Inflation Protected

Highlights Fed: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Nominal Treasuries: We project that Treasury securities will still deliver negative total returns, even if Fed liftoff is delayed until December 2022. Investors can protect returns by favoring the 2-year note (long 2yr over cash/10yr barbell) and 20-year bond (long 20yr over 10yr/30yr barbell). TIPS: Investors should short 2-year TIPS outright in anticipation of falling short-dated inflation expectations during the next 12 months. The Taper Is Done, Now Onto Liftoff The Fed announced a tapering of its asset purchases last week and the details of the tapering plan were consistent with what had already been signaled to the public. The Fed will purchase $70 billion of Treasuries this month (compared to $80 billion in October) and $35 billion of agency MBS (down from $40 billion in October). It will then reduce monthly Treasury and MBS purchases by $10 billion and $5 billion each month, respectively, until it reaches net zero asset purchases by June of next year (Chart 2). The Fed didn’t give specific guidance on what will happen with the balance sheet after June, but it’s highly likely that it will follow the pattern of the last tightening cycle and keep the balance sheet flat for a long time, until the fed funds rate is well above the zero bound. The Fed also gave itself the option to increase or decrease the pace of purchases if such changes are warranted by the economic outlook, but it would take a major shock to knock the Fed off its pre-set course. Chart 1The Market's Liftoff Expectations The Market's Liftoff Expectations The Market's Liftoff Expectations Chart 2Net Purchases Will Reach Zero By June Net Purchases Will Reach Zero By June Net Purchases Will Reach Zero By June With the tapering announcement out of the way, the Fed can now turn to the more important question of when to start lifting interest rates. Jay Powell made it clear at last week’s press conference that the committee hasn’t yet formally taken up the issue, but that didn’t stop reporters from pressing the Chairman to provide more details about when the Fed will hike. None of that should be too surprising. There’s intense market interest and a great deal of uncertainty about the timing of Fed liftoff. Two months ago, markets were pricing-in no rate hikes at all in 2022. Now, markets are looking for Fed liftoff at the September 2022 FOMC meeting and are discounting a 90% chance of 2 rate hikes by the end of next year (Chart 1). The Fed’s Thinking On Liftoff So, what did we learn from last week’s FOMC Statement and press conference about how the Fed is thinking about the liftoff date? First, we know from previous comments that the Fed would prefer to reduce net asset purchases to zero before it starts lifting rates. This means that the July 2022 FOMC meeting is the first “live meeting” where a rate hike could possibly occur, and the fed funds futures market is already pricing-in a 74% chance that liftoff will occur at that meeting (Chart 1). We aren’t so sure. In fact, we don’t see the Fed lifting rates until December 2022, and Chair Powell’s comments about inflation at last week’s press conference only increased our confidence in that view. On inflation, Powell echoed comments by Fed Governor Randal Quarles that we flagged in a recent report.1 Both Powell and Quarles put less emphasis on the length of time that inflation remains above the Fed’s target and more emphasis on the causes of that inflation and whether it’s appropriate for the Fed to lean against it. Here’s Powell from last week (emphasis added): Supply constraints have been larger and longer lasting than anticipated. Nonetheless, it remains the case that the drivers of higher inflation have been predominantly connected to dislocations caused by the pandemic, specifically the effects on supply and demand from the shutdown, the uneven reopening, and the ongoing effects of the virus itself. Our tools cannot ease supply constraints. Like most forecasters, we continue to believe that our dynamic economy will adjust to the supply and demand imbalances, and that as it does, inflation will decline to levels much closer to our 2 percent longer-run goal. Of course, it is very difficult to predict the persistence of supply constraints or their effects on inflation. Global supply chains are complex; they will return to normal function, but the timing of that is highly uncertain.2 Essentially, Powell is pointing out that it would be a mistake for the Fed to tighten policy to bring down inflation only to find out that the economy’s natural supply side response was about to do so anyways. The Fed would have dragged down aggregate demand for no reason. So what would cause the Fed to lift rates? We see two potential triggers. The first liftoff trigger would be an assessment by the FOMC that the labor market has reached “maximum employment”. This is the liftoff condition that the Fed has officially set for itself. The second liftoff trigger would be an uncomfortable increase in long-dated inflation expectations. A spike in long-dated inflation expectations would be worrying enough that the Fed would abandon its “maximum employment” goal and tighten earlier. The “Maximum Employment” Trigger Chart 3How Far From "Maximum Employment"? How Far From "Maximum Employment"? How Far From "Maximum Employment"? The concept of “maximum employment” brings a whole host of other issues along with it. How will the Fed know if the labor market is at “maximum employment”? We’ve discussed this topic at length ourselves and have come to a few helpful conclusions.3 First, we can infer from the most recent Summary of Economic Projections that the Fed views an unemployment rate of 3.8% as roughly consistent with “maximum employment”. It is therefore highly unlikely that the Fed will even consider declaring victory on its employment goal until the unemployment rate is in the vicinity of 3.8%, down from its current 4.6% (Chart 3). Second, there are good reasons to believe that the aging of the US population and the recent sharp increase in retirements will prevent the labor force participation rate from re-gaining its pre-pandemic level. However, FOMC participants seem to agree that the prime-age (25-54) labor force participation rate should be close to its February 2020 level for the “maximum employment” condition to be satisfied (Chart 3, bottom panel). Chair Powell even specifically referenced the prime-age participation rate at last week’s press conference. Chart 4 We think a declaration of “maximum employment” will only occur once the unemployment rate is near 3.8% and the prime-age (25-54) labor force participation rate is near its February 2020 level of 82.9%, up from its current 81.7%. It’s unlikely that these conditions will be met in time for a July 2022 rate hike. The Appendix to this report updates our scenarios for the average monthly nonfarm payroll growth that is required to reach different combinations of the unemployment and participation rates by specific future dates. Our scenarios use the overall participation rate (not the prime-age one), but we think the scenarios derived from the New York Fed’s Surveys of Market Participants and Primary Dealers come close to capturing reasonable conditions for “maximum employment”. Based on those scenarios, we calculate that average monthly nonfarm payroll growth of 602k to 733k is required to reach “maximum employment” by June 2022. Conversely, average monthly payroll growth of only 379k to 455k is required to reach “maximum employment” by December 2022. We see the latter as easily achievable and the former as more of a stretch. On the topic of employment growth, it’s worth noting that both monthly nonfarm payroll growth and the prime-age labor force participation rate were dragged down by the spread of the Delta variant during the past few months (Chart 4). With new COVID cases falling, we should see stronger payroll growth and a higher prime-age part rate in the months ahead. Relatedly, falling COVID cases will also help alleviate some the constraints on labor supply as workers grow less fearful of the virus and more confident about re-entering the labor force. This will not only push prime-age participation higher, but it will also take some of the sting out of wage growth. Wage growth has been extremely high recently as the number of job openings has far outpaced the number of new hires (Chart 5). Fading COVID fears should increase the pace of hiring and slow wage growth. This will give the Fed even more confidence that it should stay the course. Chart 5Peak Wage Growth? Peak Wage Growth? Peak Wage Growth? The Inflation Expectations Trigger Chart 6Inflation Expectations Are Well-Anchored Inflation Expectations Are Well-Anchored Inflation Expectations Are Well-Anchored We noted above that the Fed would abandon its “maximum employment” liftoff condition if long-dated inflation expectations rose to uncomfortably high levels. Specifically, we like to track the 5-year/5-year forward TIPS breakeven inflation rate relative to a target range of 2.3% to 2.5% (Chart 6). As long as the 5-year/5-year breakeven rate stays within that range or below, the Fed will be guided by its “maximum employment” goal. However, if that rate were to break above 2.5% for a significant period of time, the Fed would be sufficiently worried about an expectations-driven inflationary spiral that it would abandon its “maximum employment” trigger and bring forward the liftoff date. We don’t expect to see a breakout above 2.5% in the 5-year/5-year forward TIPS breakeven inflation rate anytime soon. The rate has stayed well contained throughout the past few months even as inflation skyrocketed. It would be strange for it to suddenly spike after inflation has already peaked.4 Bottom Line: Chair Powell’s remarks after the November FOMC meeting suggest that the Fed will not panic and move quickly toward tightening in the face of high inflation. Rather, the Fed will stay the course and will only lift rates once its “maximum employment” liftoff trigger is met. We continue to expect Fed liftoff in December 2022. Treasury Market Positioning For A December 2022 Liftoff To determine how we should position within the Treasury market, we translate our above views on the timing of Fed liftoff into fair value estimates for different segments of the Treasury curve. Specifically, we assume a scenario where the Fed starts hiking in December 2022 and then lifts rates at a pace of 100 bps per year until reaching a terminal rate of 2.08%. That 2.08% terminal rate is based on an expected target range of 2%-2.25% that is inferred from responses to the New York Fed’s Surveys of Market Participants and Primary Dealers. We assume that the effective fed funds rate will trade 8 bps above the lower-bound of its target range, as it does currently. Table 1 shows expected 12-month total returns for each Treasury maturity, assuming the market moves to fully price-in our expected funds rate path during the next year. Table 1Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.08% Terminal Rate A Rate Hike Next Summer? Don’t Count On It. A Rate Hike Next Summer? Don’t Count On It. The first observation that jumps out is that, except for the 2-year and 20-year maturities, expected Treasury returns are negative across the board. This justifies sticking with our recommended below-benchmark portfolio duration stance. Second, our expectation that liftoff will be delayed relative to current market expectations gives the 2-year note slightly better expected returns, particularly relative to the 10-year note. As a result, we advise investors to hold 2/10 yield curve steepeners. Specifically, investors should go long the 2-year note versus a duration-matched barbell consisting of the 10-year note and cash. Third, the 20-year bond looks to be priced cheaply on the curve. It offers expected 12-month returns of +79 bps while the 10-year note and 30-year bond are both projected to lose money. We recommend taking advantage of this situation by going long the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. This proposed trade offers positive carry of 20 bps (Chart 7). Further, the 10/20 slope is stuck in the middle of where it was on the 2015 and 2004 liftoff dates (Chart 7, panel 2). The 20/30 slope, meanwhile, is inverted and well below where it was on the 2015 and 2004 liftoff dates (Chart 7, bottom panel). Our 20 over 10/30 trade will profit as the 20/30 slope re-steepens, even if the 10/20 slope doesn’t move that much. Chart 7Buy 20s Versus 10s30s Buy 20s Versus 10s30s Buy 20s Versus 10s30s It could be argued that our recommend trades are all predicated on a fed funds rate scenario that embeds too low of a terminal rate. In fact, the median projection of FOMC participants would place the terminal rate closer to 2.5% than to 2%. If we alter our scenario by increasing the terminal rate assumption from 2.08% to 2.58%, it only improves the outlook for our recommended positions (Table 2). Table 2Projected 12-Month Treasury Returns: Dec 2022 Liftoff/100 Bps Per Year Pace/2.58% Terminal Rate A Rate Hike Next Summer? Don’t Count On It. A Rate Hike Next Summer? Don’t Count On It. In the new scenario, expected Treasury returns are more negative – especially at the long-end. However, the 2-year note is still expected to earn a small profit. Our 20 over 10/30 trade performs slightly worse in this second scenario compared to the first one (+1.79% versus +1.95%), but it is still expected to make money.  TIPS Chart 8A Lot Of Upside In Short-Maturity Real Yields A Lot Of Upside In Short-Maturity Real Yields A Lot Of Upside In Short-Maturity Real Yields We have one final government bond recommendation based on our expectation that Fed liftoff will be delayed until December 2022. That trade is to go short 2-year TIPS. Alternatively, investors could enter 2/10 inflation curve steepeners or 2/10 real yield curve flatteners. Our base case economic outlook is that supply side constraints (both in global supply chains and in the labor market) will loosen during the next 12 months. This will push down short-dated inflation expectations while long-dated inflation expectations stay relatively close to the Fed’s target. If we assume that both the 2-year and 10-year TIPS breakeven inflation rates trend towards the middle of the Fed’s 2.3% to 2.5% target range during the next 12 months and that the nominal 2-year and 10-year yields follow the paths predicted by the fair value scenario presented in Table 1, then we see that the 2-year real yield has a lot of upside (Chart 8). This is true both in absolute terms and relative to the 10-year real yield. We advise investors to short 2-year TIPS outright. Alternatively, 2/10 inflation curve steepeners or 2/10 real yield curve flatteners will also perform well during the next 12 months. Bottom Line: We suggest four different ways that bond investors can profit from the Fed delaying liftoff until December 2022. Investors should keep portfolio duration low, enter 2/10 nominal curve steepeners, buy the 20-year T-bond versus a 10/30 barbell and short 2-year TIPS.  Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a significant increase in the labor force participation rate (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 62.7%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +455k in order to hit “maximum employment” by the end of 2022. Image Image Image Image Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart is to help us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth prints +400k per month going forward, we would expect Fed liftoff between December 2022 and June 2023. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 2 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20211103.pdf 3 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 4 For more details on our inflation outlook please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021. 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Highlights Duration & Country Allocation: Global bond yields have been driven by growth and inflation expectations over the past year, but shifting policy expectations are now the more important driver. Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Inflation-Linked Bonds: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe. Downgrade strategic (6-18 months) exposure to inflation-linked bonds (vs nominals) to underweight in Germany, France and Italy. Feature Chart of the WeekGlobal Bond Yield Drivers: Inflation Now, Labor Later Global Bond Yield Drivers: Inflation Now, Labor Later Global Bond Yield Drivers: Inflation Now, Labor Later “Actually, we talked about inflation, inflation, inflation. That has been a topic that has occupied a lot of our time and a lot of our debates.” – ECB President Christine Lagarde Are you tired of talking about inflation? Central bankers likely are. The only problem is that is the job of monetary policymakers to worry about inflation – and the appropriate policy response – when it is rising as fast as been the case in 2021. The current global inflation surge, on the back of supply squeezes for both durable goods and commodity prices, will ease to some degree in 2022. This does not mean, however, that global bond yields have seen their cyclical peak. The driver of higher yields is already starting to transition from high inflation to tightening labor markets and rising wage costs – more enduring sources of potential inflation that will require monetary tightening in many, but not all, countries (Chart of the Week). This week, we discuss the implications of this shift to more policy-driven yields for the country allocation decisions in a government bond portfolio, for both nominal and inflation-linked debt. Shorter-Term Bond Yields Awaken, Longer-Term Yields Take Notice October represented a shift in the relative performance of developed economy government bond markets compared to the previous three months, most notably at the extremes (Chart 2). UK Gilts were the largest underperformer in Q3, down 1.8% versus the Bloomberg Global Treasury index (in USD-hedged terms, duration-matched to the benchmark), while Spain (+0.7%), Australia (+0.4%) and Italy (+0.3%) were the outperformers. In October, that script was flipped with Gilts being the best performer (+2.3%), Australia being the worst performer (-4.2%) and Spain (-0.6%) and Italy (-1.5%) reversing the Q3 gains. Chart 2 Those particular swings in relative performance were a result of shifting market views on policy changes in those countries. The UK Gilt rally was largely contained to a single day, and focused at the long-end of the Gilt curve after the Conservative government announced a smaller-than-expected budget deficit on October 26 - with much less issuance of longer-maturity bonds – which triggered a huge -22bps decline in 30-year Gilt yields. The Australian bond selloff was a triggered by a rapid market reassessment of the next move in monetary policy for the Reserve Bank of Australia (RBA) after an upside surprise on Q3 inflation data. Italian and Spanish debt also sold off on the back of growing fears that even the European Central Bank (ECB) would be forced to tighten policy in response to higher inflation. The backup in Australian and European yields ran counter to the latest policy guidance of from the RBA and ECB, indicating speculation of a bond-bearish hawkish policy shift. In countries where policymakers have been more explicit about the need for monetary tightening, like Canada and New Zealand, government bonds performed poorly in both Q3 and October. While US Treasury returns were “flattish” in both Q3 (0.1%) and October (0.1%), the 2-year Treasury yield doubled from 0.27% to 0.52% during October as the market pulled forward the timing and pace of Fed rate hikes starting next year (Chart 3). Shifting views on monetary policy have not only impacted the relative performance of bond markets, but also the shapes of yield curves. The bigger increases seen in shorter-maturity bond yields have resulted in a fairly synchronized global move towards curve flattening (Chart 4). This would not be unusual during an actual monetary policy tightening cycle involving rate hikes. However, within the developed economies, only Norway and New Zealand have seen an actual rate hike. In other words, yield curves have been flattening on the anticipation of a rate hiking cycle – but one that is expected to be relative mild. Chart 3A Bond-Bearish Repricing Of Global Rate Expectations A Bond-Bearish Repricing Of Global Rate Expectations A Bond-Bearish Repricing Of Global Rate Expectations ​​​​​​ Chart 4Some Violent Repricing Of Policy Expectations Some Violent Repricing Of Policy Expectations Some Violent Repricing Of Policy Expectations ​​​​​​ Forward interest rates in Overnight Index Swap (OIS) curves are discounting higher rates in 2022 and 2023 across most countries, but with stable rates in 2024 (Chart 5). Yet the cumulative amounts of tightening are very modest, especially when compared to inflation (both realized and expected). Only in New Zealand are policy rates expected to go above 2% by 2023, with the US OIS curve discounting the Fed lifting policy rates to just 1.4%. In the UK, markets are discounting 123bps of hikes by the end of 2022 and a rate cut in 2024 – market pricing that strongly suggests that the Bank of England will make a “policy error” by tightening too much, too quickly, over the next year. Chart 5Markets Still Think Central Banks Will Not Have To Hike Much Markets Still Think Central Banks Will Not Have To Hike Much Markets Still Think Central Banks Will Not Have To Hike Much After the October repricing of rate expectations, and reshaping of yield curves, we see a few conclusions – and investment opportunities – that stand out: US Treasuries With the Fed set to begin tapering asset purchases, the market discussion has moved on to the timing and pace of the post-taper rate hike cycle. The US OIS curve is discounting two Fed hikes in the second half of 2022, starting shortly after the likely end of the Fed taper in June. That timing and pace for 2022 is a bit more aggressive than we are expecting, but a rapidly tightening US labor market and rising wage growth could force the Fed to at least match the market pricing for hikes next year. On that note – the US Employment Cost Index in Q3 rose +1.3%, the fastest quarterly pace since 2001, and +3.7% on a year-over-year basis, the highest since 2004. The greater medium-term risk for the Treasury market is that the Fed starts to signal a need to go higher and faster than the market expects in 2023 and even into 2024. US Treasury yields remain well below levels implied by growth indicators like the ISM index. Thus, there is upside potential as the Fed tightens because of persistent above-trend growth and falling unemployment over the next couple of years (Chart 6). Chart 6Stay Below-Benchmark On US Duration Exposure Stay Below-Benchmark On US Duration Exposure Stay Below-Benchmark On US Duration Exposure We continue to recommend a below-benchmark duration strategic stance for dedicated US bond investors, based on our expectation that US bond yields will climb higher over the next 12-18 months. However, our more preferred way to play this for global investors is as a spread trade versus euro area bond yields – specifically, selling 10-year US Treasury versus 10-year German bunds (Chart 7). Chart 7Position For UST Underperformance Vs. Europe Position For UST Underperformance Vs. Europe Position For UST Underperformance Vs. Europe ​​​​​​ While headline inflation in the euro area has rapidly converged to the pace of US inflation over the past few months, this is overwhelmingly due to surging European energy costs. The pace of underlying inflation, as proxied by measures like the Cleveland Fed trimmed mean CPI and the euro area trimmed mean CPI constructed by our colleagues at BCA Research European Investment Strategy, has diverged sharply with the latter barely above 0%. The ECB will not follow the Fed into a rate hiking cycle next year, which will push US government yields higher versus European equivalents. Australia Government Bonds Chart 8Fade The RBA 'Rate Shock' In Australia Fade The RBA 'Rate Shock' In Australia Fade The RBA 'Rate Shock' In Australia The RBA fought back against the sharp repricing of Australian interest rate expectations earlier this week by signaling that no rate hikes are expected until 2023. This is a modest change from the previous forward guidance of 2024 liftoff, but a surprisingly dovish message for markets that had rapidly moved to price in rate hikes next year after the big upside surprise on Q3/2021 Australian inflation With underlying trimmed mean inflation now having crept back into the RBA’s 2-3% target range, although just barely at 2.1%, the RBA would be justified in removing some degree of monetary accommodation. The central bank has already been doing so, on the margin, with some earlier tapering of the pace of asset purchases and last week’s decision to formally abandon its yield control target on shorter-dated government bond yields. Per the RBA’s current forward guidance, however, a move to actual rate hikes would require more evidence of tighter labor markets and faster wage growth – and thus, a more sustainable move to the 2-3% inflation target - that is not yet evident in measures like the Wage Cost Index (Chart 8). We plan on doing a deeper dive into Australia for next week’s report, where we’ll more formally evaluate our strategic view on Australian bond markets. For now, we remain comfortable with our overweight stance on Australian government bonds, as the RBA is still projected to be one of the less hawkish central banks in 2022. UK Gilts Chart 9 The sharp rally in longer-dated UK Gilts seen at the end of October was due to a downside surprise in the expected size of the UK budget deficit next year, and the amount of Gilt issuance that will be needed to finance it. The UK Debt Management Office (DMO) said it planned to issue 194.8 billion pounds ($267.5 billion) of bonds in the current 2021/22 financial year, 57.8 billion pounds less than its previous remit back in March. The pre-budget market expectation was for a far smaller reduction of 33.8 billion pounds. The cut in issuance was most pronounced for longer-dated Gilts, -35% lower than the March budget issuance projection (Chart 9). With longer-maturity Gilts always in high demand from longer-term UK institutional investors, a major “supply shock” of reduced issuance can temporarily boost bond prices and lower yields. This is especially true in the UK where more aggressive rate hike expectations, and more defensive bond market positioning after the August/September selloff, left Gilts vulnerable to a short squeeze. The most important medium-term drivers of Gilt yields are still expectations of growth, inflation and future policy rates. There was very little change in shorter-dated Gilt yields or UK OIS forward rates after last week’s budget announcement – all the price action was the long end of the Gilt yield curve, resulting in an overall bull flattening. As we discussed in last week’s report, we expect the next move in the shape of the Gilt curve will be towards a steeper curve, likely bond-bearishly as long-term yields are still priced too low relative to how high UK policy rates will eventually have to climb in the upcoming BoE hiking cycle. The post-budget flattening has made the valuation of longer-maturity Gilt curve steepeners far more attractive, according to our UK butterfly spread valuation model (Table 1). Table 1UK Butterfly Spread Valuations From Our Curve Models Transitioning From Inflation To Policy As The Driver Of Bond Yields Transitioning From Inflation To Policy As The Driver Of Bond Yields Chart 10A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell A New UK Tactical Trade: Long 10yr Bullet Vs. 7/30 Barbell The trade that stands out as most attractive is to go long the 10-year Gilt bullet versus selling a 7-year/30-year Gilt curve barbell – a butterfly spread that was last priced this attractively in 2013 (Chart 10). We are adding this as a new recommended trade in our Tactical Overlay portfolio, the details of which (specific bonds and weightings for each leg of the trade) can be found on page 17. Bottom Line: Tighter monetary policies will pressure global bond yields higher over the next 6-12 months, but not equally. Stay underweight countries where tapering and rate hikes are more likely (the US, the UK, Canada, New Zealand) relative to countries where policymakers will move much more slowly (euro area, Australia, Japan). Global Breakevens: How Much More Upside? The surge in global inflation this year has helped boost the performance of inflation-linked government bonds versus nominal equivalents. Yet current breakeven inflation rates have reached levels not seen in some time. Last week, the 10-year US TIPS breakeven hit a 15-year high of 2.7%, the 10-year German breakeven reached a 9-year high of 2.1%, while the 10-year UK breakeven climbed to 4.2% - the highest level since 1996 (!). With market-based inflation expectations reaching such historically high levels, how much more can breakevens widen – especially with central banks incrementally moving towards tighter monetary policies? To answer that question, we turn to our Comprehensive Breakeven Indicators (CBIs). The CBIs measure the upside/downside potential for breakevens for the US, Germany, France, Italy, Japan, the UK, Canada and Australia. The CBIs incorporate the following three measures: The residuals from our 10-year breakeven inflation spread fair value models, as a measure of valuation. The spread between 10-year breakevens and survey-based measures of inflation expectations, as a measure of the inflation risk premium embedded in breakevens The gap between headline inflation and the central bank inflation target, as an indication of the existing inflation backdrop and of future monetary policy moves in response to an inflation trend that can help to reverse that trend. Each of the three measures is standardized and added together to produce a single CBI. A higher reading on CBI suggests less potential for additional increases in breakevens, and vice versa. The latest readings from our CBIs are shown in Chart 11. The red diamonds for each country are the actual CBI, while the stacked bars show the individual CBI components. The highest CBI readings are in Germany and the US, while the lowest are in Canada and France. Importantly, no country has a CBI significantly below zero, indicative of the more limited upside potential for breakevens after the big run-up since mid-2020. Chart 11 As a way to assess the usefulness of the CBIs as an indicator of the future breakeven moves, we constructed a simple backtest. We looked at how 10-year breakevens performed in the twelve months after the CBI hit certain thresholds (Chart 12). The backtest results show that the CBIs work as intended, signaling reversals of existing trends once the CBIs climb above +0.5 or below -0.5. The average (mean) size of the breakeven reversal gets larger as the CBI moves further to extremes. Chart 12 Based on the latest reading from the CBIs, we are making significant changes to the recommended allocations (Chart 13) to inflation-linked bonds (ILBs) in our model bond portfolio on pages 14-15: Chart 13No Overweights In Our Revised Allocations To Global Linkers No Overweights In Our Revised Allocations To Global Linkers No Overweights In Our Revised Allocations To Global Linkers Downgrading ILBs to underweight (versus nominal government bonds) in Germany, France, Italy & Spain from the current overweight allocation. The backtested CBI history for those countries suggests breakevens are more likely to fall over the next twelve months. Furthermore, realized euro area inflation is more likely to fall in 2022, given the lack of underlying euro area inflation described earlier in this report. Downgrade Japan ILBs to neutral from overweight. While the CBI is not at a stretched level, realized Japanese core inflation has struggled to stay in positive territory – even in the current environment of soaring commodity and durable goods prices. Upgrade ILBs in Canada and Australia to neutral from underweight. The former has a CBI that is still below zero, while the latter benefits from the lack of RBA hawkishness compared to other central banks. We are maintaining our other ILB allocations in the UK (underweight vs. nominals) and the US (neutral vs. nominals). In the UK, stretched breakevens are at risk from the hawkish turn by the BoE, which is a clear response to the higher UK inflation expectations. While the US CBI is at a high level, we see better value in playing for narrowing TIPS breakevens at shorter maturity points that are even more exposed to a likely slowing of commodity fueled inflation in 2022 than longer maturity TIPS breakevens. In other words, we see a steeper US breakeven curve, but a flatter real yield curve as the Fed tightens. Bottom Line: An update of our Comprehensive Breakeven Indicators shows limited scope for a further widening of breakeven inflation rates between nominal and index-linked government bonds in most developed economies, most notably in Europe.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.co Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

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

Highlights Bank of Canada: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Bank of England: Markets have aggressively shifted UK interest rate expectations, with a rate hike now expected before year-end. We expect that outcome to occur, but the vote will be close. Stay underweight UK Gilts in global bond portfolios. Maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Feature Chart of the WeekAn Inflation Shock For Bond Yields An Inflation Shock For Bond Yields An Inflation Shock For Bond Yields Steadily climbing inflation expectations, fueled by rising energy prices and persistent supply-chain disruptions, remain a thorn in the side of global bond markets. 10-year US TIPS breakevens have climbed to a 15-year high of 2.7%, while breakevens on 10-year German inflation-linked bonds are at a 9-year high of 2%. Rising inflation expectations are keeping upward pressure on nominal bond yields in the major developed economies, as markets start to slowly reprice the pace and timing of future interest rate increases (Chart of the Week). Market expectations on interest rates, however, can adjust much more quickly when policymakers change their tune. We have already seen that recently in smaller countries like Norway and New Zealand. Rate hikes delivered by the Norges Bank and Reserve Bank of New Zealand over the past month - which were telegraphed well in advance by the central banks – were a negative shock that pushed up bond yields in those countries. The next central bank “liftoff” within the developed economies is expected to occur in the UK and Canada, according to pricing in overnight index swap (OIS) curves (Table 1). In this report, we consider the outlook for monetary policy and government bond yields in both countries, which represent two of our highest conviction underweight recommendations. Table 1Markets Are Pulling Forward Rate Hikes UK & Canada: Next Up For A Rate Hike? UK & Canada: Next Up For A Rate Hike? Canada: Watch For A Bond Bearish Policy Shift In Canada, given the economic backdrop and policy constraints, we believe the Bank of Canada (BoC) will have to deliver on the hawkish market-implied path for interest rates, which calls for an initial rate hike to occur in Q2/2022 – much sooner than the central bank’s current messaging on liftoff. Chart 2ACanadian Inflation Not Looking So "Transitory" Anymore Canadian Inflation Not Looking So 'Transitory' Anymore Canadian Inflation Not Looking So 'Transitory' Anymore First on the BoC’s mind is inflation. Canadian CPI inflation came in at 4.4% year-over-year in September, blowing through analyst expectations and hitting an 18-year high (Charts 2A and 2B). The CPI-trim, a measure of core inflation which strips out extreme price movements, hit 3.4% year-over-year, the highest reading since 1991. All eight major components of the CPI rose on a yearly basis. On an annualized monthly basis, the energy-driven Transportation aggregate declined and less volatile components like Shelter (+1.1%) and Clothing (+0.7%) led the pack in terms of their contribution to the overall figure.   Chart 2 The data show that inflationary pressures are clearly broadening out in the Great White North, no longer constrained to “transitory” sectors. The effect of this inflationary pressure is also starting to make its mark on consumer and business sentiment. Chart 3Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment Rising Inflation Expectations Are Hurting Canadian Consumer Sentiment According to the BoC Survey of Consumer Expectations, the 1-year-ahead forecast of inflation reached a series high of 3.7% in Q3/2021 (Chart 3). While longer-term inflation expectations are more subdued, that doesn’t mean that inflation is not a worry for the Canadian consumer. With inflation expected to run much higher than expected wage growth (+2%) over the next year, consumers expect a decline in their real purchasing power. Correspondingly, consumer confidence is taking a hit—the Bloomberg/Nanos consumer sentiment index has fallen 7.3 points since the July peak. Canadian businesses are much more upbeat. The overall summary indicator from the BoC’s Business Outlook Survey for Q3/2021 climbed to the highest level in the 18-year history of the series (Chart 4). Firms reported continued expectations of strong demand, but with capacity constraints starting to weigh on sales - a quarter of firms surveyed reporting that a lack of capacity and skills will have a negative impact on sales over the next twelve months. In response, more companies are planning on increasing capital expenditure and hiring over the next year (Chart 4, middle panel). More than half of firms surveyed by the BoC indicated that investment spending will be higher over the next two years compared to typical pre-pandemic levels. Chart 4Canadian Businesses Are Brushing Up Against Capacity Constraints Canadian Businesses Are Brushing Up Against Capacity Constraints Canadian Businesses Are Brushing Up Against Capacity Constraints However, hiring plans will likely face difficulty, given the large share of firms (64%), reporting more intense labor shortages (Chart 4, bottom panel). A net 50% of respondents now expect wage growth to accelerate over the coming year, driven by a need to attract and retain workers amid strong labor demand. With regards to inflation, the BoC Business Outlook Survey measures the share of respondents that expect inflation over the next two years to fall within four different ranges—below 1%, between 1% and 2%, between 2% and 3%, and above 3% (Chart 5). We can “back out” a point estimate of expected inflation for Canadian firms by assigning a specific level to each of these ranges – 0.5, 1.5%, 2.5%, and 3.5%, respectively – and using the shares of respondents to calculate a weighted average expected inflation rate for the next two years.1 Based on this estimate, Canadian business inflation expectations have bounced rapidly since the 2020 trough and are now at all-time highs. The BoC has already begun to respond to the normalization of the economy and rising inflationary pressures indicated by its business survey by tapering the pace of its bond buying program. The Bank is now targeting weekly bond purchases of C$2bn, down from C$5bn at the start of the program and with another reduction expected at this week’s policy meeting (Chart 6). The size of the balance sheet has also fallen in absolute terms, driven by the Bank drawing down its holdings of treasury bills to virtually zero while also ending pandemic emergency liquidity programs. Chart 5Putting A Number To Canadian Business Inflation Expectations Putting a Number To Canadian Business Inflation Expectations Putting a Number To Canadian Business Inflation Expectations Chart 6The BoC Is Moving Towards Normalizing Policy The BoC Is Moving Towards Normalizing Policy The BoC Is Moving Towards Normalizing Policy The BoC now owns a massive 36.5% of Canadian government bonds outstanding – a share acquired in a very short time for this pandemic-era stimulus program. Thus, tapering now is not only necessary from a forward guidance perspective, signaling an eventual shift to less accommodative monetary policy and rate hikes, but also to ensure liquidity in the Canadian sovereign bond market. The remaining BoC tapering will be fairly quick, setting up the more important shift to the timing of the first rate increase. The Canadian OIS curve is currently pricing in BoC liftoff in April 2022, ahead of the BoC’s current guidance of a likely rate hike in the second half of the year (Chart 7). Given the developments on the inflation front, we are inclined to side with the market’s assessment of an earlier hike. Chart 7 In the longer run, rates might even be able to rise further than discounted in swap curves. The real policy rate, calculated as the policy rate minus the BoC’s CPI-trim measure, is negative and a significant distance from the New York Fed’s Q2/2020 estimate of the natural real rate of interest (R-star) for Canada of 1.4%. Admittedly, those estimates have not been updated by the New York Fed for over a year, given the uncertainties over trend growth and output gap measurement created by the pandemic shock. The BoC’s own estimates for the neutral nominal policy interest rate - last updated in April 2021 and therefore inclusive of any structural impacts of the pandemic on potential growth - range from 1.75% to 2.75%.2 The OIS forward curve expects the BoC to only lift rates to 2% in the next hiking cycle, barely in the lower end of the BoC’s neutral range of estimates. After subtracting the mid-point of the BoC’s 1-3% inflation target, presumably a level of inflation consistent with a neutral policy rate, the BoC’s implied real policy rate range is -0.25% to +0.75%. The current level of the real policy rate is near the bottom of that range. Thus, real rates, and the real bond yields that track them over time, have room to rise if the BoC begins to hike rates at a faster pace, and to a higher level, than the market expects. We see this as a likely outcome given the extent of the Canadian inflation overshoot and the robust optimism evident in Canadian business sentiment, thus justifying our current negative view on Canadian government bonds. To think about this mix of rising inflation expectations and increased BoC hawkishness down the road, and its implication for the Canadian inflation-linked bond market, we turn to our Canadian comprehensive breakeven indicator (Chart 8). This indicator combines three measures, on an equal-weighted and standardized basis, to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and the midpoint of the BoC’s 1-3% target inflation, and the gap between market-based and survey-based measures of inflation expectations. Going forward, we will be using the Canadian Business Outlook Survey measure of inflation expectations, introduced in Chart 5, for this indicator. Chart 8Upgrade Canadian Inflation-Linked Bonds To Neutral Upgrade Canadian Inflation-Linked Bonds To Neutral Upgrade Canadian Inflation-Linked Bonds To Neutral Two out of three measures point towards Canadian breakevens having further upside. Firstly, they are cheap under our fair value model, where the rise in breakevens has lagged the yearly growth in oil prices. Secondly, breakevens are a long distance away from the survey-based business inflation expectations. However, both forces are more than counteracted with Canadian headline inflation nearly two standard deviations from the BoC’s target, which indicates that the central bank must step in to address high realized inflation. Given these diverging signals on the upside potential for breakevens, we see a neutral allocation to Canadian linkers as more appropriate for the time being Bottom Line: Rising inflation, high capacity utilization, and monetary policy constraints will force the Bank of Canada to taper further and move up the timing of its first rate hike to H1/2022. Stay underweight Canadian government bonds in global government bond portfolios. Also, upgrade Canadian real return bonds to neutral within the underweight allocation to better reflect the mixed signals from our suite of Canadian inflation breakeven indicators. Will The BoE Actually Hike By December? Chart 9UK Gilts Have Been Hammered By BoE Hawkishness UK Gilts Have Been Hammered By BoE Hawkishness UK Gilts Have Been Hammered By BoE Hawkishness We downgraded our recommended stance on UK government bonds to underweight on August 11 and, since then, Gilts have severely underperformed their developed market peers (Chart 9).3 We had anticipated that the Bank of England (BoE) would be forced to shift their policy guidance in a less dovish direction because of rising UK inflation expectations. Yet we have been surprised by how quickly the BoE has shifted to an open discussion about the potential for imminent interest rate hikes. The BoE’s new chief economist, Huw Pill, commented in the Financial Times last week that UK inflation will likely hit, or even exceed, 5% by early next year, and that the November 4 Monetary Policy Committee (MPC) was “live” with regards to a potential rate hike.4 This followed BoE Governor Andrew Bailey’s comment that the Bank “will have to act” to contain rising inflation expectations. Mixed signals on economic momentum are not making the BoE’s decisions any easier. The preliminary October Markit PMIs ticked higher for both manufacturing and services, but remain below the peak seen last May. At the same time, UK consumer confidence has fallen since August, thanks in part to rapidly rising inflation that has reduced the perceived real buying power of UK consumers. High Inflation Might Last Longer Chart 10Why The BoE Is More Worried About Inflation Why The BoE Is More Worried About Inflation Why The BoE Is More Worried About Inflation The BoE’s last set of economic forecasts, published in August, called for headline inflation to temporarily climb to 4% by year-end, before gradually returning to the central bank’s 2% target level in 2022. Yet the BoE’s newfound nervousness over inflation is well-founded, for a number of reasons (Chart 10): The domestic economic recovery has led to a robust labor market, with job vacancies relative to unemployment fully recovering to pre-COVID levels. The 3-month moving average of wage growth remains elevated at 6.9%, although the BoE believes some of that increase could be due to compositional issues related to the pandemic. The BoE is projecting that the UK output gap is narrowing rapidly and would be fully closed in the second half of 2022. This suggests growing underlying inflation pressures were already in place before the latest boost to inflation from global supply-chain disruptions. UK energy costs are soaring, particularly for natural gas which remains the main source for UK electricity production. UK natural gas inventories are the lowest within Europe, yet the supply response from major providers has been slow to develop – most notably, Russia, which is seeking regulatory approval to begin shipping gas through the Nord Stream 2 pipeline. While natural gas prices have stopped rising, for now, inadequate supplies during an expected cold UK winter could keep the upward pressure on UK inflation from energy. UK house price inflation remains well supported, even with the recent expiration of the stamp duty reductions initiated as a form of pandemic economic stimulus. According to the Royal Institution of Chartered Surveyors (RICS), the ratio of UK home sales to inventories is still quite elevated (bottom panel). Given a still-favorable demand/supply balance, and low borrowing costs, UK house price inflation will likely not cool as much as the BoE would prefer to see. Stay Defensive On UK Rates Exposure The combination of rising UK inflation and increasingly hawkish BoE comments has resulted in a rapid upward repricing of UK interest rate expectations over the past few months (Chart 11). Markets now expect the BoE to raise Bank Rate to 1%, from the current 0.1%, by late 2022. More interesting is what is discounted after that. The OIS curve is pricing in no additional rate increases in 2023 and a rate cut in 2024. In other words, the market now believes that the BoE is about to embark on a policy mistake with rate hikes that will need to be quickly reversed. Chart 11Markets Are Pricing In A BoE Policy Error Markets Are Pricing In A BoE Policy Error Markets Are Pricing In A BoE Policy Error We think there is a risk of a more aggressive-than-expected BoE tightening cycle. The surge in UK inflation expectations is not trivial nor “transitory”. Looking at survey-based measures of expectations like the YouGov/Citigroup survey, or market-based measures like CPI swaps, inflation is expected to reach at least 4% both in the short-term and over the longer-run (Chart 12). If Bank Rate were to peak at a mere 1%, as indicated in the OIS curve, that would still leave UK real interest rates in deeply negative territory even if there was a pullback in inflation expectations. We expect the votes on whether to hike rates at either the November or December MPC meetings to be close. There will be a new Monetary Policy Report published for the November 4 meeting, which will include a new set of economic and inflation forecasts that will give the BoE a platform to signal, or deliver, a rate hike. In the end, we think that the senior leadership on the MPC has already revealed too much of its hawkish hand, and a rate hike will occur by year-end. Looking beyond liftoff into 2022, we still see markets pricing in too shallow a path for Bank Rate over the next couple of years, leaving us comfortable to maintain our underweight stance on UK Gilts. With regards to positioning along the Gilt yield curve, however, we see the potential for more curve steepening even if after the BoE begins to lift rates. The implied path for UK real interest rates, taken as the gap between the UK OIS forwards and CPI swap forwards, shows that markets expect the BoE to keep policy rates well below expected inflation for well into the next decade (Chart 13). At the same time, the wide current gap between the actual real policy rate (Bank Rate minus headline inflation) and the New York Fed’s most recent estimate of the UK neutral real rate (r-star) suggests that the Gilt curve is far too flat (bottom panel). Chart 12The BoE Cannot Ignore This The BoE Cannot Ignore This The BoE Cannot Ignore This Perversely, this creates a situation where the UK curve steepeners can be an attractive near-term hedge to an underweight stance on UK Gilts. Chart 13 If the BoE does not deliver on the strongly hinted rate hike in November or December, the Gilt curve can steepen as shorter-maturity Gilt yields fall but longer-dated yields remain boosted by high inflation expectations.However, if the BoE does hike and more tightening is signaled, longer-term yields will likely rise more than shorter-term yields as the market prices in a higher future trajectory for policy rates. Bottom Line: Stay underweight UK Gilts in global bond portfolios, but maintain a curve steepening bias that would win if a hike is delayed to 2022 or, counterintuitively, even if the Bank of England does indeed hike in November or December - longer-term UK yields are still too low relative to the likely peak in Bank Rate. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 For this calculation, we exclude firms that did not provide a response to the BoC Business Outlook Survey. 2 The Bank of Canada’s Staff Analytical Note on neutral rate estimation can be found here: https://www.bankofcanada.ca/2021/04/staff-analytical-note-2021-6/ 3 Please see BCA Research Global Fixed Income Strategy and European Investment Strategy Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. 4https://www.ft.com/content/bce7b1c5-0272-480f-8630-85c477e7d69 Recommendations Duration Regional Allocation Spread Product Tactical Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Image The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

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

Highlights Duration: We recommend that investors run below-benchmark portfolio duration in US bond portfolios on the expectation that the Treasury curve will bear-flatten between now and Fed liftoff in December 2022. Nominal Treasury Curve: We recommend positioning for curve flattening by going short the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. TIPS: Investors should position for higher short-maturity real yields. This can be done through an outright short position in 2-year TIPS, an inflation curve steepener or a real yield curve flattener. The Long And Short Of It Chart 1Short-End Joins The Selloff Short-End Joins The Selloff Short-End Joins The Selloff It’s still a bit early for a 2021 retrospective, but unless something dramatic happens during the next 2 ½ months it’s likely that the year will go into the books as a bad one for US bonds. Looking back, we can identify three phases of bond market performance in 2021. First, a selloff in long-dated bonds early in the year driven by economic re-opening and fiscal stimulus. Second, a partial reversal of this long-end selloff that lasted through the spring and early summer. Finally, a renewed selloff involving both the long and short ends of the yield curve (Chart 1). The Long End Looking first at the long end of the curve, we don’t see any immediate signs that yields have risen too far. Estimates of the 10-year term premium created by taking the difference between the spot 10-year Treasury yield and survey estimates of the future 10-year average fed funds rate show that the term premium is not as elevated as it was when yields peaked last March or when they peaked in 2018 (Chart 2). The 25-delta risk reversal on 30-year Treasury futures – a technical indicator with a strong track record of calling turning points in the 30-year yield – also remains below the 1.5 level that has historically signaled a peak in the 30-year yield (Chart 3). Table 1 shows that while it is rare for the risk reversal to rise above 1.5, such a move usually indicates that yields have risen too far, too fast Chart 210-Year Term Premium Still Low 10-Year Term Premium Still Low 10-Year Term Premium Still Low Chart 3Technicals Not Stretched Technicals Not Stretched Technicals Not Stretched Table 1Track Record Of Risk Reversal Indicator Right Price, Wrong Reason Right Price, Wrong Reason Finally, we look at the 5-year/5-year forward Treasury yield relative to a range of survey estimates of the long-run neutral fed funds rate (Chart 4). At 2.09%, the 5-year/5-year yield is close to median survey estimates of the long-run neutral fed funds rate.1 We take this to mean that the 5y5y yield has limited upside. Further increases in yields will take the form of the rest of the curve catching up to the 5y5y. Put differently, further increases in yields are more likely to coincide with curve flattening, not steepening.2  Chart 45y5y Is At Its Fair Value 5y5y Is At Its Fair Value 5y5y Is At Its Fair Value The Short End While long-maturity bond yields have moved up during the past few months, it is the breakout in short-maturity Treasury yields that has been the most notable feature of the recent bond selloff (Chart 1, bottom panel). In particular, near-term interest rate expectations have adjusted sharply higher since the September FOMC meeting (Chart 5). Prior to the September FOMC meeting, the overnight index swap (OIS) market was priced for Fed liftoff in February 2023 and for a total of 80 bps of rate hikes by the end of 2023. Now, the OIS curve is priced for Fed liftoff in September 2022 and for a total of 113 bps of rate hikes by the end of 2023. Chart 5Fed Funds Rate Expectations Fed Funds Rate Expectations Fed Funds Rate Expectations We continue to view the December 2022 FOMC meeting as the most likely date for the first rate hike. We also think it’s reasonable to expect the Fed to lift rates at a pace of 75-100 bps per year once tightening begins. In other words, we view fair pricing at the front-end of the curve as consistent with liftoff in December 2022 and a total of 100-125 bps of rate hikes by the end of 2023. The recent selloff has made front-end pricing more consistent with our assessment of fair value. Therefore, we don’t see any huge opportunities for directional bets on short-dated nominal yields. That said, we also contend that the bond market has arrived at the correct conclusion about the near-term pace of Fed tightening, but for the wrong reason. As is discussed in the next section of this report (see section titled “Massive Upside In Short-Maturity Real Yields”), this presents some attractive opportunities to trade short-maturity real yields and short-maturity inflation breakevens. One other observation from Chart 5 is that the market’s expected pace of Fed tightening flattens off considerably in 2024 and beyond. The market is priced for a mere 34 bps of tightening in 2024 and 2025 and the fed funds rate is still expected to be below 1.6% by the end of 2025. This highlights that, while pricing at the front-end of the yield curve looks reasonable, yields with slightly longer maturities remain too low. Bottom Line: We recommend that investors run below-benchmark portfolio duration in US bond portfolios on the expectation that the Treasury curve will bear-flatten between now and Fed liftoff in December 2022. We recommend positioning for curve flattening by going short the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Massive Upside In Short-Maturity Real Yields Table 2Yield Changes Since September FOMC (BPs) Right Price, Wrong Reason Right Price, Wrong Reason The prior section noted that the market’s near-term rate expectations have risen considerably during the past few weeks. While we think that pricing looks reasonable compared to our own monetary policy expectations, we alluded to the idea that the market has brought forward its rate hike expectations for the wrong reason. Table 2 illustrates what we mean. Practically all the increase in nominal Treasury yields since the September FOMC meeting has been driven by a rising cost of inflation compensation. Real yields, on the other hand, have either been relatively stable (for long maturities) or have fallen massively (at the short-end of the curve). In fact, the 2-year real yield has declined 34 bps since the September FOMC meeting even as the 2-year nominal yield has increased by 16 bps. What the stark divergence between real yields and the cost of inflation compensation tells us is that the market is concerned that inflation may not fall as much as was previously assumed and the Fed may be forced to tighten more quickly in response. First off, we think concerns about persistently high inflation are a tad overblown. It’s certainly true that 12-month headline and core CPI inflation remain extremely high, at 5.4% and 4.0% respectively, but 3-month rates of change have moderated during the past few months and the 12-month figures will soon follow suit (Chart 6). Second, even if inflation is slow to moderate, the composition of what is driving that high inflation has implications for how the Fed will respond. Specifically, if elevated inflation continues to be driven by extreme readings from a few sectors that have been inordinately impacted by the pandemic, the Fed will be inclined to write-off that inflation as “transitory” while it awaits more broad-based inflationary pressures driven by tight labor markets and accelerating wages. It continues to be worth noting that after stripping out COVID-impacted services and cars, core inflation remains well contained near levels consistent with the Fed’s target (Chart 7). Chart 6Inflation Is Falling Inflation Is Falling Inflation Is Falling Chart 7Inflation Pressures Are Narrow Inflation Pressures Are Narrow Inflation Pressures Are Narrow In a speech last week, Atlanta Fed President Raphael Bostic said that the Fed should use the word “episodic” instead of “transitory” to describe the nature of the current inflationary shock.3 The problem with the word “transitory” is that it is linked to a notion of time. It implies that inflation pressures are expected to fade quickly, but this is not the message that the Fed meant to convey with that word. Rather, in Bostic’s words, the Fed meant to convey that “these price changes are tied specifically to the presence of the pandemic and, once the pandemic is behind us, will eventually unwind, by themselves, without necessarily threatening longer-run price stability.” In other words, the Fed will not tighten policy to lean against narrow inflationary pressures driven by a few sectors that can easily be traced back to the pandemic. Rather, the Fed will only respond if inflationary pressures are sufficiently broad and/or if long-run inflation expectations become un-anchored to the upside. On the first point, there is some evidence that inflation pressures are broadening. As of September, 49% of the CPI index was growing at a 12-month rate above 3%, up from a 2021 low of 22% (Chart 8). However, long-run inflation expectations remain well-anchored near the Fed’s target levels (Chart 9). Chart 8CPI Breadth Indicator CPI Breadth Indicator CPI Breadth Indicator Chart 9Long-Term Inflation Expectations Long-Term Inflation Expectations Long-Term Inflation Expectations Our sense is that inflationary pressures will fade during the next 12 months as pandemic fears abate. Long-dated inflation expectations will remain close to current levels, but short-dated inflation expectations will fall. The Fed will start to lift rates in December 2022 as broad-based inflationary pressures emerge, but inflation will be only slightly above the Fed’s target by then. The best way to position for this outcome is to go short 2-year TIPS. The cost of 2-year inflation compensation will fall as inflation moderates during the next 12 months, but the nominal 2-year yield will rise modestly as we advance toward a Fed tightening cycle. These two factors will combine to drive the 2-year real yield sharply higher (Chart 10). If you prefer not to put on an outright short 2-year TIPS position, there are a few other ways to position for the same trend. First, investors could position for a steeper inflation curve. Chart 11 shows that the cost of short-maturity inflation compensation is much further above the Fed’s target level than the cost of long-maturity inflation compensation. Further, Table 3 shows that monthly changes in the cost of short-maturity inflation compensation are more sensitive to CPI than are changes in the long-maturity cost of inflation compensation. This means that the inflation curve will steepen during the next 12 months as inflation moderates and the short-term cost of inflation compensation falls. Chart 10Short 2-Year TIPS Short 2-Year TIPS Short 2-Year TIPS Chart 11Position For Inflation Curve Steepening... Position For Inflation Curve Steepening... Position For Inflation Curve Steepening... Table 3Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present) Right Price, Wrong Reason Right Price, Wrong Reason   Second, you could also position for a flatter TIPS yield curve (Chart 12). The combination of inflation curve steepening and nominal curve flattening will lead to a supercharged flattening of the real yield curve during the next 12 months. Chart 12... And Real Yield Curve Flattening ... And Real Yield Curve Flattening ... And Real Yield Curve Flattening Bottom Line: Investors should position for higher short-maturity real yields. This can be done through an outright short position in 2-year TIPS, an inflation curve steepener or a real yield curve flattener.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The median response from the New York Fed’s Survey of Market Participants pegs the long-run neutral fed funds rate at 2.0%. The same measure from the Survey of Primary Dealers sits at 2.25%. 2 For more details on the relationship between the proximity of the 5-year/5-year yield to its fair value range and the slope of the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 3 https://www.atlantafed.org/news/speeches/2021/10/12/bostic-the-current-inflation-episode.aspx Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures Cyclical UST Curve Flattening Pressures Cyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Stay In Our 2/5/10 UST Butterfly Trade Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation ECB Will Not React To This Cyclical Bout Of Inflation ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based Euro Area Inflation Upturn Is Not Broad-Based Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade Close Our Long Dec/23 Euribor Futures Trade Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Enter A New 10yr UST-Bund Spread Widening Trade Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening UST-Bund Technical Backdrop Positioned For Widening UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread Relative Data Surprises Favor Wider UST-Bund Spread Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade Take Profits On Our Long 10yr French Breakevens Trade Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves An Inflation-Induced Bear Steepening Of Yield Curves An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model Inputs Into Our Australia-US Spread Model Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Market Expectations For The RBA Are Too Hawkish Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Go Long 10-Yr Australian Inflation Breakevens Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Thematic Update Of Our Tactical Trades A Thematic Update Of Our Tactical Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Next week is the BCA Annual Conference, at which I will debate Professor Nouriel Roubini on ‘The Outlook For Cryptocurrencies’. I will make the passioned case for cryptos, and Nouriel will make the passioned case against. I do hope that many of you can join the debate, as well as the other insightful sessions at the conference. As such, there will be no report next week and we will be back on October 28. Highlights The anomaly of the current ‘inflation crisis’ is not that goods and commodity prices have surged. The anomaly is that state intervention protected services prices from a massive (and continuing) negative demand shock. Absent the state intervention, there would not be the current ‘inflation crisis’. On a 6-12-month horizon: Underweight the durables-heavy consumer discretionary sector versus the market. Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Fractal analysis: Natural gas, plus industrial metals versus industrial metal equities. Feature Chart of the WeekServices Prices Suffered In The Post-GFC Services Slump... Services Prices Suffered In The Post-GFC Services Slump... Services Prices Suffered In The Post-GFC Services Slump... Chart of the Week...But Not In The Post-Pandemic Services Slump. Why Not? ...But Not In The Post-Pandemic Services Slump. Why Not? ...But Not In The Post-Pandemic Services Slump. Why Not? The great writers, artists, and musicians tell us that the most profound messages often come from what is not said, not painted, and not played. What does not happen is sometimes more significant than what does happen. In this vein, we believe that the real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. The real story is that while goods and commodity prices have reacted exactly as would be expected to a positive demand shock, services prices have not reacted as would be expected to the mirror-image negative demand shock. The Anomaly Is Not Goods Prices, It Is Services Prices The following analysis quantifies the impact of the pandemic on different parts of the economy by examining the deviations of current spending and prices from their pre-pandemic trends. The analysis uses US data simply because of its timeliness and granularity, but the broad patterns and conclusions apply equally to most other developed economies. Looking at the overall economy, we know that, thus far, we have experienced neither a lasting negative demand shock from the pandemic, nor a lasting positive demand shock from the ensuing stimulus. We know this, because current spending is not far short of its pre-pandemic trend. The real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. Yet when we drill down to the components of spending, we see a different story. The pandemic and its policy response unleashed a massive and unprecedented displacement of spending from services to goods (Chart I-2). Chart I-2The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods By March 2021, while US spending on services was still below its pre-pandemic trend by $700 billion, or 8 percent, the displacement of those dollars of spending had boosted spending on the smaller durable goods component by 26 percent. Suffice to say, a 26 percent excess demand for durable goods cannot be satisfied by a modern manufacturing sector that utilises just-in-time supply chains and negligible spare capacity! As surging demand met relatively fixed supply, the price of durable goods skyrocketed to the current 11 percent above its pre-pandemic trend (Chart I-3). Chart I-3The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational It follows that the inflation in durables prices is the perfectly rational outcome of a classic positive demand shock – meaning, surging demand in the face of limited supply. What is much less rational is that a massive negative demand shock for services has had almost no negative impact on services prices. This is the untold story of the current ‘inflation crisis’ which requires further explanation. Government Intervention Prevented A Collapse In Services Prices If the pandemic had unleashed a classic negative demand shock for services, then services prices would have collapsed. We know this because in the aftermath of the global financial crisis (GFC), services prices fell below their pre-GFC trend exactly in line with the decline in services demand. But in the aftermath of the pandemic’s massive negative shock for services spending, services prices have remained on their pre-pandemic trend (Chart of the Week). The question is, how? The answer is that this was not a classic negative demand shock. The reason that service spending collapsed was that a large swathe of services – such as leisure and hospitality – became unavailable because of mandated shutdowns or lockdowns. In this case, there was no point in reducing prices to reattract demand from durable goods because nobody could buy these services anyway! In effect, while the goods sector remained subject to market forces, a large swathe of the service sector came under state intervention, and was no longer subject to market forces. Meanwhile, statisticians continued to record the seemingly unaffected price of eating out or going to the theatre, even though most restaurants and entertainment venues were shuttered, making their prices meaningless. Absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. Absent state intervention, these service providers would have had to reduce their prices to attract wary consumers amid a pandemic. This we know from Sweden, the one major economy that did not have any mandated shutdowns or lockdowns. While leisure and hospitality have remained largely open, Sweden’s services prices have declined markedly from their pre-pandemic trend – in sharp contrast to the unchanged trend in the US (Chart I-4). Chart I-4Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Hence, while inflation now stands at a sedate 2 percent in Sweden, it stands at a hot 5 percent in the US. If the US (and other country) governments had not intervened in the services sector, then the evidence from the GFC in 2008 and Sweden today strongly suggests that services prices would be below their pre-pandemic trend, offsetting goods prices that are above their pre-pandemic trend. The result would be that the overall price level would be on, or close to, its pre-pandemic trend. Just as overall spending is on its pre-pandemic trend. To repeat the key message of this analysis, the anomaly in most economies is not that goods and commodity prices have surged. The price surge is the perfectly rational response to a positive demand shock. The anomaly is that services prices did not react negatively to a negative demand shock (Chart I-5 and Chart I-6), as they did post-GFC and post-pandemic in non-interventionist Sweden. Chart I-5The Anomaly Is Not That Goods Prices ##br##Rose... The Anomaly Is Not That Goods Prices Rose... The Anomaly Is Not That Goods Prices Rose... Chart I-6...The Anomaly Is That Services Prices Did Not Fall ...The Anomaly Is That Services Prices Did Not Fall ...The Anomaly Is That Services Prices Did Not Fall The untold story is that, absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. What Happens Next? The surging demand for durables is correcting. Since March, it is already down by 15 percent but requires a further 7 percent decline to reach its pre-pandemic trend, which we fully expect to happen. After all, there are only so many smartphones and used cars that you can own! Meanwhile, as manufacturers respond with a lag to recent high prices, expect a tsunami of durables supply to hit in 6-12 months just as demand has fallen off a cliff. The result will be a major threat to any durable good or commodity price that has not already corrected. As a salutary warning of what lies ahead, witness the recent 75 percent crash in lumber prices. The same principle applies to non-durables such as food and energy. Non-durables spending is likely to fall back to its pre-pandemic trend, and non-durables prices are likely to follow. Again, outside a short-lived surge in demand from, say, a very cold winter, there is only so much energy and food that you can consume. For services, there are two opposing forces. The inflationary force is that the recent inflation in goods will transmit into wages and therefore into services prices. Against this, the deflationary force is that structural changes, such as hybrid home/office working, mean that services spending will struggle to make the near 6 percent increase to reach its pre-pandemic trend. Underweight the durables-heavy consumer discretionary sector versus the market. Pulling these effects together, we reiterate three investment recommendations on a 6-12 month horizon: Underweight the durables-heavy consumer discretionary sector versus the market (Chart I-7). Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Chart I-7As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms Natural Gas Prices Are Technically Extreme The surge in natural gas prices in both Europe and the US has reached a point of extreme fragility on its 130-day fractal structure. Hence, if the tight fundamentals show the slightest signs of abating, natural gas prices would be vulnerable to a sharp reversal (Chart I-8). Chart I-8Natural Gas Prices Are Technically Extreme Natural Gas Prices Are Technically Extreme Natural Gas Prices Are Technically Extreme Elsewhere, we see an arbitrage opportunity between industrial metal prices, which are still close to highs, and industrial metal equities, which have plunged by 20 percent since May. The relationship between the underlying metal prices and the metals equities sector is now stretched versus its history, and on its composite 65/130-day fractal structure (Chart I-9). Chart I-9The Relationship Between Metal Prices And Metal Equities Is Stretched The Relationship Between Metal Prices And Metal Equities Is Stretched The Relationship Between Metal Prices And Metal Equities Is Stretched Hence, the recommended trade is to go short the LMEX Index/ long nonferrous metals equities. One way to implement the long side of the pair is through the ETF PICK. Set the profit target and symmetrical stop-loss at 8 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- 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 ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Equity valuations are extremely stretched versus bonds, so there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. We estimate that bond yields can rise by no more than 30 bps, before the Fed is forced to talk them back down again. Starting from an earnings yield that is extreme versus its history, we should prudently assume that the prospective long-term real return from equities will be far below the current earnings yield of 4.6 percent, and closer to zero, even if not actually negative. In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. Fractal analysis: Cotton, and Polish equities. Feature Chart of the WeekTech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Tech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Tech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Equity valuations are extremely stretched versus bonds. The upshot is that there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. This is not just an abstract hypothesis – it is an empirical fact, as recent market action is making painfully clear. Since February, the global tech sector has tracked the 30-year T-bond price almost one-for-one. The near perfect fit proves that the tech (and broader growth stock) rally has been entirely premised on the bond market rally. Hence, on the three occasions that bonds have sold off sharply – including in the last couple of weeks – tech stocks have sold off sharply too (Chart of the Week). Put simply, the performance of the tech sector is being driven by the change in its valuation, and the change in its valuation is being driven by the change in the bond yield (Chart I-2). Chart I-2Tech Stock Valuations Are Being Driven By The Bond Yield Tech Stock Valuations Are Being Driven By The Bond Yield Tech Stock Valuations Are Being Driven By The Bond Yield Of course, stock prices are also premised on earnings. So, given enough time, rising earnings can make valuations less stretched, adding more wiggle room for bonds to sell off. The trouble is that a change in earnings happens much more gradually than can a change in valuation – a 10 percent rise in earnings can take a year, whereas a 10 percent fall in valuation can happen in a week. Bond Yields Remain The Dominant Driver Of The Stock Market For the next few months at least, the movement in bond yields will remain the dominant driver of the most stretched parts of the stock market and, by extension, the overall market itself. This is especially true for the growth-heavy S&P 500 which, since March, has been tracking the 30-year T-bond price one-for-one (Chart I-3). Chart I-3The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The key question for investors is, what is the upper limit to bond yields before stock market damage causes the Federal Reserve to talk them down again? To answer this question, our working assumption is that a 15 percent drawdown in growth stocks would damage the growth-heavy S&P 500 enough – and thereby worsen ‘financial conditions’ enough – for the Fed to change its tone. Based on this year’s very tight relationship between tech stocks and the 30-year T-bond yield, a 15 percent drawdown would occur if the 30-year T-bond yield increased to 2.4 percent from 2.1 percent today (Chart I-4). Chart I-4The Fed's 'Pain Point' Is Only 30 Basis Points Away The Fed's 'Pain Point' Is Only 30 Basis Points Away The Fed's 'Pain Point' Is Only 30 Basis Points Away This confirms our view that the resistance level to long-duration bond yields is around 30 bps above current levels, equivalent to around 1.8 percent on the 10-year T-bond yield. More About The ‘Negative Equity Risk Premium’ Our recent report The Equity Risk Premium Turns Negative For The First Time Since 2002 caused quite a stir. So, let’s elaborate and clarify the arguments we made about the equity risk premium (ERP) – the estimated excess return that stocks will deliver over bonds over a long investment horizon, such as 10 years. Many investors estimate the ERP by taking the stock market’s earnings yield – currently 4.6 percent in the US1 – and subtracting the real 10-year bond yield – currently -0.9 percent on US Treasury Inflation Protected Securities (TIPS). At first glance, this presents a very generous ERP of 5.5 percent. So, equities are attractively valued versus bonds, right? Wrong. The glaring error is that the earnings yield estimates the stock market’s prospective return only if the earnings yield starts and ends at the same level. If it does not, then the prospective return could be very different to the earnings yield. For example, imagine that the stock market was trading at a bubble price-to-earnings multiple of 100, meaning an earnings yield of 1 percent. Clearly, from such a bubble valuation, nobody would expect the market to return 1 percent. Instead, as the bubble burst, and valuations normalised, the prospective return would be deeply negative. It follows that when, as now, the earnings yield is extreme versus its history, we must build in some prudent normalisation to estimate the prospective return. The question is, how? One approach is to use history to inform us of the likely normalisation. Chart I-5 does this using the ‘best-fit’ relationship between the earnings yield at each point through 1990-2011 and subsequent 10-year real return from each starting point. Using the best-fit for this specific episode, the current earnings yield of 4.6 percent implies a prospective 10-year real return not of 4.6 percent, but of -1.1 percent. Chart I-5Based On History, The Current Earnings Yield Implies A Prospective 10-Year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 10-year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 10-year Real Return Much Less Than 4.6 Percent Yet this best-fit approach meets a common reproach – that the best-fit for this specific episode is massively distorted by the dot com bubble peak and the global financial crisis (GFC) trough occurring (by coincidence) almost 10 years apart. We can counter this reproach in two ways. First, the best-fit relationship is much better than the raw earnings yield even for undistorted 10-year periods such as 1995-2005 or 2011-2021. Better still, we can change the prospective return from 10 years to 7 years and thereby remove the dot com bubble peak to GFC trough distortion. Chart I-6 shows that this 7-year best-fit relationship also works much better than the raw earnings yield. Chart I-6Based On History, The Current Earnings Yield Implies A Prospective 7-Year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 7-year Real Return Much Less Than 4.6 Percent Based On History, The Current Earnings Yield Implies A Prospective 7-year Real Return Much Less Than 4.6 Percent Admittedly, the best-fit comes from just one episode in history, and there is no certainty that the 10-year and 7-year relationships that applied during that one episode should apply through 2021-31 and 2021-28 respectively. Nevertheless, starting from an earnings yield that is extreme versus its history, as is the case now, we should prudently assume that the prospective long-term real return from equities will be far below 4.6 percent, and closer to zero, even if not actually negative. Will The ‘Real’ Real Yield Please Stand Up Measuring the ERP also requires an estimate of the prospective real return on bonds. This part should be easy because the yield on the US 10-year TIPS – currently -0.9 percent – is the guaranteed 10-year real return of buying and holding that investment. It is derived by taking the yield on the 10-year T-bond – currently 1.5 percent – and subtracting the market’s expected rate of inflation over the next 10 years – currently 2.4 percent. But the equivalent real return on the much larger conventional bond market could be quite different. In this case, it will be the 10-year T-bond yield minus the actual rate of inflation over the next 10 years. To the extent that the actual rate of inflation turns out less than the expected rate of 2.4 percent, the real return on the T-bond will turn out higher than that on the TIPS. In fact, this has consistently turned out to be the case. The market has consistently overestimated the inflation rate over the subsequent 10 years, meaning that the real return on T-bonds has been around 1 percent higher than that on TIPS (Chart I-7). Chart I-7Will The 'Real' Real Yield Please Stand Up Will The 'Real' Real Yield Please Stand Up Will The 'Real' Real Yield Please Stand Up Yet given the current surge in inflation, and no end in sight for supply chain disruptions and bottlenecks, is it plausible that the next ten years’ rate of inflation will be lower than 2.4 percent? The answer is yes. Because, as my colleague Peter Berezin points out: in capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. And gluts always cause prices to collapse. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. The Cotton Is Stretched, And So Are Polish Equities Talking of shortages, cotton now adds to the list of commodities in which supply bottlenecks have raised prices to extremes. Cotton prices have reached a 10-year high due to weather conditions in the US (the world’s biggest cotton producer) combined with shipping disruptions. However, with cotton now exhibiting extreme fragility on its combined 130/260-day fractal structure, there is a high likelihood of a price reversal in the coming months when the shortage turns into a glut (Chart I-8). Chart I-8The Cotton Is Stretched The Cotton Is Stretched The Cotton Is Stretched Meanwhile, the bank-heavy Polish equity market has surged on the back of the spectacular outperformance of its banks sector. This strong uptrend has now reached the point of fragility on its 130-day fractal structure that has indicated several previous reversals (Chart I-9). Chart I-9Poland's Outperformance Is Stretched Poland's Outperformance Is Stretched Poland's Outperformance Is Stretched Accordingly, this week’s recommended trade is to underweight the Warsaw General Index versus the Eurostoxx 600, setting a profit target and symmetrical stop-loss at 6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Based on the 12-month forward earnings yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades     Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- 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 ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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 ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations      

Highlights Q3/2021 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark index by +8bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +4bps, led by the timely downgrade of UK Gilts to underweight in early August. Spread product allocations outperformed by +4bps, coming entirely from the overweights to high-yield in the US and Europe. Portfolio Positioning For The Next Six Months: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries. Feature Global bond markets have had a lot of sources of uncertainty to digest over the past few months. Renewed COVID fears due to the spread of the Delta variant, slowing global growth momentum, supply chain disruptions leading to surging realized inflation, the ongoing US fiscal policy debate in D.C., concerns over Chinese corporate debt and the increasingly hawkish monetary policy signals sent by global central banks, most notably the Fed. The net result of these narratives has been some major swings in government bond market performance during the third quarter of 2021. The benchmark 10-year government bond yield in the US started the quarter at 1.48%, fell to an intraday low of 1.12% on August 4, then soared higher to end the quarter back at 1.50%. Even bigger moves were seen in other countries, with the 10-year UK Gilt yield doubling from its Q3 low of 0.48% on August 4 while the 10-year German bund yield is now 30bps above its low for the quarter. Despite this yield volatility, however, spreads for riskier credit market assets like US high-yield have remained generally well behaved. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during Q3/2021. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. We anticipate that bond investor uncertainty will switch from concerns about global growth to worries that stubbornly elevated inflation will elicit bond-bearish monetary policy responses from central banks. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2021 Model Bond Portfolio Performance: Positive Returns In An Uncertain Environment Chart 1Q3/2021 Performance: Riding The Duration Roller Coaster Q3/2021 Performance: Riding The Duration Roller Coaster Q3/2021 Performance: Riding The Duration Roller Coaster The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was +0.21%, slightly outperforming the custom benchmark index by +8bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +4bps of outperformance versus our custom benchmark index while the latter also outperformed by +4bps. Those small positive excess returns should be considered a victory, given the huge yield swings within the quarter, particularly for government bonds. We maintained a significant underweight position to US Treasuries in the portfolio during Q3, given our view that markets were underestimating the risks that the US economy would weather the summer Delta storm. As Treasury yields declined steadily during July and August, so did the relative performance of our model bond portfolio. The government bond portion of the portfolio was underperforming the benchmark by as much as -30bps before global bond yields bottomed out in early August. In the end, there was only a slight underperformance (-2bps) from the US Treasury portion of the portfolio during the quarter (Table 2). Table 2GFIS Model Bond Portfolio Q3/2021 Overall Return Attribution GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Our biggest government bond overweights have been concentrated in the euro area. There, the sum of active returns during Q3 from our government bond allocations was +3bps, although that came entirely from above-benchmark allocations to inflation-linked bonds in Germany, France and Italy. We did make one major shift in our government bond allocations during the quarter, and it was both timely and successful. We downgraded our recommended UK Gilt exposure to underweight on August 11.2 We observed that the Bank of England (BoE) was starting to prepare the markets for less accommodative monetary policy, with the UK economy holding up well as its Delta variant surge was losing momentum. The BoE rhetoric has proven to be even more hawkish than we anticipated, hinting at a possible rate hike before the end of 2021, leading Gilts to be the worst performing government bond market in our model portfolio universe during the quarter. The result: our UK underweight contributed +4bps to the portfolio performance during the quarter. Turning to the credit side of the portfolio, the most successful positions were our overweight tilts on high-yield in the US (+3bps) and euro area (+1bps). All other exposures contributed little to returns, an unsurprising development given our neutral allocations to investment grade corporates in the US, UK and euro area, as well as for USD-denominated EM corporates. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q3/2021 Government Bond Performance Attribution GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Chart 3GFIS Model Bond Portfolio Q3/2021 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Biggest Outperformers: Overweight UK Gilts with a maturity greater than 10-years (+4bps) Overweight Italian inflation-linked bonds (+2bps) Overweight US high-yield: Ba-rated (+2bps) and B-rated (+1bps) Biggest Underperformers: Underweight US Treasuries with a maturity greater than 10-years (-2bps) Overweight Japanese Government Bonds in longer maturity buckets: 7-10 years (-1bps) and greater than 10-years (-1bps) Overweight UK inflation-linked bonds (-1bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2021. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q3 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q3/2021 GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare 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. As can be seen in the chart, the bars look very close to that ideal for Q3/2021. Among the markets that represent our overweights, the most notably positive returns came from all euro area government bonds (a combined +136bps) and euro area corporates (a combined +20bps from investment grade and high-yield). Returns within our recommended underweight positions were even more notable: UK Gilts (-302bps), New Zealand government bonds (-103bps), EM USD-denominated sovereigns (-85bps), and Canadian government bonds (-45bps). Bottom Line: Our model bond portfolio slightly outperformed its benchmark index in the third quarter of the year by +8bps – a moderately positive result coming equally from underweight positions in government bonds and overweight allocations to spread product. Future Drivers Of Portfolio Returns Chart 5Negative Real Yields: The Biggest Mispricing In Global Bond Markets Negative Real Yields: The Biggest Mispricing In Global Bond Markets Negative Real Yields: The Biggest Mispricing In Global Bond Markets Looking ahead, the performance of the model bond portfolio will continue to be driven primarily by our below-benchmark overall duration tilt – focused on our underweight stance on US Treasuries – and our overweight stance on high-yield corporates. Our most favored cyclical indicators for global bond yields are still, in aggregate, signaling more upside potential over at least the next six months, although the nature of the signal is changing (Chart 5). While our Global Duration Indicator, comprised of leading economic indicators and measures of future economic sentiment, has peaked, the overall level of 10-year bond yields within the major developed markets remains well below levels implied by the Indicator (top panel). That is most clearly evident when looking at the large gap between deeply negative real bond yields and the still-elevated level of the global manufacturing PMI, which typically leads real yields by around six months (second panel). We continue to view this gap between real yields and growth as the biggest mispricing in global bond markets – one that will eventually be rectified by the incremental reduction in monetary accommodation that is signaled by our Global Central Bank Monitor (bottom panel). The combined message from our Central Bank Monitor, Duration Indicator and the manufacturing PMI is that global bond yields are still too low, suggesting a below-benchmark overall portfolio duration stance remains appropriate. With regards to country allocation within the government bond side of our model portfolio, we continue to overweight countries where central banks are less likely to begin normalizing pandemic-era monetary policy quickly (Germany, France, Italy, Spain, Japan, Australia), while underweighting countries where normalization is expected to begin within the next 6-12 months (the US, UK and Canada). We have the highest conviction on the US and UK underweights, with a curve-flattening bias for both markets relative to the rest of the major developed markets (Chart 6). The bond-friendly (and risk asset-friendly) impact of global quantitative easing programs is fading, on the margin, with the annual growth rate of central bank balance sheets having already slowed sharply (Chart 7). The pace of tapering, and any subsequent rate hikes, will differ by country and support our government bond country allocations in the model portfolio. Chart 6Expect More Relative Curve Flattening In The US & UK Expect More Relative Curve Flattening In The US & UK Expect More Relative Curve Flattening In The US & UK Chart 7The 'Great Global Taper' Has Begun The 'Great Global Taper' Has Begun The 'Great Global Taper' Has Begun   Chart 8Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens Less Scope For Wider Global Inflation Breakevens We expect the Fed to taper its pace of bond purchases over the first half of 2022, setting up a first Fed rate hike late next year. The Bank of Canada and the BoE will be the other developed market central banks that will both end QE and lift rates before the Fed does the same. On the other hand, the ECB, Bank of Japan and the Reserve Bank of Australia will maintain a more relatively dovish stance in 2022, with very modest tapering (at worst) and no rate hikes. Turning to inflation-linked bonds, we are maintaining an overall neutral allocation given the competing forces of rising global inflation and rich valuations. Our Comprehensive Breakeven Indicators combine three measures to determine the upside potential for 10-year inflation breakevens: the distance from fair value based on our models, the spread between headline inflation and central bank target inflation, and the gap between market-based and survey-based measures of inflation expectations. Those indicators suggest that the most attractive markets to position for further upside potential for breakevens are Italy, France, Canada and Japan (Chart 8). On the back of this, we are maintaining our overweight allocations to inflation-linked bonds in the euro area and Japan in our model portfolio, while staying neutral on US TIPS. Chart 9Fading Support For Credit Markets From Global QE In 2022 Fading Support For Credit Markets From Global QE In 2022 Fading Support For Credit Markets From Global QE In 2022 Moving our attention to the credit side of our model portfolio, a moderate overweight stance on overall global corporates (focused on high-yield) versus governments remains appropriate. However, the slowing trend in developed market central bank balance sheets is flashing a warning sign for the future performance of global spread product. The annual growth rate of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has been an excellent leading indicator (by about twelve months) of the annual excess returns of both global investment grade and high-yield corporates during the “QE Era” since the 2008 financial crisis (Chart 9). That growth rate peaked back in February of this year, suggesting a peak of global corporate bond outperformance around February 2022, particularly for high-yield versus government bonds and investment grade (top two panels). At the same time, our preferred measure of the attractiveness of credit spreads - the historical percentile ranking of 12-month breakeven spreads – shows that lower-rated high-yield credit tiers in the US and euro area offer spreads that are relatively high versus their own history compared to other credit sectors in our model bond portfolio universe (Chart 10). Using this metric, investment grade corporate spreads look much more fully valued, particularly in the US. Chart 10Lower-Rated High-Yield & EM Sovereigns Offer Relatively Attractive Spreads GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Given sharply reduced default risks in the US and Europe, with strong nominal growth supporting corporate revenues alongside low borrowing rates, the fundamental backdrop for riskier high-yield corporates is still positive. Thus, we are maintaining our overweights to high-yield bonds in both the US and euro area, while sticking with only a neutral stance on investment grade corporates in the US, euro area and the UK. We do anticipate starting to reduce that exposure in the model portfolio sometime in early months of 2022, however, based on the ominous leading signal from the growth of central bank balance sheets – and what that means about the future path for global monetary policy and risk asset performance. Within the euro area, we are maintaining overweights to Italian and Spanish government bonds given the likelihood that the monetary policy backdrop will remain supportive (Chart 11). We expect the ECB to be one of the most accommodative central banks within our model portfolio universe in 2022. At worst, the ECB could deliver a modest reduction of total asset purchases, but with no rate hikes. Chart 11A Relatively Dovish ECB Will Be Positive For European Credit A Relatively Dovish ECB Will Be Positive For European Credit A Relatively Dovish ECB Will Be Positive For European Credit Chart 12EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering EM Headwinds: A Firmer USD, China Tightening & Global QE Tapering Finally, we are sticking with a cautious stance on emerging market (EM) spread product in our model bond portfolio. Slowing Chinese economic growth, a firming US dollar, rate hikes across EM in response to high inflation, and the coming turn in the Fed policy cycle are all headwinds to the relative performance of EM USD-denominated corporates and sovereigns (Chart 12). We are sticking with our overall modestly underweight stance on EM USD-denominated credit. However, rebounding global growth and some potential policy stimulus in China could prompt us to consider an upgrade in the coming months.   Summing it all up, our overall allocations and risks in our model portfolio leading into Q4/2021 look like this: An overall below-benchmark stance on global duration, equal to -0.75 years versus the custom index (Chart 13). A moderate overweight stance on global spread product versus government debt, equal to five percentage points of the portfolio (Chart 14). This overweight comes almost entirely from allocations to US and euro area high-yield corporates. The tracking error of the portfolio, or its expected volatility versus that of the benchmark index, is relatively low at 55bps (Chart 15). This fits with our desire to maintain only a moderate level of absolute portfolio risk, while focusing exposures more on relative tilts between countries and credit sectors. Chart 13Overall Portfolio Duration: Stay Below Benchmark GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Chart 14Overall Portfolio Allocation: Small Spread Product Overweight GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare The yield of the portfolio is now slightly higher than that of the benchmark, with a small “positive carry” of 16bps (Chart 16).   Chart 15Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Chart 16Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Overall Portfolio Yield: Small Positive Carry Vs. Benchmark Scenario Analysis & Return Forecasts We now turn to 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 2A). 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 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Table 2BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare We see global growth momentum, the stickiness of supply-driven inflation pressures and the Fed monetary policy outlook as the three most important factors for fixed income markets over the next six months, thus our scenarios are defined along those lines. Base case Global growth rebounds from the dip seen during July and August as fears over the spread of the Delta variant subside. Unemployment rates across the developed economies continue to decline on the back of ongoing demand/supply imbalances in labor markets. China is a relative growth laggard, but this will trigger fresh macro stimulus measures (credit, monetary, perhaps fiscal) from policymakers concerned about missing growth targets. Global supply chain disruptions will remain stubbornly persistent, keeping upward pressure on realized inflation rates in most countries even as commodity price momentum cools a bit on a rate of change basis. Most developed market central banks will move to dial back pandemic monetary policy stimulus to varying degrees, most notably the Fed and the Bank of England. The Fed will begin tapering its asset purchases around the turn of the year, to be completed during Q4/2021 thus setting the stage for a Fed rate hike in December. In this scenario, we expect the US Treasury curve to see some initial mild bear-steepening alongside moderately wider longer-term TIPS breakevens, before entering a more typical cyclical bear-flattening as the Fed begins tapering and rate hike expectations get pulled forward. The net result over the next six months: the entire US Treasury curve shifts higher in roughly parallel fashion, with the 10-year reaching 1.70% by next March. The VIX drifts a bit lower from the current 21 to 18, the US dollar is flattish (faster global growth offsets more USD-favorable real yield differentials versus other developed markets), the Brent oil price goes up +5% on the back of stronger global demand, and the fed funds target rate is unchanged at 0-0.25%. Upside growth & inflation surprise Global growth accelerates amid sharply diminished COVID risks and rallying stock and credit markets that loosen financial conditions. Consumer & business confidence recover smartly, as do hiring and capex. Global inflation rates accelerate from current elevated levels, but less from supply squeezes and more from fundamental pressures and faster wage growth. China loosens macro policies, but developed market central banks shift in an even more hawkish direction. The Fed signals a rapid 2022 taper and a funds rate liftoff well before year-end. In this scenario, real bond yields drift higher globally, but inflation breakevens stay elevated with the earlier surge in realized inflation proving not to be “transitory”. The US Treasury curve shifts much higher than in our base case, led by the 5-year maturity with bear-flattening beyond that point. The 10-year US Treasury yield climbs to 1.90% by the end of Q1/2022. The VIX moves higher to 25, the US dollar falls -3% (faster global growth offsetting a relatively modest increase in US/non-US real yield differentials), the Brent oil price goes up +10% and the fed funds target range is unchanged at 0-0.25%. Downside growth & inflation surprise Global growth loses additional momentum as consumer and business confidence stay muted. Supply/demand mismatches in labor markets remain unresolved, leading to a slower pace of employment growth. China does not signal adequate stimulus to offset its slowdown, while a weakened Biden administration implements a much smaller-than-expected US fiscal stimulus. Supply chain disruptions persist, keeping inflation elevated even as growth slows (stagflation). Developed market central banks, stuck between slowing growth and elevated inflation, are unable to ease in response to slower growth. The Fed chooses a slower drawn-out taper with liftoff delayed to 2023. Diminished economic optimism leads to a pullback in global equity values, lower government bond yields and wider global credit spreads. The US Treasury curve bull flattens as longer-maturity yields fall, with the 10-year yield moving back down to 1.25% alongside lower inflation breakevens. The VIX rises to 30, the safe-haven US dollar rises +5%, the Brent oil price falls -10% and the fed funds target range stays at 0-0.25%. The inputs into the scenario analysis are shown in Chart 17 (for the USD, VIX, oil and the fed funds rate), while the US Treasury yield scenarios are in Chart 18. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B). Chart 17Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Chart 18US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis     Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare The model bond portfolio is expected to deliver a positive excess return over the next six months of +60bps in the base case scenario and +57bps in the optimistic growth scenario, but is projected to underperform by -26bps in the pessimistic growth scenario. Bottom Line: We are maintaining an overall below-benchmark portfolio duration exposure, concentrated in the US and UK. We expect global growth will rebound from the Delta variant and supply chain disruptions will keep inflation elevated for longer, both of which will push global bond yields higher as central banks – led by Fed – turn less dovish. We are maintaining a moderate overweight to global spread product versus government debt, concentrated on an overweight to US high-yield where valuations still look the least stretched compared to corporate debt in other countries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Research Global Fixed Income Strategy/ European Investment Strategy Weekly Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare GFIS Model Bond Portfolio Q3/2021 Performance Review & Current Allocations: Fading A Growth Scare Global Fixed Income - Strategic Recommendations* Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns