risk Of Recession Just because US inflation can fall to 4% in the absence of recession doesn’t mean that the Fed won’t get impatient and cause one anyways. In fact, the Fed made it clear last week that it isn’t interested in nuanced inflation forecasts. The Fed will tighten aggressively until it is apparent that inflation is rolling over, even if it causes economic pain. In this section, we run through several economic and financial market indicators that often send signals near the peak of Fed tightening cycles and in advance of recessions. We conclude that economic growth is slowing, but we do not yet see any evidence of an imminent recession or of any growth slowdown that would be large enough for the Fed to pause or reverse its tightening cycle. First, we look at financial conditions (Chart 5). The Goldman Sachs Financial Conditions Index has tightened rapidly during the past few months and that tightening is broad-based across all five of the index’s components. That said, the index has still not quite moved into “restrictive” territory. Typically, Fed tightening cycles only end once financial conditions are already restrictive, and in this cycle, high inflation means that the Fed will likely tolerate even more tightening of financial conditions than usual. Second, we observe that the end of a Fed tightening cycle is often marked by a dip in the ISM Manufacturing PMI to below 50. Presently, the PMI is a solid 56.1 but it is falling, and regional Fed surveys suggest that it may soon dip into contractionary territory (Chart 6). Chart 5Financial Conditions Financial Conditions Financial Conditions Chart 6PMIs Are Slowing PMIs Are Slowing PMIs Are Slowing Third, residential construction activity is a strong predictor of both recession and the end of Fed tightening cycles. Specifically, we have observed that Fed tightening cycles tend to terminate once the 12-month moving average of housing starts falls below the 24-month moving average.4  At present, there is strong evidence that higher mortgage rates are starting to bite the housing market. Housing starts dipped sharply in May and homebuilder confidence is trending down (Chart 7). That said, our housing starts indicator still has a long way to go before it signals the end of the Fed’s tightening cycle (Chart 7, bottom panel). Finally, we turn to the labor market where we do not yet see any evidence of an economic slowdown. Nonfarm payroll growth usually turns negative prior to recession, but right now it is running at a rate of 4.5% during the past 12 months and 3.3% during the past three months (Chart 8). The unemployment rate, for its part, is extremely low, but this only reinforces the idea that the Fed won’t be inclined to abandon its tightening cycle anytime soon. Chart 7US Housing US Housing US Housing Chart 8The US Labor Market The US Labor Market The US Labor Market Consider that the Congressional Budget Office estimates that the natural unemployment rate is 4.4% and the median FOMC member estimates that it is 4.0%. In other words, the Fed would still consider the labor market tight even if the unemployment rate rose from its current 3.6% level to around 4%. Even though such an increase in the unemployment rate might technically be consistent with a recession, the Fed would not be inclined to ease monetary policy into such a labor market if inflation is still above its 2% target. Additionally, we must also consider that the labor force participation rate is trending up and it still has breathing room before it reaches its pre-pandemic level. Further increases in labor force participation – which seem likely – could support employment growth going forward even if the unemployment rate stops falling. Bottom Line: The Fed’s rate hikes, and tighter financial conditions more generally, will slow economic growth going forward. However, we don’t see any evidence that growth will be weak enough for the Fed to abandon its tightening cycle within the next 6-12 months. This is especially true because above-target inflation increases the amount of financial conditions tightening and labor market pain that the Fed will tolerate. Investment Implications Portfolio Duration & US Treasury Curve May’s surprisingly elevated CPI number caused US Treasury yields to move above their 2018 peaks across the entire yield curve (Chart 9). But we wouldn’t be surprised to see that uptrend take a breather during the next few months as inflation descends toward its 4-5% underlying trend. As noted above, falling inflation will likely cause the Fed to tighten by no more than what is already discounted between now and the end of the year, this should keep US Treasury yields rangebound. As a result, we advise investors to keep duration close to benchmark in US bond portfolios, with an eye toward re-evaluating this positioning once core inflation moves closer to its underlying trend. Chart 9US Treasury Yields US Treasury Yields US Treasury Yields On the Treasury curve, the 5-year note continues to trade cheap relative to the 2-year/10-year slope (Chart 9, bottom panel). We recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes. TIPS Chart 10Underweight TIPS Versus Nominals Underweight TIPS Versus Nominals Underweight TIPS Versus Nominals Investors should position for inflation falling back to trend by underweighting TIPS versus duration-matched nominal US Treasuries. Not only will falling inflation weigh on TIPS breakeven inflation rates during the next few months but a resolutely hawkish Fed will also apply downward pressure (Chart 10). We are particularly bearish on short-maturity TIPS, and we advise investors to initiate outright short positions in 2-year TIPS (Chart 10, bottom panel). In last week’s press conference, Chair Powell pointed to negative short-maturity real yields as evidence that financial conditions have room to tighten further. To us, this suggests that the Fed will not quit until real yields move into positive territory across the entire yield curve. In an environment of falling inflation, this is likely to occur because of falling TIPS breakeven inflation rates. However, the Fed has now demonstrated that even if inflation doesn’t fall it will push real yields higher with its policy rate actions and forward guidance. Corporate Credit The combination of slowing economic growth and increasingly restrictive Fed policy compels us toward a defensive positioning on corporate bond spreads. Specifically, we advise investors to carry an underweight (2 out of 5) allocation to investment grade US corporate bonds and a neutral (3 out of 5) allocation to high-yield US corporate bonds. Our slight preference for high-yield comes from the view that spread widening is likely to take a breather this year as inflation turns down and the Fed tightens by no more than what is already discounted in the yield curve. Though the long-run prospects for corporate bond returns remain bleak, if inflation moderates this year as we expect, then spreads could easily re-tighten to the average levels seen during the last tightening cycle (2017-19). That would equate to 31 bps of spread tightening for investment grade US corporate bonds (Chart 11), or roughly 300 bps of excess return versus duration-matched US Treasuries.5 For high-yield, a return to average 2017-19 spread levels would equate to 133 bps of spread tightening (Chart 12), or roughly 875 bps of excess return versus duration-matched US Treasuries.6 Chart 11IG Spreads IG Spreads IG Spreads Chart 12HY Spreads HY Spreads HY Spreads In our view, this warrants a slightly higher allocation to high-yield for the time being, though we will likely turn increasingly bearish should spreads tighten to average 2017-19 levels or once inflation converges with its 4-5% trend.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220615.pdf 2 For more info on the Atlanta Fed’s sticky and flexible CPIs please see: https://www.atlantafed.org/research/inflationproject/stickyprice 3 For more info on the Underlying Inflation Gauge please see https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 4 For more details on this indicator please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 This excess return estimate is roughly 31 bps of spread tightening multiplied by average index duration of 7.5. We then add half of the index OAS as an estimate of the carry earned during the next six months. 6 This excess return estimate is roughly 133 bps of spread tightening multiplied by average index duration of 4.3. We then add half of the index OAS, less estimated default losses of 200 bps, as an estimate of the carry earned during the next six months. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Bonds sold off dramatically in response to Friday’s surprisingly high CPI number. Markets are now pricing in a much more rapid increase in the fed funds rate, with some probability of a 75 bps move this week. We think a 75 bps rate hike at any one FOMC meeting is possible, but unlikely. Rather, we see the Fed continuing to hike by 50 bps per meeting until inflation shows signs of rolling over. The guts of the CPI report were less concerning than the headline figure, and it is still more likely than not that core CPI will trend down during the next 6-12 months. Contribution To Month-Over-Month Core CPI No Relief From High Inflation No Relief From High Inflation Bottom Line: Investors should maintain benchmark portfolio duration as it is unlikely that the Fed will deliver a more aggressive pace of tightening than what is already in the price. Investors should also underweight TIPS versus nominal Treasuries as a play on a hawkish Fed and moderating consumer prices. The May CPI Print Ensures An Ultra-Hawkish Fed  The “peak inflation” narrative took a blow last week when core CPI came in well above expectations for May. While the annual rate ticked down due to base effects, monthly core CPI saw its largest increase since last June (Chart 1). The bond market reacted to the news with an abrupt bear-flattening of the Treasury curve. The 2-year Treasury yield rose above 3% for this first time this cycle and the 10-year yield hit 3.27% on Monday morning (Chart 2). The 2-year/10-year Treasury slope flattened sharply, and it now sits at just 5 bps (Chart 2, bottom panel). Chart 1Strong Inflation In May Strong Inflation In May Strong Inflation In May Chart 2A Big Bear-Flattening A Big Bear-Flattening A Big Bear-Flattening With core inflation not showing any signs of slowing, the Fed will maintain its ultra-hawkish tone when it meets this week. While there’s an outside chance that the Fed will try to shock markets with a 75 basis point rate hike, we think it’s more likely that it will deliver the 50 basis point rate increase that Jay Powell teased at the last meeting while signaling that further 50 basis point rate increases are likely at both the July and September FOMC meetings. While inflation is not falling as quickly as either we or the Fed had previously anticipated, a look through the guts of the CPI report still leads to the conclusion that core inflation is more likely to fall than rise in the second half of this year. The main reason for this conclusion is that we aren’t seeing much evidence that inflation is transitioning from the goods sectors that were most heavily impacted by the pandemic to non-impacted service sectors. Rather, the main issue is that core goods inflation remains stubbornly high. Chart 3 shows the breakdown of core CPI into its three main components: (i) goods, (ii) shelter, and (iii) services excluding shelter. We can see that after only one month of decline in March, core goods prices accelerated to +0.69% in May, the largest monthly increase since January. The bulk of the May increase in goods inflation came from new and used cars (Chart 4), a sector where we should see price declines in the second half of this year now that motor vehicle production is ramping back up. Chart 3Contribution To Month-Over-Month Core CPI No Relief From High Inflation No Relief From High Inflation Chart 4Contribution To Month-Over-Month Core Goods CPI No Relief From High Inflation No Relief From High Inflation Turning to services, we observe a deceleration in May relative to April (Chart 3), and also notice that airfares continue to account for an outsized chunk of services inflation (Chart 5). Excluding airfares, core services inflation was just 0.36% in May. Chart 5Contribution To Month-Over-Month Core Services CPI (Excluding Shelter) No Relief From High Inflation No Relief From High Inflation Finally, we see that shelter CPI increased by 0.61% in May, up from 0.51% in April. Shelter is the most cyclical component of CPI and as such it tends to closely track the unemployment rate. The unemployment rate has been flat at 3.6% for three consecutive months and it is more likely to rise than fall going forward. Therefore, we don’t anticipate further acceleration in shelter inflation during the next 6-12 months. Monetary Policy & Investment Implications At the last FOMC meeting, Chair Powell went out of his way to guide market expectations toward 50 basis point rate hikes at both the June and July FOMC meetings. After which, Powell hinted that the Fed would re-assess the economic outlook and would likely continue to lift rates at each meeting in increments of either 50 bps or 25 bps, depending on the outlook for inflation. Powell clearly wanted to set a firm marker down for the pace of rate hikes so that Fed policy doesn’t “add uncertainty to what is already an extraordinarily uncertain time.”1 For this reason, we don’t expect the Fed to lift rates by more than 50 basis points at any single meeting. However, May’s elevated CPI number will likely cause Powell to tease an additional 50 basis point rate hike for September. After September, if inflation finally does soften, the Fed will likely downshift to a pace of 25 bps per meeting. Taking a look at market expectations, we see that fed funds futures are fully priced for a 50 bps rate hike this week and are even discounting a small chance of a 75 bps hike (Chart 6A). Meanwhile, the market is almost fully priced for 125 bps of tightening by the end of the July FOMC meeting, i.e., one 50 bps hike and one 75 bps hike (Chart 6B). Looking out to the September FOMC meeting, we see the market priced for 180 bps of cumulative tightening (Chart 6C). This is consistent with a little more than two 50 basis point rate increases and one 75 basis point rate increase at the next three FOMC meetings. Chart 6AJune FOMC Expectations June FOMC Expectations June FOMC Expectations Chart 6BJuly FOMC Expectations July FOMC Expectations July FOMC Expectations Chart 6CSeptember FOMC Expectations September FOMC Expectations September FOMC Expectations   Looking even further out, we find the market priced for the fed funds rate to hit 3.28% by the end of the year and to peak at 3.88% in June 2023 (Chart 7).2 Chart 7Rate Expectations Rate Expectations Rate Expectations Our own expectation is that the Fed will deliver three or four more 50 basis point rate increases this year, followed by a string of 25 basis point hikes. This will bring the fed funds rate up to a range of 2.75% to 3.25% by the end of 2022, slightly below what is currently priced in the yield curve. As for portfolio duration, we recommend keeping it close to benchmark for the time being. Many indicators – such as economic data surprises, the CRB Raw Industrials/Gold ratio and the relative performance of cyclical versus defensive equities – suggest that bond yields are too high.3 That said, with inflation surprising to the upside and the Fed in a hawkish frame of mind, it is not wise to bet too aggressively on bonds. We also reiterate our view that investors should underweight TIPS versus nominal Treasuries. It’s notable that long-maturity TIPS yields moved higher and that the 10-year TIPS breakeven inflation rate was close to unchanged on Friday, despite the surprisingly high CPI number. This tells us that the market is not pricing-in a scenario where the Fed is losing control of long-dated inflation expectations. Rather, the market is discounting a scenario where the Fed does what is necessary to bring inflation back down. Softish Or Volckerish? Chart 8The Everything Selloff The Everything Selloff The Everything Selloff Of course, the big question for financial markets is whether the Fed will be forced to cause a recession to bring inflation down, or whether it will achieve what Jay Powell called a “softish” landing.4 The Fed’s hoped for “softish landing” scenario is one where inflation recedes naturally as we gain further distance from the pandemic. This outcome would limit the speed at which the Fed is forced to lift rates and push back the expected start date of the next recession. Unfortunately, trends in financial markets suggest that investors are putting less faith in the softish landing scenario. Our BCA Counterpoint Strategy recently observed that stocks, bonds, industrial metals and gold have recently all sold off in concert (Chart 8).5 It is rare for all four of these assets to sell off at the same time, but they did in 1981 when Paul Volcker was in the midst of dramatically lifting rates to conquer inflation. If we truly are on the cusp of the Fed tightening the economy into recession, then it makes sense for all four of those assets to perform poorly. Bond yields rise because the Fed is hiking much more quickly than was previously anticipated. Stocks and industrial metals sell off because of an increase in recession fears. Finally, gold sells off because of rising expectations that the Fed will do what it takes to bring inflation back down. And it’s not just financial markets that are warning that the Fed will be forced to repeat Chairman Volcker’s aggressive tightening. Two influential macroeconomists, Larry Summers and Olivier Blanchard, recently put out papers suggesting that the Fed needs another Volcker moment.6 Summers’ paper (with two co-authors) notes that changes in how the Bureau of Labor Statistics calculates shelter inflation make historical comparisons using CPI problematic. The authors estimate what core CPI would look like prior to 1983 if the current methodology had been employed and find that year-over-year core CPI peaked at 9.9% in 1980 well below the originally published figure of 13.6% and much closer to today’s 6% (Chart 9). The implication is that inflation is already almost as out of control now as it was in the early-1980s, and it will take a similar amount of monetary policy tightening to conquer it. In his paper, Olivier Blanchard makes a similar point by noting that the gap between the real fed funds rate and 12-month core CPI is as wide today as it was in 1975. The implication is that the Fed must play a similar amount of catch-up to bring inflation back down. Chart 9Properly Measured, Core CPI Was Much Lower In 1980 Properly Measured, Core CPI Was Much Lower In 1980 Properly Measured, Core CPI Was Much Lower In 1980 We think comparisons to the early-1980s are mistaken for three reasons. First, the Fed targets PCE inflation not CPI and PCE inflation does not suffer from the methodological inconsistencies that Summers et al identified. If we look at core PCE inflation, of which data only go to April, we see that 12-month core PCE inflation is currently 4.9% compared to a peak of 9.8% in 1980 (Chart 10). In other words, there is still a fair amount of distance between today’s PCE inflation and what was seen in the early 1980s. Chart 10The Fed Targets PCE Inflation The Fed Targets PCE Inflation The Fed Targets PCE Inflation Second, inflation was more broadly distributed in the 1970s/80s than it is today. At different points in the 1970s and early-1980s all three of the major components of core inflation – goods, shelter and services excluding shelter – were above 10% in year-over-year terms (Chart 11). Today, only core goods inflation has moved above 10% and year-over-year shelter and services ex. shelter inflation sit at 5.4% and 4.8%, respectively. Chart 11Inflation Is Less Broad-Based Than In The 1970s/80s Inflation Is Less Broad-Based Than In The 1970s/80s Inflation Is Less Broad-Based Than In The 1970s/80s Finally, wages had been accelerating rapidly for a full decade before inflation peaked in 1980 and this led to the emergence of a wage/price spiral (Chart 12). Firms increased prices to compensate for rising labor costs and then employees demanded further wage gains to compensate for rising consumer prices. Today, the evidence of a wage/price spiral is far less convincing. Wage growth has just recently moved above 5%, and we have seen recent indications that it is already starting to moderate.7  Typically, it takes a prolonged period of rapid wage growth for long-dated inflation expectations to rise and for a wage/price spiral to take hold. At present, we have seen only a modest move up in long-dated inflation expectations (Chart 13) and, as noted above, market-based measures of long-dated inflation expectations barely budged in response to last Friday’s inflation report. Chart 12No Wage/Price Spiral Yet No Wage/Price Spiral Yet No Wage/Price Spiral Yet Chart 13Inflation Expectations Inflation Expectations Inflation Expectations The bottom line is that inflation is still more likely to fall than rise during the next 6-12 months, and this will prevent the Fed from tightening more quickly than what is already priced in the yield curve. That said, while inflation is likely to dip, it will remain above the Fed’s 2% target and a recession will eventually be required to restore price stability. That recession, however, may not occur until late-2023 and it will likely be preceded by far less aggressive monetary tightening than what Paul Volcker delivered in the early-1980s.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  For more details on the Fed’s forward guidance please see US Bond Strategy Weekly Report, “On A Dovish Hike And A 3% Bond Yield”, dated May 10, 2022. 2 These numbers are as of last Friday’s close. 3 For details on these indicators please see US Bond Strategy Webcast, “Will The Fed Get Its Soft Landing?”, dated May 17, 2022. 4 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220504.pdf 5 Please see BCA Counterpoint Weekly Report, “Markets Echo 1981, When Stagflation Morphed Into Recession”, dated May 19, 2022. 6 Please see Bolhius, Cramer, Summers, “Comparing Past and Present Inflation”, June 2022. https://www.nber.org/papers/w30116. And also Blanchard, “Why I worry about inflation, interest rates, and unemployment”, March 2022. https://www.piie.com/blogs/realtime-economic-issues-watch/why-i-worry-about-inflation-interest-rates-and-unemployment.  7 Please see US Bond Strategy Portfolio Allocation Summary, “The Case For A Soft Landing”, dated June 7, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Chart 1Wage Growth Is Cooling Wage Growth Is Cooling Wage Growth Is Cooling In a speech last week, Fed Governor Christopher Waller presented the theoretical underpinnings for how the Fed plans to achieve a soft landing for the US economy.1 The Fed’s hope is that tighter monetary policy will slow demand enough to reduce the number of job openings – of which there are currently almost two for every unemployed person – without leading to a significant increase in layoffs and the unemployment rate. A reduction in the ratio of job openings to unemployed will lead to softer wage growth and lower inflation. The May employment report – released last Friday – provides some evidence that the Fed’s plan may be working. In May, an increase in labor force participation led to strong employment gains and kept the unemployment rate flat. We also saw continued evidence of a deceleration in average hourly earnings (Chart 1). Fifty basis point rate hikes are all but assured at the June and July FOMC meetings, but softer wage growth and falling inflation make it more likely that the Fed will downshift to a pace of 25 bps per meeting starting in September. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance The Case For A Soft Landing The Case For A Soft Landing Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 79 basis points in May, bringing year-to-date excess returns up to -215 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 131 bps. Similarly, our quality-adjusted 12-month breakeven spread downshifted to its 45th percentile since 1995 (Chart 2). A recent report made the case for why investors should underweight investment grade corporate bonds on a 6-12 month horizon.2 The main rationale for this recommendation is that the slope of the Treasury curve is very flat, signaling that we are in the mid-to-late stages of the credit cycle. Corporate bond performance tends to be weak during such periods unless spreads start from very high levels. Despite our underweight 6-12 month investment stance, we see a high likelihood that spreads will narrow during the next few months as inflation falls and the Fed tightens by no more than what is already priced in the curve. That said, the persistent removal of monetary accommodation and flatness of the yield curve will limit how much spreads can compress. Last week’s report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.3  That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* The Case For A Soft Landing The Case For A Soft Landing High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 35 basis points in May, dragging year-to-date excess returns down to -316 bps. More specifically, high-yield sold off dramatically early in the month – the junk index lagged Treasuries by 368 bps between May 1 and May 20 – but then staged a rally near the end of May, outperforming Treasuries by 333 bps between May 20 and May 31. 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 – moved higher in May. It currently sits at 5.1% (Chart 3). Last week’s report reiterated our view that investors should favor high-yield over investment grade within an overall underweight allocation to spread product versus Treasuries.4 Our main rationale for this view is that there are historical precedents for high-yield bonds outperforming investment grade during periods when the yield curve is very flat but when corporate balance sheet health is strong. The 2006-07 period is a prime example. With that in mind, our outlook for corporate profit and debt growth is consistent with a default rate of 2.7% to 3.7% during the next 12 months, well below the 5.1% that is currently priced in the index. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 70 basis points in May, bringing year-to-date excess returns up to -109 bps. We discussed the outlook for Agency MBS in a recent report.5 We noted that MBS’s poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is at its end. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have the incentive to refinance at current mortgage rates (panel 4). The implication is that excess MBS returns will be stronger going forward. That said, we still don’t see enough value in MBS spreads to increase our recommended allocation. The average index spread for conventional 30-year Agency MBS remains close to its lowest level since 2000 (bottom panel). At the coupon level, we observe that low-coupon MBS have much higher duration than high-coupon MBS and that convexity is close to zero for the entire coupon stack. This makes the relative coupon trade a direct play on bond yields. Given that we see some potential for yields to fall somewhat during the next six months, we recommend favoring low-coupon MBS (1.5%-2.5%) within an overall underweight allocation to the sector.ext 12 months, well below the 5.1% that is currently priced in the index. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Markets Overview Emerging Markets Overview Emerging Market (EM) bonds outperformed the duration-equivalent Treasury index by 29 basis points in May, bringing year-to-date excess returns up to -565 bps. EM sovereigns outperformed the Treasury benchmark by 125 bps on the month, bringing year-to-date excess returns up to -664 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 28 bps, dragging year-to-date excess returns down to -501 bps. The EM Sovereign Index underperformed the duration-equivalent US corporate bond index by 27 bps in May. The yield differential between EM sovereigns and duration-matched US corporates remains negative (Chart 5). As such, we continue to recommend a maximum underweight allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index underperformed duration-matched US corporates by 109 bps in May, but it continues to offer a significant yield advantage (panel 4). As such, we maintain our neutral allocation (3 out of 5) to the sector. Despite modest weakness in the trade-weighted US dollar in May, EM currencies continue to struggle (bottom panel). If the Fed tightens no more quickly than what is already priced in the curve for the next six months – as we expect – it could limit the upward pressure on the US dollar and benefit EM spreads in the near term. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 61 basis points in May, bringing year-to-date excess returns up to -78 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread product volatility. As we noted in a recent report, state & local government revenue growth has been strong and yet governments have also been slow to hire.6 The result is that net state & local government savings are incredibly high (Chart 6) and it will take some time to deplete those coffers even as economic growth slows and federal fiscal thrust turns to drag. On the valuation front, munis have cheapened up relative to both Treasuries and corporates during the past few months. The 10-year Aaa Muni/Treasury yield ratio is currently 83%, up significantly from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation Municipal bonds and duration-matched corporates is 85%. The same measure for 17-year+ Revenue bonds stands at 92%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-steepened in May. The 2-year/10-year Treasury slope steepened 13 bps on the month and the 5-year/30-year slope steepened 22 bps. The 2/10 and 5/30 slopes now stand at 30 bps and 16 bps, respectively. In a recent Special Report we noted the unusually large divergence between flat slopes at the long end of the curve and steep slopes at the front end.7 For example, the 5-year/10-year Treasury slope is currently 1 bp while the 3-month/5-year slope is 178 bps. The divergence is happening because the market has moved quicky to price-in a rapid near-term pace of rate hikes. However, so far, the Fed has only delivered 75 bps of tightening and this is holding down the very front-end of the curve. The oddly shaped curve presents us with an excellent trading opportunity. Specifically, we recommend buying the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. This trade looks attractive on our model (Chart 7) and will profit if the rate hike cycle moves more slowly than what is currently priced but lasts longer. We also continue to recommend a position long the 20-year bullet versus a duration-matched 10/30 barbell as an attractive carry trade. TIPS: Underweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 144 basis points in May, dragging year-to-date excess returns down to +237 bps. The 10-year TIPS breakeven inflation rate fell 25 bps last month, but it remains above the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Our TIPS Breakeven Valuation Indicator shows that TIPS remain “expensive”, but not as expensive as they were a month ago (panel 2). While TIPS have become less expensive during the past month, we think TIPS breakeven inflation rates will continue to fall during the next few months as inflation moves lower. This will be particularly true at the front-end of the curve where breakevens remain disconnected from the Fed’s target (panel 4) and where breakevens exhibit a stronger correlation with the incoming inflation data. To take advantage of falling inflation between now and the end of the year, investors should position for a steeper TIPS breakeven curve (bottom panel) and/or a flatter real (TIPS) curve. We also recommend that investors hold outright short positions in 2-year TIPS.     ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in May, dragging year-to-date excess returns down to -63 bps. Aaa-rated ABS underperformed by 26 bps on the month, dragging year-to-date excess returns down to -59 bps. Non-Aaa ABS underperformed by 22 bps on the month, dragging year-to-date excess returns down to -88 bps. During the past two years, substantial federal government support for household incomes caused US households to build up an extremely large buffer of excess savings. Nowhere is this more evident than in the steep drop in the amount of outstanding credit card debt that was witnessed in 2020 and 2021 (Chart 9). In 2022, consumers have started to re-lever. The personal savings rate was just 4.4% in April, the lowest print since September 2008, and the amount of outstanding credit card debt has almost recovered its pre-COVID level. But while household balance sheets are starting to deteriorate, they remain exceptionally strong in level terms. In other words, it will be some time before we see enough deterioration to cause a meaningful uptick in consumer credit delinquencies. 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: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 105 basis points in May, dragging year-to-date excess returns down to -189 bps. Aaa Non-Agency CMBS underperformed Treasuries by 84 bps on the month, dragging year-to-date excess returns down to -152 bps. Non-Aaa Non-Agency CMBS underperformed by 165 bps on the month, dragging year-to-date excess returns down to -290 bps. CMBS spreads remain wide compared to other similarly risky spread products. However, after several quarters of easing, commercial real estate lending standards shifted closer to ‘net tightening’ territory in Q1 (Chart 10). This trend will bear monitoring in the coming quarters.  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 19 basis points in May, bringing year-to-date excess returns up to -23 bps. The average index option-adjusted spread tightened 2 bps on the month. It currently sits at 49 bps, not that far from its average pre-COVID level (bottom panel). Agency CMBS spreads also continue to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 251 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The Case For A Soft Landing The Case For A Soft Landing Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 31, 2022) The Case For A Soft Landing The Case For A Soft Landing 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 May 31, 2022) The Case For A Soft Landing The Case For A Soft Landing 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 -51 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 51 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Case For A Soft Landing The Case For A Soft Landing Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of May 31, 2022) The Case For A Soft Landing The Case For A Soft Landing Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.federalreserve.gov/newsevents/speech/waller20220530a.htm 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 3 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 4  Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 5 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 6 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 7 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022.       Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Executive Summary Investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023. High conviction recommendation: Overweight healthcare versus basic resources. In other words, tilt towards sectors that benefit the most from rising bond prices and that suffer the least from contracting profits. New high conviction recommendation: Go long the Japanese yen. As bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. Fractal trading watchlist: JPY/USD, GBP/USD, and Australian basic resources. If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market Bottom Line: The risk is that the valuation-driven sell-off morphs into a profits-driven sell-off. Feature In May, many stock markets reached the drawdown of 20 percent that defines a technical bear market. Yet what has caught many people off guard is that the bear market in stocks has happened during a bull market in profits. Since the start of 2022, US profits are up by 5 percent.1 The bear market in stocks has happened during a bull market in profits… so far. This shatters the shibboleth that bear markets only happen when there is a profits recession. The 2022 bear market has been a valuation-driven bear market. US profits rose 5 percent, but the multiple paid for those profits collapsed by 25 percent, taking the market into bear territory. None of this should come as any surprise to our regular readers. As we have pointed out many times, a stock market can be likened to a bond with a variable rather than a fixed income. So, just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like. It turns out that that long-duration US stock market has the same duration as a 30-year bond. This means that: The US stock market = (The 30-year T-bond price) multiplied by (US profits) It follows that if the 30-year bond price falls by more than profits rise, then the stock market will sell off. And if the 30-year bond price falls by much more than profits rise, then the stock market will enter a valuation-driven bear market. Therein lies the story of 2022 so far (Chart I-1). Chart I-1The Bear Market Is Valuation-Driven. Profits Are Up... For Now The Bear Market Is Valuation-Driven. Profits Are Up... For Now The Bear Market Is Valuation-Driven. Profits Are Up... For Now Just As In 1981-82, Will The Sell-Off Morph From Valuation-Driven To Profits-Driven? In Markets Echo 1981, When Stagflation Morphed Into Recession, we argued that a good template for what happens to the economy and the markets in 2022-23 is the experience of 1981-82. Does 2022-23 = 1981-82? Then, just as now, the world’s central banks were obsessed with ‘breaking the back’ of inflation, and piloting the economy to a ‘soft landing’. Then, just as now, the central banks were desperate to repair their badly damaged credibility in managing the economy. And then, just as now, an invasion-led war between two major commodity producers – Iran and Iraq – was disrupting commodity supplies and adding to inflationary pressures. In 1981, just as now, the equity market sell-off started as a valuation sell-off, driven by a declining 30-year T-bond price. Profits held up through most of 1981, just as they have so far in 2022. In September 1981, US core inflation finally peaked, with bond yields following soon after. In the current experience, March 2022 appears to have marked the equivalent peak in US core inflation (Chart I-2 and Chart I-3). Chart I-2Does September 1981... Does September 1981... Does September 1981... Chart I-3...Equal March 2022? ...Equal March 2022? ...Equal March 2022? In late 1981, when the 30-year T-bond price rebounded, the good news was that beaten-down equity valuations also reached their low point. The bad news was that just as the valuation-driven sell-off ended, profits keeled over, and the valuation-driven sell-off morphed into a profits-driven sell-off (Chart I-4). In 2022-23, could history repeat? Chart I-4In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven Recession Or No Recession? That Is Not The Question History rhymes, it rarely repeats exactly. What if the 2022-23 experience can avoid the outright economic recession of the 1981-82 experience? This brings us to another shibboleth that needs to be shattered. You don’t need the economy to go into recession for profits to go into recession. To understand why, we need to visit the concept of operational leverage. Profits is a small number that comes from the difference of two large numbers: sales and the costs of generating those sales. As any company will tell you, sales can be volatile, but costs – which are dominated by wages – are sticky and much slower to change. The upshot is that if sales growth exceeds costs growth, there is a massively leveraged impact on profits growth. This is the magic of operational leverage. But if sales growth falls below sticky cost growth, the magic turns into a curse. The operational leverage goes into reverse, and profits collapse. Using US stock market profits as an example, the magic turns into a curse at real GDP growth of 1.25 percent, above which profits grow at six times the difference, and below which profits shrink at six times the difference (Chart I-5). Chart I-5A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 Strictly speaking, we should compare US profits growth with world GDP growth because multinationals generate their sales globally rather than domestically. But to the extent that the US has both the world’s largest stock market and the world’s largest economy, it is a reasonable comparison. We should also compare both profits and sales in either nominal or real terms, rather than a mixture. But even with these tweaks, we would still find that the dominant driver of profit growth is operational leverage. ‘Recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Therefore, the conclusion still stands – ‘recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Such a period of low growth is now likely. If 2022-23 = 1981-82, What Happens Next? To repeat: The US stock market = (The 30-year T-bond price) multiplied by (US profits) This means that investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. This was the precise set-up in December 1981, the equivalent of June 2022 in our historical template. In which case, what can we expect next? 1. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield 2. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023 (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market 3. Long-duration defensive sectors will outperform short-duration cyclical sectors. In other words, tilt towards sectors that benefit the most from rising bond prices and suffer the least from contracting profits. As such, a high conviction recommendation is to overweight healthcare versus basic resources (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources 4. In foreign exchange, the setup is very bullish for the Japanese yen through the next 12 months. The yen’s recent sell-off is explained by bond yields rising outside Japan. As these bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. A new high conviction recommendation is to go long the Japanese yen (Chart I-9). Chart I-9The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan Fractal Trading Watchlist Supporting our bullish fundamental case for the Japanese yen, the sell-off in JPY/USD has reached the point of fragility on its 260-day fractal structure that marked previous major turning points in 2013 and 2015 (Chart 10). Hence, a first new trade is long JPY/USD, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 5 percent. Chart I-10The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point Supporting our bearish fundamental case for resources stocks, the outperformance of Australian basic resources has reached the point of fragility on its 130-day fractal structure that marked previous turning points in 2013, 2015, and 2021 (Chart I-11). Hence, a second new trade is short Australian basic resources versus the world market, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 10 percent. Chart I-11The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal Finally, we are adding GBP/USD to our watchlist, given that its 260-day fractal structure is close to the point of fragility that marked major turns in 2014, 2015, and 2016. Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 1AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Chart 2Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 8CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined as 12-month forward earnings per share. Fractal Trading System More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers ​​​​​ Chart 2Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening ​​​​​​ The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates ​​​​​ Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate ​​​​​ Chart 5The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak ​​​​​ This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment ​​​​​​ Chart 9Headwinds For The Australian Consumer Headwinds For The Australian Consumer Headwinds For The Australian Consumer ​​​​​​ The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 The New Normal In Australia The New Normal In Australia Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge The New Normal In Australia The New Normal In Australia There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Chart 12Canada Offers Clue To Size Of Australian Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade ​​​​​ Chart 14The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming ​​​​​ Chart 16Australia Is Resource Superstar Australia Is Resource Superstar Australia Is Resource Superstar ​​​​​ Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com

Executive Summary Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers ​​​​​ Chart 2Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening ​​​​​​ The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates ​​​​​ Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate ​​​​​ Chart 5The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak ​​​​​ This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment ​​​​​​ Chart 9Headwinds For The Australian Consumer Headwinds For The Australian Consumer Headwinds For The Australian Consumer ​​​​​​ The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 The New Normal In Australia The New Normal In Australia Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge The New Normal In Australia The New Normal In Australia There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Chart 12Canada Offers Clue To Size Of Australian Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade ​​​​​ Chart 14The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming ​​​​​ Chart 16Australia Is Resource Superstar Australia Is Resource Superstar Australia Is Resource Superstar ​​​​​ Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com

Next Thursday May 26, we will hold the BCA Debate – High Inflation: Here To Stay,Or Soon In The Rear-View Mirror? – a Webcast in which I will debate my colleague, Chief Commodity & Energy Strategist, Bob Ryan on the outlook for inflation, and take the side that inflationary fears will soon recede. I do hope you can join us. As such, the debate will replace the weekly report, though we will renew the fractal trading watchlist on our website. Dhaval Joshi Executive Summary The second quarter’s synchronised sell-off in stocks, bonds, inflation protected bonds, industrial metals and gold is an extremely rare star alignment. The last time that the ‘everything sell-off’ star alignment happened was in early 1981 when the Paul Volcker Fed ‘broke the back’ of inflation and turned stagflation into an outright recession. In 2022, the Jay Powell Fed risks doing the same. If history repeats itself, then the template of 1981-82 could provide a useful guide for 2022-23. In which case, bond prices are now entering a bottoming process.  Stocks would bottom next. While the near term outlook is cloudy, we expect stock prices to be higher on a 12-month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty will be industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal trading watchlist: FTSE 100 versus Stoxx Europe 600, Czech Republic versus Poland, Food and Beverages, US REITS versus Utilities, CNY/USD. 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 Bottom Line: The 1981-82 template for 2022-23 suggests that bonds will bottom first, followed by stocks. But steer clear of gold and industrial metals. Feature Investors have had a torrid time in the second quarter, with no place to hide.1  Stocks are down -10 percent. Bonds are down -6 percent. Inflation protected bonds are down -6 percent. Industrial metals are down -13 percent. Gold is down -6 percent. To add insult to injury, even cash is down in real terms, because the interest rate is well below the inflation rate! (Chart I-1) Chart I-1The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession Such a star alignment of asset returns, in which stocks, bonds, inflation protected bonds, industrial metals, and gold all sell off together, is unprecedented. In the eighty calendar quarters since the inflation protected bond market data became available in the early 2000s there has never been a quarter with an ‘everything sell-off’. Everything Has Sold Off, But Does That Make Sense? The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all five asset-classes should fall together (Chart I-2 and Chart I-3). Chart I-2An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare Chart I-3An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare An 'Everything Sell-Off' Is Extremely Rare A scenario dominated by rising inflation is bad for bonds, but good for inflation protected bonds, especially relative to conventional bonds. Yet inflation protected bonds have not outperformed either in absolute or relative terms. A scenario of rising inflation should also support the value of stocks, industrial metals and certainly gold, given that all three are, to varying degrees, ‘inflation hedges.’ Yet the prices of stocks, industrial metals, and gold have all plummeted. The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all asset classes should fall together. Conversely, a scenario dominated by slowing growth is bad for industrial metal prices, but good for conventional bond prices – as bond yields decline on diminished expectations for rate hikes. Yet conventional bonds have sold off. What about a scenario dominated by both rising inflation and slowing growth – which is to say, stagflation? In this case, we would expect inflation protected bonds to perform especially well. Meanwhile, with the economy still growing, the prices of industrial metals should not be collapsing, as they have been recently.  In a final scenario of an imminent recession we would expect stocks, industrial metals and even gold to sell off, but conventional bonds to perform especially well. The upshot is there are virtually no economic scenarios in which stocks, bonds, inflation protected bonds, industrial metals, and gold plummet together, as they have recently. So, what’s going on? To answer, we need to take a trip back to the 1980s. 1981 Was The Last Time We Had An ‘Everything Sell-Off’ Inflation protected bonds did not exist before the late 1990s. But considering the other four asset-classes – stocks, bonds, industrial metals, and gold – to find the last time that they all fell together we must travel back to 1981, the time of Margaret Thatcher, Ronald Reagan, and the Paul Volcker Fed. And suddenly, we discover spooky similarities with the current Zeitgeist. Just like today, the world’s central banks were obsessed with ‘breaking the back’ of inflation, which, like a monster in a horror movie, kept appearing to die before coming back with second and third winds (Chart I-4). Chart I-4In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation Just like today, the central banks were desperate to repair their badly damaged credibility in managing the economy. As the biography “Volcker: The Triumph of Persistence” puts it: “He restored credibility to the Federal Reserve at a time it had been greatly diminished.” And just like today, central bankers hoped that they could pilot the economy to a ‘soft landing’, though whether they genuinely believed that is another story. Asked at a press conference if higher interest rates would cause a recession, Volcker replied coyly “Well, you get varying opinions about that.” 2022 has spooky similarities with 1981. In fact, in its single-minded aim ‘to do whatever it takes’ to kill inflation, the Volcker Fed hiked the interest rate to near 20 percent, thereby triggering what was then the deepest economic recession since the Depression of the 1930s (Chart I-5 and Chart I-6). With hindsight, it was a price worth paying because the economy then began a quarter century of low inflation, steady growth, and mild recessions – a halcyon period for which the Volcker Fed’s aggressive tightening in the early 1980s have been lauded. Chart I-5In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... In 1981, The Fed Hiked Rates To Near 20 Percent... Chart I-6...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession ...And Thereby Morphed Stagflation Into Recession Granted, the problems of 2022 are a much scaled down version of those in 1981, yet there are spooky similarities – a point which will not have gone unnoticed by the current crop of central bankers. It is no secret that Jay Powell is a big fan of Paul Volcker.   The Echoes Of 1981-82 In 2022-23 The answer to why everything sold off in early 1981 is that central banks took their economies from stagflation to outright recession, and the risk is that the same happens again in 2022-23 (Chart I-7). Chart I-7The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession In the transition from stagflation fears to recession fears, everything sells off because first the stagflation casualties get hammered, and then the recession plays get hammered. This leaves investors with no place to hide, as no mainstream asset is left unscathed. Just as in 1981, a transition from stagflation fears to recession fears likely explains the recent ‘everything sell-off’ because the sell-off in April was most painful for the stagflation casualties – bonds. Whereas, the sell-off in May has been most painful for the recession casualties – industrial metals and stocks.  In a stagflation that morphs to recession, everything sells off. What happens next? The template of 1981-82 could provide a useful guide. Bond prices bottomed first, in the late summer of 1981, as it became clear that the economy was entering a downturn which would exorcise inflation. Of the three other asset classes – all recession casualties – stocks continued to remain under pressure for the next few months but were higher 12 months later. Gold fell another 30 percent, though rebounded sharply in 1982. But the greatest pain was in the industrial metals, which fell another 30 percent and did not recover their highs for several years (Chart I-8). Chart I-82022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 Could Be An Echo Of 1981-82 2022-23 could be an echo of 1981-82, with bond prices now entering a bottoming process.  Stocks would bottom next, with one difference being a quicker recovery than in 1981-82 because of their higher sensitivity to bond yields. While the near term outlook is cloudy, we expect stock prices to be higher on a 12 month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty of a stagflation that morphs into a recession will be the overvalued industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal Trading Watchlist This week’s new additions are Czech Republic versus Poland, and Food and Beverages versus the market, which appear overbought. And US REITS versus Utilities, and CNY/USD, which appear oversold. Finally, our new trade recommendation is to underweight the FTSE 100 versus the Stoxx Europe 600. The resource heavy FTSE 100 is especially vulnerable to our anticipated sell-off in commodities, and its recent outperformance is at a point of fragility that has marked previous turning points (Chart I-9). Set the profit target and symmetrical stop-loss at 5 percent. Chart I-9FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion FTSE 100 Outperformance Is Near Exhaustion Fractal Trading Watchlist: New Additions Chart I-10Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart I-11Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart I-12US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart I-13CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 14The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 15The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 16Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 17Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 20The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 21A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 24The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 25The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 26Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 27Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Food And Beverage Outperformance Near Exhaustion CHART 1 Chart 28US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 US REITS Are Oversold Versus Utilities CHART 12 Chart 29CNY/USD At A Support Level CNY/USD At A Support Level CNY/USD At A Support Level   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The returns are based on the S&P 500, the 10-year T-bond, the 10-year Treasury Inflation Protected Security (TIPS), the LMEX index, and gold.   Fractal Trading System Fractal Trades Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession Markets Echo 1981, When Stagflation Morphed Into Recession 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations