Inflation Protected

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

Highlights Monetary Policy: It’s all but certain that tapering will begin next month and conclude by the middle of next year, but the FOMC is currently split right down the middle on whether it will be appropriate to lift rates in H2 2022. We present five factors to track to decide when the Fed will hike rates. Yield Curve: A bear-flattening of the nominal yield curve remains the most likely scenario for the next 6-12 months. Maintain a position short the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Investors should enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. The 2-year real yield, in particular, has a lot of upside during the next 6-12 months. EM Bonds: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling. Feature This past week was quite eventful for US bond investors. First, the Fed presented its September update on Wednesday, offering some hints about the timing and pace of asset purchase tapering alongside its updated economic and interest rate forecasts. Then, bonds sold off sharply on Thursday, Friday and Monday with the 10-year Treasury yield rising all the way to 1.49%. The first section of this week’s report looks at what we learned from last week’s FOMC meeting and opines on some monetary policy questions that remain unanswered. The second section updates our views on portfolio duration, the yield curve and TIPS in light of last week’s large market moves. Finally, we conclude with an update on the outlook for USD-denominated Emerging Market bonds. Powell Answers Some Small Questions, Avoids The Big One The Small Questions The start date for asset purchase tapering is the first small question that the Fed answered last week. A new sentence was added to the post-meeting statement saying that “a moderation in the pace of asset purchases may soon be warranted” and, in his press conference, Chair Powell clarified that the purpose of the new language is “to put notice out there that [tapering] could come as soon as the next meeting”. After this statement from the Fed, we expect asset purchase tapering to be announced at the next FOMC meeting on November 3rd. A delay until December is possible if September’s employment report is a massive disappointment, but the bar for delaying tapering beyond November appears high. Chair Powell also shed some light on a second small question related to the Fed’s balance sheet. Specifically, the pace of asset purchase tapering. In his press conference the Chair said that “participants generally view that, so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.” The information about the pace of tapering is slightly more interesting than the start date, if only because Fed policymakers have expressed a desire for net purchases to reach zero before the first interest rate increase. The fact that the Fed is planning to reach net zero purchases by the middle of next year suggests that it wants to leave the door open for a possible rate hike in the second half of 2022. This message was confirmed by the Fed’s updated interest rate projections (Chart 1). The projections revealed an even split (9 vs. 9) on the Committee between those that expect at least one 25 basis point rate increase before the end of 2022 and those that do not expect to lift rates next year. It’s also notable that, out of the 9 participants that don’t expect a rate hike in 2022, 8 anticipate lifting rates in 2023. Chart 1Rate Expectations Rate Expectations Rate Expectations Of course, as Chair Powell often points out, the Fed’s interest rate projections are contingent on the future state of the economy and will almost certainly be revised as the outlook evolves. What’s more important from a forecasting perspective is knowing how the Fed will react to different economic conditions. The Big Question With that in mind, we know that the Fed has promised not to lift rates until the labor market reaches “maximum employment”. However, as we noted in a recent report, the Fed hasn’t provided much detail on what “maximum employment” actually means.1 Powell’s comments last week didn’t add much clarity, but we can hunt for clues in the Summary of Economic Projections (SEP). In the SEP, we first notice that 13 FOMC participants expect the unemployment rate to be 3.8% - 3.9% or lower by the end of 2022 (Chart 2A). It is logical to assume that this group includes the 9 participants who expect to lift rates in 2022 and 4 additional ones. We also observe that 17 out of 18 participants anticipate an unemployment rate of 3.8% - 3.9% or lower by the end of 2023 (Chart 2B), exactly matching the number of participants who expect to lift rates by then. We can therefore infer that the Fed views an unemployment rate of roughly 3.8% as consistent with “maximum employment”. That is, FOMC participants tend to have rate hikes penciled into their forecasts once the unemployment rate is below 3.8%. Chart 2AFOMC 2022 Unemployment Rate Projection Distribution Damage Assessment Damage Assessment Chart 2BFOMC 2023 Unemployment Rate Projection Distribution Damage Assessment Damage Assessment The SEP’s inflation forecasts are less illuminating than the unemployment ones. All but 4 participants expect core PCE inflation to be above the Fed’s 2% target at the end of 2022 (Chart 3A) and no FOMC participant is forecasting below-2% core PCE at the end of 2023 (Chart 3B).2 The most we can take away from these forecasts is that 14 FOMC participants expect inflation to be above target in 2022, but five of those participants don’t see the labor market as being tight enough to lift rates by then. Chart 3AFOMC 2022 Core PCE Inflation Rate Projection Distribution Damage Assessment Damage Assessment Chart 3BFOMC 2023 Core PCE Inflation Rate Projection Distribution Damage Assessment Damage Assessment The revelation that FOMC participants view a 3.8% unemployment rate as consistent with “maximum employment” is illuminating, but it doesn’t tell the entire story. We don’t know, for example, what assumptions about labor force participation the different Fed officials are using. Our sense is that the following five criteria will ultimately determine when the Fed starts to lift interest rates: An unemployment rate in the neighborhood of 3.8%. Prime-age (25-54) labor force participation close to its pre-pandemic level (Chart 4, top panel). Accelerating wage growth (Chart 4, bottom 2 panels). Long-dated inflation expectations at or above target levels (Chart 5, top 2 panels). Non-transitory inflation at or above target levels (Chart 5, bottom panel). Bottom Line: The FOMC is currently split right down the middle on whether it will be appropriate to lift rates in 2022, but these forecasts aren’t set in stone and next year’s economic data – particularly the five factors listed above – will determine which group is correct. Chart 4Part Rate & Wage Growth Part Rate & Wage Growth Part Rate & Wage Growth Chart 5Inflation & Inflation Expectations Inflation & Inflation Expectations Inflation & Inflation Expectations Our own view is that the labor market will be sufficiently tight for the Fed to deliver its first rate hike in December 2022, and that rate hikes will proceed more quickly than what is currently priced in the yield curve. US bond investors should maintain below-benchmark portfolio duration. The Fallout In Bond Markets Bonds sold off sharply last Thursday and again yesterday morning. At the time of publication, the 30-year Treasury yield had risen from 1.81% on Wednesday to 2.02% (Chart 6). The 10-year Treasury yield had risen from 1.30% to 1.49% (Chart 6, panel 2). The 5-year yield is up to 0.98% from 0.85% on Wednesday (Chart 6, panel 3), and the 2-year yield is up to 0.28% from 0.24% (Chart 6, panel 4). The yield curve has also steepened since Wednesday, though the 2/10 slope remains well below its March peak (Chart 7). The trend during the past few months has been one of curve steepening out to the 5-year maturity point (Chart 7, panel 2) and flattening beyond that point (Chart 7, bottom 2 panels). Recent market action has led to some steepening beyond the 5-year maturity, but so far that steepening is minor compared to the flattening move we’ve witnessed since the spring. Chart 6Treasury Yield Trends Treasury Yield Trends Treasury Yield Trends Chart 7Treasury Curve Trends Treasury Curve Trends Treasury Curve Trends Nominal Curve We have been recommending a position short the 5-year bullet and long a duration-matched barbell consisting of the 2-year and 10-year notes, and we think this trade will continue to outperform. First, the 5-year/5-year forward Treasury yield is back above 2%, consistent with median estimates of the long-run neutral fed funds rate from the New York Fed’s Surveys of Market Participants (2%) and Primary Dealers (2.25%) (Chart 6, bottom panel). We think it will be difficult for the 5-year/5-year forward yield to rise much above these levels, which makes curve flattening more likely than steepening going forward.3 Second, we updated our work on yield curve scenarios to incorporate recent market action and some new information gleaned from last week’s SEP. In this analysis we estimate fair value levels for different parts of the yield curve as of the end of 2022 based on a scenario for the path of the fed funds rate. For example, if we assume that Fed liftoff occurs in December 2022 and rate hikes proceed at a pace of 75 bps per year (the median pace in the SEP) until the fed funds rate levels-off at 2.08% (consistent with a 2%-2.25% range for the long-run neutral fed funds rate), we calculate that the 2-year yield has 74 bps of upside between now and the end of 2022. This is slightly more than the 65 bps of upside in the 5-year yield and much more than the 37 bps of upside in the 10-year yield (Table 1). Comparing this expected change to what is already discounted in the forward curve, we see that both the 2-year and 10-year yields are expected to exceed their forwards by 6 bps. The 5-year yield is expected to exceed its forward by 16 bps. Table 1Treasury Curve Scenario Analysis Damage Assessment Damage Assessment To us, the message is clear. We want to remain short the 5-year note versus a duration-matched 2/10 barbell. Real & Inflation Curves Chart 8Real & Inflation Curves Real & Inflation Curves Real & Inflation Curves The increase in the 10-year nominal yield since last Wednesday was roughly evenly split between the real and inflation compensation components. Interestingly, inflation drove a greater proportion of the increase at the front-end of the curve, and the 2-year real yield actually fell. We maintain a neutral recommendation on TIPS versus nominal Treasuries, but this week we recommend taking advantage of recent market action by implementing some curve trades across the real and inflation curves. Specifically, we note that the cost of short-maturity inflation compensation remains well above the cost of long-maturity inflation compensation (Chart 8). Going forward, the cost of front-end inflation compensation will fall as inflation moderates from its current extremely high level. Meanwhile, the cost of long-maturity inflation compensation will remain sticky near the Fed’s target levels. This will lead to a steepening of the inflation curve (Chart 8, panel 2). The combination of a steeper inflation curve and a flatter nominal curve will lead to a much flatter real yield curve (Chart 8, bottom 2 panels). The 2-year real yield, in particular, has a lot of upside if inflation moderates, as we expect, and the 2-year nominal yield rises in line with the projections shown in Table 1. Bottom Line: Investors should remain short the 5-year bullet versus a duration-matched 2/10 barbell on the nominal Treasury curve. Investors should also enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. A Quick Update On Emerging Market Bonds The collapse of Chinese real estate behemoth Evergrande dominated headlines for most of the past week, though so far there has been little contagion into USD-denominated credit markets. Unsurprisingly, the spread on Chinese corporate and quasi-sovereign bonds has widened, and there has been some passthrough into both the High-Yield EM USD Corporate & Quasi-Sovereign Index and the High-Yield EM USD Sovereign Index (Chart 9). However, investment grade EM credit spreads have been relatively unaffected by the turmoil, as have US corporate bond spreads (both IG and HY) (Chart 9, bottom 2 panels). While the Evergrande drama – and weakening Chinese economic growth in general – could weigh on USD-denominated EM bond performance in the near-term, we see an excellent buying opportunity in investment grade EM bonds on a 6-12 month horizon. Investment grade EM Sovereigns outperformed credit rating and duration-matched US corporate bonds in the early months of the recovery but have lagged during the past few months (Chart 10). The same is true for the investment grade EM Corporate and Quasi-Sovereign index (Chart 10, panel 3). This is not to say that EM bond performance has been poor – the EM Sovereign index is still up 97 bps versus duration-matched Treasuries on the year – it has simply failed to keep pace with the stellar performance of US corporate bonds. Chart 9No Contagion No Contagion No Contagion Chart 10EM Bonds Versus US Corporates EM Bonds Versus US Corporates EM Bonds Versus US Corporates But that recent stellar performance of US investment grade corporate bonds has left spreads in the sector near historically tight levels. In last week’s report we ran some scenarios for US investment grade corporate bond returns during the next 12 months and concluded that excess returns versus Treasuries are probably capped at 85 bps.4 This makes the current spread advantage in EM Sovereigns (Chart 10, panel 2) and EM Corporates & Quasi-Sovereigns (Chart 10, bottom panel) very compelling. This will be especially true if Emerging Market growth accelerates in 2022 on the back of increased Chinese stimulus and a COVID vaccination campaign that is already picking up steam.5 Bottom Line: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 2 Chart 3B shows that 4 participants expect core PCE inflation of 1.9%-2.0% in 2023, but the SEP also reveals that the minimum forecast for core PCE in 2023 is 2.0%. In other words, all 4 participants in that range are forecasting 2.0%, not 1.9%. 3 For more details on the relationship between our 5-year/5-year forward yield target and the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 For a recent debate about the outlook for Emerging Market assets please see last Friday’s Webcast: https://www.bcaresearch.com/webcasts/detail/458 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Global Inflation: Most central banks, led by the Fed, have stuck to the narrative that surging inflation is a temporary phenomenon that will not require an aggressive monetary policy response. However, global supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will prove to be longer lasting, leading to higher global bond yields. Real Bond Yields: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Feature The month of September has often not been kind to financial markets and September 2021 is already providing many reasons for investors to be nervous. Slowing global growth momentum, uncertainty over the Delta variant, yet another US Debt Ceiling debate in D.C. and worries about excessive Chinese corporate leverage and contagion risks from the looming Evergrande default are all valid reasons for market participants to become more risk averse. On top of that, the monetary policy backdrop is threatening to become less overwhelmingly supportive for markets with the Fed set to begin tapering its asset purchases. Chart of the WeekInflation Expected To Slow But Remain Above Bond Yields Inflation Expected To Slow But Remain Above Bond Yields Inflation Expected To Slow But Remain Above Bond Yields One other source of angst that markets seem less concerned about is inflation. Markets have generally come around to the view of most major central banks, led by the Fed, that the surge in inflation seen this year has been all pandemic related - base effect comparisons to 2020 and temporary supply chain squeezes – and will not last into 2022. Yet we have seen very strong realized global inflation readings in the August data, beyond the point of maximum base effect comparisons versus a year ago, while supply squeezes and soaring shipping costs are showing no signs of slowing as we approach the fourth quarter. Global bond markets have made a collective bet that current high rates of inflation will prove to be temporary. Developed market bond yields are all trading well below actual inflation, as are riskier fixed income asset classes like US and European high-yield (Chart of the Week). While consensus expectations are calling for some rise in government bond yields in 2022, yields are expected to remain below inflation. Those persistent negative real yield expectations remain the biggest source of vulnerability for global bond markets. If inflation turns out to be “less transitory” than expected, nominal bond yields will need to move higher to reprice both real yields and the risk of more hawkish central bank responses to sustained high inflation. A Persistent Inflation Threat From Supply Chain Disruptions Chart 2A Broad-Based Surge In Global Inflation A Broad-Based Surge In Global Inflation A Broad-Based Surge In Global Inflation Our base-case view remains that global inflation will slow in 2022, but not by enough to prevent the major developed market central banks from tapering asset purchases. We expect the Fed to begin buying fewer bonds in January. Central banks that have already begun to slow the pace of quantitative easing (QE) like the Bank of Canada and Bank of England will likely continue to taper as fast, if not even faster, than the Fed. Even the ECB will likely not roll the full amount of the expiring Pandemic Emergency Purchase Program (PEPP) into the existing pre-COVID asset purchase programs, resulting in a mild form of tapering next year. Our view on global inflation has been predicated on an expected shift away from more externally-driven inflation towards more sustainable domestic price pressures stemming from tightening labor markets and the closing of pandemic output gaps (Chart 2). So the mix of inflation in most developed market countries will be more “core” and less “non-core” inflation driven by higher commodity prices and global supply chain disruptions. Yet there is little sign that those non-core inflation pressures are slowing, particular in price gauges most exposed to supply chains like producer price indices (PPI). US PPI inflation climbed to 15-year high of 8.3% on a year-over-year basis in August, while annual growth in the euro area PPI hit 12.1% in July – the fastest pace in the 30-year history of that data series (Chart 3). Surging PPI inflation reflects global price pressures, with import prices expanding at double-digit rates in both the US and Europe. Some of that more externally driven price pressure stems from commodity markets. While the prices for some notable commodities like lumber and iron ore have seen significant retracements from pandemic-era highs over the past several months, more economically sensitive commodities like aluminum and natural gas have all seen very strong price increases (Chart 4). Copper and oil prices are also holding firm, although both are off 2021 highs. Chart 3No Sign Of Slowing Global Inflation At The Producer Level No Sign Of Slowing Global Inflation At The Producer Level No Sign Of Slowing Global Inflation At The Producer Level The price momentum of overall commodity price indices like the CRB Raw Industrials has clearly rolled over, but has held up much better than would be expected given signs of slowing global growth. Chart 4Commodity Markets Still More Inflationary Than Disinflationary Commodity Markets Still More Inflationary Than Disinflationary Commodity Markets Still More Inflationary Than Disinflationary The current depressed level of the China credit impulse, and the flat year-over-year change of the global PMI, would typically be associated with flat commodity prices rather than the current 34% annual growth rate (Chart 5). A lack of sustained upward pressure on the US dollar is likely helping keep commodity prices, which are priced in dollars, more elevated than expected. Even more important, however, are the low inventories for many commodities relative to firm demand (which largely explains the current surge in aluminum and natural gas prices). This mirrors a broader global economic trend towards companies running lower inventories relative to sales, which has been exacerbated by the economic uncertainties of the COVID-19 pandemic. The US overall business inventory-to-sales ratio is now at the lowest level in the history of the series (Chart 6). Chart 5Commodity Price Inflation Peaking, But Not Slowing Much Commodity Price Inflation Peaking, But Not Slowing Much Commodity Price Inflation Peaking, But Not Slowing Much Chart 6Supply Squeezes Are Likely To Persist Supply Squeezes Are Likely To Persist Supply Squeezes Are Likely To Persist Before the pandemic, firms have gotten away with running very lean inventories because of globalized supply chains that allow firms to maintain the minimum amount of inventory to meet demand. Yet “just-in-time” inventory management only works when suppliers can deliver raw materials or finished goods in a timely fashion at low cost. The pandemic has blown up that model, making it much harder to deliver products and materials from critical countries like China. Global shipping costs have exploded higher and are showing no signs of slowing (bottom panel), while supplier delivery times remain well above historical averages according to measures like the US ISM index. Those higher costs are feeding through into overall inflation measures, particularly for the components most exposed to supply chain disruption. In Chart 7, we show a breakdown of the overall CPI inflation data for the US, euro area, UK and Canada. The groupings shown in the chart are based on an analysis done by the Bank of Canada back in August to measure pandemic impacts on Canadian inflation.1 The top panel of the chart shows the contribution to overall inflation for elements most exposed to supply constraints (like autos and durable goods). The second panel of the chart shows the contribution from sectors more exposed to increased demand as economies reopen from pandemic restrictions, like dining at restaurants and travel. The remaining panels of the chart show the contributions from energy prices and all other components not covered in the top three panels. Chart 7Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Fed's Transitory Narrative At Risk From Lingering Supply Chain Disruption Chart 8High US Inflation May Not Prove To Be So Transitory High US Inflation May Not Prove To Be So Transitory High US Inflation May Not Prove To Be So Transitory The conclusion from our chart is that supply disruptions have added more to US and Canadian inflation so far in 2021, while reopening demand has been more meaningful for UK and US inflation. The pickup in euro area inflation has been mostly an energy price story, although reopening demand has started to contribute to the rising trend of overall inflation. The implication from this analysis is that persistent supply chain disruptions could become a bigger issue for future inflation – and monetary policy decisions – in the US and Canada. The acceleration of US realized inflation in 2021 has already begun to broaden out from the most volatile components, according to measures like the Dallas Fed Trimmed Mean PCE (Chart 8). Faster inflation is also feeding through into higher US consumer inflation expectations according to surveys from the New York Fed and the University of Michigan. Those increases are not deemed to be temporary, with longer-term inflation expectations now moving higher. The New York Fed’s survey shows that inflation is expected to be 4% over the next three years, two full percentage points above the Fed’s target, which must be ringing some alarm bells on the FOMC. Chart 9European Consumers Are Waking Up To Higher Inflation European Consumers Are Waking Up To Higher Inflation European Consumers Are Waking Up To Higher Inflation Consumer inflation expectations are also starting to perk up outside the US. The YouGov/Citigroup survey shows an expectation of UK inflation over the next 5-10 years of 3.5%, while the Bank of England/Kantar survey is at 3% over the next five years (Chart 9, top panel). Both are above the Bank of England’s 2% inflation target. The European Commission confidence surveys have shown a sharp increase in the net share of respondents expecting higher inflation in the coming months (bottom panel), while the Bundesbank’s August consumer survey shows that Germans now expect 3.5% inflation over the next 12 months, up from 2% back in March. Bottom Line: Supply chain disruptions are lasting for much longer than originally expected, while faster realized global inflation is feeding through into higher longer-term consumer inflation expectations, most notably in the US. This raises the risk that the 2021 inflation pickup will last much longer than expected and force a bond-bearish repricing of future interest rate expectations. Negative Real Yields – The Achilles Heel For Bond Markets It is clear that supply chain disruptions are having a more lasting effect on global inflation than investors, and policymakers, expected earlier this year. Yet while both market-based and survey-based measures of inflation expectations are moving higher, interest rate markets are still pricing in a very dovish future path for policy rates of the major developed market central banks. For example, our 24-month discounters, which measure the change in interest rates over the next two years discounted in overnight index swap (OIS) curves, show that only 71bps, 61bps and 13bps of rate hikes are expected in the US, UK and euro area, respectively, by September 2023 (Chart 10). This continues a trend that we have highlighted in recent reports – the persistence of negative real interest rate expectations in the developed markets that is also keeping real bond yields in sub-0% territory. In the US, the OIS forward curve shows that the first Fed rate hike is expected in early 2023 with a very slow pace of rate increases over the following 2-3 years (Chart 11). The funds rate is expected to level off at 1.75% and stay there through 2030. At the same time, the CPI swap forward curve has inflation falling steadily over the next couple of years, but leveling off around 2.35% for the rest of the upcoming decade. Combining those two forward projections comes up with an implied path for the real fed funds rate that is persistently negative for the next ten years, “settling” at -0.6% by the end of the decade. Chart 10Bond Markets Exposed To More Hawkish Central Banks Bond Markets Exposed To More Hawkish Central Banks Bond Markets Exposed To More Hawkish Central Banks Chart 11US Real Yields Priced For Extended Fed Dovishness US Real Yields Priced For Extended Fed Dovishness US Real Yields Priced For Extended Fed Dovishness An even more deeply negative real rate path is discounted in the euro area forward curves. The ECB is expected to begin lifting rates in 2023, eventually moving out of negative (nominal) territory in 2026 before climbing to +0.5% by 2030 (Chart 12). Euro area CPI swaps are priced for a fall in inflation back below 2% over the next two years, eventually stabilizing at 1.75% over the latter half of the next decade. The real ECB policy rate is therefore expected to settle at -1.25% by 2030. In the UK, markets are discounting much of what has been seen in the years since the 2008 financial crisis – a Bank of England that does very little with interest rates. The central bank is expected to begin lifting rates in 2023, but only a handful of rate hikes are expected in the following years with Bank Rate only climbing to 1% and settling there for most of the upcoming decade. The UK CPI swap curve is discounting relatively high inflation over the next decade, settling at 3.6% in 2030. Thus, the market is discounting a long-run real Bank of England policy rate of -2.6%. This pricing of negative real policy rates so far into the future goes a long way to explain why longer-term real government bond yields have also been consistently negative in the US, Germany, UK and elsewhere in the developed markets. That can be seen in Charts 11, 12 and 13, where we have added the 10-year inflation-linked (real) bond yield for US TIPS, French OATis and UK index-linked Gilts. In all three cases, the 10-year real yield has “gravitated” towards the realized path of the real policy rate – the nominal rate minus headline CPI inflation – over the past two decades. Chart 12Negative Real Rates Forever In Europe? Negative Real Rates Forever In Europe? Negative Real Rates Forever In Europe? Chart 13BoE Not Expected To Do Much Over The Next Decade BoE Not Expected To Do Much Over The Next Decade BoE Not Expected To Do Much Over The Next Decade Chart 14Nominal Yields Will Move Higher If Negative Real Yields Persist Nominal Yields Will Move Higher If Negative Real Yields Persist Nominal Yields Will Move Higher If Negative Real Yields Persist Persistent low government bond yields, both in nominal and inflation-adjusted terms, have resulted in lower yields across the global fixed income markets as investors have been forced to take on more risk to find acceptable yields. This has resulted in a situation where nominal yields on riskier assets like US high-yield corporate bonds and Italian government debt are trading below prevailing headline inflation rates in the US and Europe (Chart 14). Bond investors would likely only be comfortable accepting such negative real yields on the riskier parts of the fixed income universe if a) inflation was expected to decline, and/or b) real yields on risk-free government bonds were expected to stay negative for longer as central banks stay dovish. In either case, the “bet” made by investors is that the inflation surge seen this year will indeed prove to be transitory, as central banks are forecasting. If that benign outlook proves to be incorrect and inflation stays resilient for longer – potentially because of the risk of lingering supply chain disruptions described earlier in this report - nominal bond yields will have to reprice higher to account for faster realized inflation (and, most likely, rising inflation expectations). This process will start in government bond markets, as global central banks will be forced to respond to stubbornly high inflation by turning more hawkish, first with faster tapering of QE bond buying and, later, with interest rate hikes. We continue to see persistent negative real yields as the biggest source of risk in developed economy bond markets over the next couple of years. Those yields discount a benign path for both inflation and future monetary policy that is looking increasingly less likely – especially with tightening labor markets and rising consumer inflation expectations already forcing central banks, led by the Fed, to move incrementally towards less accommodative policy settings. Bottom Line: Global bond markets have made a collective bet on the “transitory” inflation narrative by driving yields on government bonds, and even the riskier parts of the corporate credit universe like US and European high-yield, below actual inflation. Markets will have to reprice those negative real bond yields higher if inflation proves to be more persistent than expected - particularly with central banks likely to respond with faster tapering and, in some cases, eventual rate hikes. Stay below-benchmark on overall global duration exposure in fixed income portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have attempted to match the groupings shown in the Bank of Canada analysis as much as possible for the other countries, although there are some minor differences based on how each country’s consumer price index sub-indices are defined. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What If Higher Inflation Is Not Transitory? What If Higher Inflation Is Not Transitory? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Employment Growth Will Rebound Employment Growth Will Rebound Employment Growth Will Rebound August’s weak employment growth reflects the surge of Delta variant COVID cases in the United States. This is evidenced by the fact that Leisure & Hospitality sector payrolls held flat in August after having grown by 415k in July and 397k in June (Chart 1). While Delta could still be a drag on employment growth for another month or two, there is mounting evidence that the daily new case count is close to its peak. Leisure & Hospitality employment growth will regain its prior pace as new Delta cases trend down. This will lead to a resumption of strong monthly payroll reports (500k – 1000k) as we head into the new year. For monetary policy, we calculate that average monthly nonfarm payroll growth of 414k will be sufficient for the Fed to start rate hikes before the end of 2022 (bottom panel). We anticipate that this threshold will easily be met. The Treasury curve will bear-flatten as employment growth improves and the market prices-in an earlier start and quicker pace of Fed rate hikes. Investors should maintain below-benchmark portfolio duration and stay short the 5-year Treasury note versus a duration-matched 2/10 barbell. Feature Table 1Recommended Portfolio Specification The Delta Drag The Delta Drag Table 2Fixed Income Sector Performance The Delta Drag The Delta Drag Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 5 basis points in August, dragging year-to-date excess returns down to +166 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 91 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled for corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated Emerging Market sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Delta Drag The Delta Drag Table 3BCorporate Sector Risk Vs. Reward* The Delta Drag The Delta Drag 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 66 basis points in August, bringing year-to-date excess returns up to +502 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 3.0% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first seven months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in August, dragging year-to-date excess returns down to -67 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 4 bps in August. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 2 bps in August (panel 2), and it is now starting to look attractive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 38 bps, below the 56 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 35 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 outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to +84 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 122 bps in August, bringing year-to-date excess returns up to +7 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +44 bps. Local Authority bonds outperformed by 9 bps in August, bringing year-to-date excess returns up to +382 bps. Domestic Agency bonds outperformed by 3 bps, bringing year-to-date excess returns up to +30 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to +31 bps. USD-denominated Emerging Market (EM) Sovereign bonds outperformed US corporates in August and relative valuation between the two sectors is starting to equalize (panel 4). That said, we retain a preference for EM sovereigns over US corporates, particularly the bonds of Russia, Mexico, Saudi Arabia, UAE and Qatar where value remains attractive. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 9 basis points in August, dragging year-to-date excess returns down to +262 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 5% breakeven tax rate versus corporates with the same credit rating and duration. 12-17 year Revenue munis actually offer a before-tax yield pick-up (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 23% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved higher in August, with the 5-year and 7-year maturities bearing the brunt of the sell-off. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 110 bps. The 5-year/30-year slope flattened 5 bps to end the month at 115 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 1.93%, the 5-year/5-year forward Treasury yield is not that far below our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.21% in one year’s time and 1.47% in five years (Chart 7). The latter rate has 146 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 265 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.  TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in August, leaving year-to-date excess returns unchanged at +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates both fell by 7 bps in August. At 2.37%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.21%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation continues to moderate from its current extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in August, bringing year-to-date excess returns up to +40 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +30 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +92 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 6 basis points in August, bringing year-to-date excess returns up to +193 bps. Aaa Non-Agency CMBS outperformed Treasuries by 10 bps in August, bringing year-to-date excess returns up to +92 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 9 bps on the month, dragging year-to-date excess returns down to +529 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 4 basis points in August, bringing year-to-date excess returns up to +91 bps. The average index option-adjusted spread held flat on the month. It currently sits at 35 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of August 31st, 2021) The Delta Drag The Delta Drag 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 August 31st, 2021) The Delta Drag The Delta Drag 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 12 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 12 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Delta Drag The Delta Drag Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of August 31st, 2021) The Delta Drag The Delta Drag Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio 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, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.

Highlights A trio of ECB hawks raised the prospect of an ECB taper. In the past, the current set of economic conditions in the Euro Area would have prompted the ECB to tighten policy. A potential economic deceleration this fall, the transitory nature of the Eurozone’s inflation spike, and the level of inflation expectation in the region limit the ECB’s ability to taper this week. We expect a one-off return to the pre-Q2 2021 level of asset purchases couched in a very dovish forward guidance. Peripheral bonds and European corporate bonds will outperform German and other core European paper. Stay long European curve steepeners, while buying US curve flatteners. Overweight German Bunds versus US Treasury Notes, on a USD-hedged basis. European productivity will remain structurally hampered compared to that of the US. US real bond yields will rise relative to Europe. Feature Last week, a chorus of ECB Governing Council members raised the idea among investors that the central bank may soon begin to taper its asset purchases, which prompted Bund yields to hit -0.35% on Wednesday. Robert Holzmann of Austria, Klaas Knot of the Netherlands, and Jens Weidmann of Germany all suggested that monetary conditions were too accommodative for the Eurozone and that the ECB needed to remedy this problem. The complaints of this hawkish trio reflect the current environment. In August, the Eurozone HICP reached a 3% annual rate while the preliminary estimate for core CPI clicked in at 1.6%. Meanwhile, July PPI rose to 12.1%. Such robust inflation readings are at odds with the low level of interest rates in the Eurozone, where the yields on European IG credit and 10-year Italian BTPs average a paltry 0.45% (Chart 1). Beyond the level of inflation, its broad geographic nature is an additional source of concern. Headline CPI is accelerating across all the bloc’s nations, and it stands above 2% in 82% of the members’ states. Historically, this kind of inflationary backdrop resulted in either higher interest rates or some tapering of asset purchases, especially when economic activity was also improving in the Eurozone (Chart 2). Chart 1A Gap For The Hawks A Gap For The Hawks A Gap For The Hawks Chart 2In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened In The Past, The ECB Would Have Tightened Will the ECB listen to its most hawkish members and follow its past script? We do not believe that the Governing Council is about to start a sustained period of decreased bond buying, even if a return to the pre-Q2 2021 pace of buying is likely this fall. Thus, a dovish taper is the most likely outcome of this week’s meeting. The ECB’s Three Constraints The outlook for growth, the temporary nature of the current spike in European inflation, and the low-level of Euro Area inflation expectations limit the ECB’s ability to remove monetary accommodation. First, European economic growth is at its apex and will decelerate over the next six months. Currently, domestic activity as approximated by the Services PMI stands at near a 15-year high of almost 60. Moreover, despite the spike in COVD-19 cases linked to the Delta variant, mobility remains very robust. If anything, the decline in cases in Spain and France should lead to further improvement in mobility (Chart 3). Nonetheless, the recent fall in consumer confidence and the recent US experience, which the European economy usually follows, point to a deceleration in the Services PMI. The case for a decline in manufacturing activity is more pronounced. The European manufacturing sector responds strongly to the fluctuation of the global industrial sector. US consumer spending on durable goods is 21% above its pre-pandemic trend and is beginning to weaken as pent-up demand for such products has been satiated and households shift their spending back toward services. Moreover, the Chinese credit cycle, which leads the Eurozone Manufacturing PMI by nine months, indicates a greater deceleration in the coming quarters, because European exports to China will slow (Chart 4, top and middle panels). In response to these two forces, Europe will not diverge from the deterioration in our Global Activity Nowcast (Chart 4, bottom panel). Chart 3So Far, No Delta Impact So Far, No Delta Impact So Far, No Delta Impact Chart 4The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown The Coming Manufacturing Slowdown Chart 5Abnormal Goods Inflation Abnormal Goods Inflation Abnormal Goods Inflation Second, most evidence still suggests that the current inflation increase will be temporary, despite its violence. To begin with, the spike in inflation remains consigned to the goods sectors, while services inflation stands at 1.1%, in line with the experience of the past 10 years (Chart 5). Even within goods prices, the spike in CPI is limited to sectors facing bottlenecks or linked closely to commodity and shipping prices. As Chart 6 illustrates, the categories experiencing abnormal inflation are directly related to higher energy prices, cars, complex machinery, hotels, and fresh food. Meanwhile, underlying inflation as estimated by our trimmed-mean CPI measure is bottoming, but remains at a very low 0.2% annual rate (Chart 7). Chart 6Inflation Remains A Commodity and Bottleneck Story The ECB Taper Dilemma The ECB Taper Dilemma In the same vein, the surge in Selling Price Expectations of the European Commission Business Survey is a function of commodity inflation (Chart 8). In other words, companies feel they can increase their selling prices, because natural resource prices have spiked. However, inflation across many commodities is currently peaking, which suggests that Selling Price Expectations will soon do so as well. Moreover, this process indicates that headline inflation should hit its summit by year end, because Selling Price Expectations are a coincident indicator of inflation (Chart 8, bottom panel). Chart 7Narrow Inflation Narrow Inflation Narrow Inflation Chart 8Rising Selling Prices And Commodities Rising Selling Prices And Commodities Rising Selling Prices And Commodities A wage-inflation spiral also remains far away. Historically, rapidly accelerating wage growth marked periods of elevated inflation. Despite current fears, such a development is not taking place in the Eurozone. For the whole bloc, negotiated wages are growing at a modest 1.7% annual rate (Chart 9). Even in Germany, negotiated wages are only increasing at the same rate. While some labor shortages have been reported, total hours worked remain below the equilibrium level based on the Euro Area demographic profile (Chart 9, bottom panel). Furthermore, the past ten years reveal that labor shortages only caused stronger salary growth with a multi-year delay. Third, the market doubts the credibility of the ECB when it comes to achieving a 2% inflation target. So far, survey-based inflation expectations remain below 2% at all tenors (Chart 10, top panel). The same is true of market-based measures, which are still lower than the levels that prevailed before the sovereign debt crisis of the past decade (Chart 10, bottom panel). Chart 9No Wages/Inflation Spiral No Wages/Inflation Spiral No Wages/Inflation Spiral Chart 10The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible The ECB's Inflation Mandate Is Not Yet Credible Bottom Line: Risks to growth over the winter, the transitory nature of the recent inflation shock, and inflation expectations that remain significantly below target are constraints limitating the ability of the ECB to announce a true tapering of its asset purchases this Thursday. A Dovish Taper? Considering the current set of conditions prevailing in the Eurozone, we expect the ECB to announce a return to the pace of asset purchases that existed prior to Q2 2021. However, the Governing Council (GC) will go out of its way to issue clear forward guidance that strongly indicates this is not the beginning of a taper campaign. Instead, the GC will hint at the transmutation of a large proportion of the PEPP monthly buying into the PSPP after March 2022. The inflation target change enacted at the conclusion of the ECB’s strategy review in July limits the central bank’s ability to go back to its old rule book and tighten policy at the first hint of inflation. First, the ECB must believe that inflation will overshoot 2% on a durable basis, which will necessitate an upgrade to its long-term inflation forecast above the target. Too many members of the GC do not share this view, which makes it unlikely that inflation forecasts will rise this much this week. Moreover, inflation expectations are also too low to warn of a meaningful change in the behavior of European economic agents, especially if the current spike in inflation proves to be transitory. Another problem for the ECB is the Fed. If the ECB were to announce a durable tapering of its asset purchase this week, it would be doing so ahead of the Fed. The GC fears that this action would put considerable upward pressure on EUR/USD, which would create a grave deflationary tendency in the Eurozone (Chart 11). Despite these shackles, the ECB will also acknowledge that the current emergency pace of asset purchases is no longer warranted. Starting Q2 2021, the ECB increased its average monthly purchase from EUR80 billion in the August 2020 to March 2021 period, to EUR95 billion since April 2021 (Chart 12). However, these increased purchases followed a 0.1% GDP contraction in Q1 in the wake of a spike in COVID-19 cases and deaths, which prompted a large reduction in mobility. Moreover, the larger bond buying also followed large increases in bond yields across the main economies of the continent, a rise which, if it had been left unchecked, would have exacerbated the economic malaise. Chart 11The ECB Fears A Strong Euro The ECB Fears A Strong Euro The ECB Fears A Strong Euro Chart 12Normalizing Purchases The ECB Taper Dilemma The ECB Taper Dilemma None of these factors are still present. The increasing level of vaccination has dulled the economic impact of the third wave of infection. The economy is expanding robustly and, even if it slows in the months ahead, growth will remain well above trend. Crucially, financial conditions are much more generous than in the first half of the year, with a euro that trades 4% below its January peak and with yields in the bloc’s four largest economies 25 to 45 basis points below their spring peaks. Bottom Line: In response to the aforementioned crosscurrents, we anticipate the ECB to announce a return of its monthly asset purchases to the level that prevailed in the August 2020 to March 2021 period. However, the GC will also clearly indicate, as it did last March, that this policy shift is a one-off, and that investors must not anticipate any further curtailment of asset purchases over the next six months. To reinforce this guidance, we expect the ECB’s inflation forecast to show a return of HICP below 2% by the end of 2023. The GC might also hint at the roll-over of the PEPP program into the PSPP after March 2022. Investment Implications An ECB that conducts a dovish taper on Thursday will support our main fixed-income themes in Europe. First, it will remain a tailwind behind an overweight position in peripheral government bonds versus German bonds. The combination of continued purchases of EUR80 billion a month of bonds over the foreseeable future, above-trend growth, and the fiscal risk mutualization from the NGEU and REACT EU programs means that investors can continue to safely pocket the yield premium offered by BTPs and BONOs. Moreover, our geopolitical strategists expect a left-wing coalition to govern Germany after the September 26 election, which will limit the pressures to tighten budgets in the periphery over the coming years. Chart 13European Corporates Remain Attractive European Corporates Remain Attractive European Corporates Remain Attractive Second, continued liquidity injections by the ECB are also consistent with a preference for European corporate credit over government securities, especially in Germany, France, and the Netherlands. European breakeven spreads for IG and high-yield debts are in the 18th and 13th percentile rank, respectively (Chart 13). Easy monetary conditions and above-trend growth will facilitate further yield-seeking behavior in the Eurozone. This process will allow these securities to offer continued excess returns over at least the next six months. Third, we hold on to our box trade of being long Eurozone curve steepeners and long US curve flatteners. In our base case scenario, the Fed will soon indicate the beginning of its tapering campaign and will be on track to raise rates by early 2023, while the ECB will still conduct a very easy monetary policy. In this context, the US yield curve will flatten relative to the European one, driven by a more rapid increase at the short end of the curve. Chart 14Still Favor Bunds Over T-Notes The ECB Taper Dilemma The ECB Taper Dilemma Finally, in a global bond portfolio, it still makes sense to overweight German Bunds (hedged into USD) relative to US Treasury Notes. Bunds display a significantly lower yield beta than their US counterparts, which creates an attractive defensive feature in an environment in which global yields are likely to rise. Moreover, as the model in Chart 14 highlights, the US/German 10-year yield spread is roughly 50bps below an equilibrium estimate based on relative inflation, unemployment and policy rates, and the size of the Fed and ECB balance sheets. US inflation is likely to remain perkier than that of Europe over the coming quarters, and the US unemployment rate will decline faster as well. Additionally, in the unlikely scenario that the Fed declines to taper its purchases this year, but the ECB does, inflation expectations will rise in the US relative to the Euro Area, which will put upward pressure on yield spreads. Bottom Line: A dovish ECB taper, whereby the GC executes a one-off adjustment in asset purchases with an easy forward guidance, will support our overweight in peripheral government bonds relative to bunds, our preference for European corporate credit relative to government paper, our Europe / US box trade, and BCA’s underweight in Treasurys relative to Bunds. Europe’s Productivity Deficit Is Not Over Compared to the US, GDP growth in the Eurozone has been trending lower since the introduction of the euro in 1999. While a weaker demographic profile has hurt Europe, so has slower productivity growth. Going forward, the gap between European and US productivity growth will somewhat narrow compared to last decade, but it will still favor the US. The cross-Atlantic gap in output per hour growth between has a cyclical and a structural component. The cyclical element is set to ebb. Last decade, the Eurozone suffered a double-dip recession, as the European sovereign debt crisis raged. As a result, capex and debt accumulation in Europe lagged that of the US, which hurt demand and, thus, output-per-hour worked (Chart 15, top panel). Going forward, the European debt crisis has been addressed, the ECB has demonstrated its willingness to do “whatever it takes” to support the monetary union and both the European Commission and the German government have thrown their full weight behind the integrity of Europe, even if it means bailing out their profligate southern neighbors. Despite this positive, some structural headwinds will continue to handicap European productivity. Since 2000, total factor productivity in the major Euro Area economies has lagged that of the US (Chart 15, bottom panel). Many factors suggest this will not change: Chart 15Europe’s Productivity Deficit The ECB Taper Dilemma The ECB Taper Dilemma The Eurozone’s big four economies continue to linger well behind the US in terms of ICT investment, which in recent decades has been a crucial driver of productivity. R&D represents a significantly lower share of GDP in the Eurozone than it does in the US (Chart 16). More investment in intangible assets has been linked to higher productivity growth. Additionally, Ortega-Argilés et al. have shown that EU companies do not convert R&D into productivity gains as well as US businesses do, because they generate lower return on investments.1 Confirming this insight, an empirical study using microdata on R&D spending for EU and US firms highlights that both R&D intensity and productivity are lower for EU firms than for their US counterparts.2 For a 10% increase in R&D intensity, US businesses generated a 2.7% increase in productivity, while EU firms enjoyed a much smaller 1% gain. The gap is larger for high-tech companies, where the same rise in R&D intensity produced a 3.3% productivity gain in the US, but only a 1.2% one in the EU. The European economy remains much more fragmented than that of the US, and the greater prevalence of small firms in the Euro Area results in a less efficient use of the human and capital stocks. Finally, the low rate of investments in recent years has caused the European capital stock to age faster than that of the US. An older pool of assets is further away from the technological frontier and thus weighs on TFP and overall labor productivity (Chart 17). Chart 16Lagging European R&D The ECB Taper Dilemma The ECB Taper Dilemma Chart 17The Ageing European Capital Stock The Ageing European Capital Stock The Ageing European Capital Stock Notwithstanding cyclical fluctuations related to the global debt cycle, the Eurozone profit margins and RoEs will not converge meaningfully toward US levels on a structural basis because of this productivity problem. Europe’s lower industry concentration ratios, lower markups, and greater share of output absorbed by wages will only accentuate this problem. Chart 18TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds TIPS Yields Vs Real Bunds As a result of the lower trend growth rate caused by lower productivity and its inferior return on invested capital, Europe’s R-Star is unlikely to catch up meaningfully to US levels. Consequently, the gap between US and Germany real rates will remain wide and will drive the increase in US yields relative to those of Germany, as the Fed begins to tighten policy while the ECB stands pat (Chart 18). Bottom Line: Europe’s productivity deficit is not the only consequence of last decade’s sovereign debt crisis. Thus, the Euro Area’s potential GDP growth and return on invested capital will lingers behind those of the US. As a corollary, the Eurozone’s R-star is well below that of the US. Hence, we expect higher real rates to drive the increase in US yields over Germany as the Fed tightens policy ahead of the ECB.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1R. Ortega-Argilés, M. Piva, and M. Vivarelli, “The Transatlantic Productivity Gap: Is R&D the Main Culprit?,” Canadian Journal of Economics 47.4 (2014), pp. 1342-71. 2D. Castellani, M. Piva, T. Schubert, and M. Vivarelli, “The Productivity Impact of R&D Investment: A Comparison between the EU and the US,” IZA Discussion Papers 9937 (2016). Tactical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Cyclical Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Structural Recommendations The ECB Taper Dilemma The ECB Taper Dilemma Closed Trades The ECB Taper Dilemma The ECB Taper Dilemma Currency Performance Fixed Income Performance Equity Performance

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 17 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST and August 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Scheduling Note: There will be no US Bond Strategy report next week. The following week (August 31), clients will receive a report written by our Global Fixed Income Strategist Rob Robis. The regular US Bond Strategy publication schedule will resume on September 8 with the publication of September’s Portfolio Allocation Summary. Best regards, Ryan Swift, US Bond Strategist

Highlights Chart 1Still Close To Fair Value Still Close To Fair Value Still Close To Fair Value Treasury yields fell significantly in July, particularly at the long end of the curve. We continue to view this move as an overreaction to mediocre economic data that will be reversed this fall when labor supply constraints ease and employment surprises to the upside. It’s important to note, however, that despite the drop in long-dated yields the 5-year/5-year forward Treasury yield remains within the bounds of its 1.75% to 2.5% fair value range (Chart 1). That is, shorter-maturity Treasury yields have much more upside than long-dated yields on a 6-12 month investment horizon. We expect the next big move in bonds to be a bear-flattening of the yield curve as the market prices in a Fed rate hike cycle that we see starting near the end of 2022. Investors should position for that outcome today by keeping portfolio duration low and by entering yield curve flatteners. Feature Table 1Recommended Portfolio Specification It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 2Fixed Income Sector Performance It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +172 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 89 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated EM sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Table 3BCorporate Sector Risk Vs. Reward* It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +433 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first six months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms.   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in July, dragging year-to-date excess returns down to -64 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 8 bps in July. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 3 bps in July (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 36 bps, below the 54 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 34 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +57 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 149 bps in July, dragging year-to-date excess returns down to -113 bps. Foreign Agencies underperformed the Treasury benchmark by 11 bps on the month, dragging year-to-date excess returns down to +35 bps. Local Authority bonds underperformed by 19 bps in July, dragging year-to-date excess returns down to +372 bps. Domestic Agency bonds outperformed by 2 bps, bringing year-to-date excess returns up to +28 bps. Supranationals performed in line with Treasuries in July, year-to-date excess returns held flat at +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +271 bps (before adjusting for the tax advantage). The economic and policy back-drop is favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 10% breakeven tax rate versus corporates with the same credit rating and duration. The breakeven tax rate for Revenue munis is just 2% (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened in July. Bond yields were down across the curve, but by much more at the long end. The 2-year/10-year slope flattened 15 bps to end the month at 105 bps. The 5-year/30-year slope steepened 1 bp to end the month at 120 bps. While we expect the recent decline in bond yields to reverse during the next 6-12 months, we do not think this reversal will coincide with a re-steepening of the 2/10 yield curve. We noted on the first page of this report that the 5-year/5-year forward Treasury yield remains close to its fair value range. Last week’s report demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.17% in one year’s time and 1.36% in five years (Chart 7). While the latter rate has 157 bps of upside if it converges all the way back to its 2018 high, this pales in comparison to the 269 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell.   TIPS: Neutral Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in July, bringing year-to-date excess returns up to +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose by 9 bps and 8 bps, respectively, on the month. At 2.43%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below.  ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to +37 bps. Aaa-rated ABS underperformed by 3 bps on the month, dragging year-to-date excess returns down to +28 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +88 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, pushing the savings rate higher yet again (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 3 basis points in July, bringing year-to-date excess returns up to +187 bps. Aaa Non-Agency CMBS performed in-line with Treasuries in July, keeping year-to-date excess returns steady at +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 16 bps on the month, bringing year-to-date excess returns up to +539 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 underperformed the duration-equivalent Treasury index by 28 basis points in July, dragging year-to-date excess returns down to +87 bps. The average index option-adjusted spread widened 5 bps on the month and it currently sits at 34 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. 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 July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners 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 July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners 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 26 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 26 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) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 30TH, 2021) It’s Time For Bear-Flatteners It’s Time For Bear-Flatteners Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio 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, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.

Dear Client, I will be on vacation next week. In lieu of our regular report, we will be sending you a Special Report written by my colleague Arthur Budaghyan, BCA Research’s Chief Emerging Markets Strategist. Arthur’s report will discuss the long-term outlook for industrial companies. He argues that the US is entering an industrial boom prompted by infrastructure stimulus and onshoring. This will benefit US industrial equities, or ones selling into the US on a multi-year horizon. I trust you will find it insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Investors keep asking whether the recent increase in US inflation is transitory. However, this is the wrong question to ask. Annualized core CPI inflation reached 10.6% in the second quarter. There is little doubt that inflation will fall from such elevated levels. The key question that investors should be asking is whether inflation will decline more or less than what the market is discounting. The widely watched 5-year/5-year forward TIPS inflation breakeven rate has sunk to 2.11%, below the Fed’s “comfort zone” of 2.3%-to-2.5%. Thus, the market already expects a substantial decline in inflation. Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. As inflation surprises on the upside, long-term bond yields will rise. This should revive bank shares and other reflationary plays. The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO). The Right Question About Inflation Chart 1After A Spike In Q2, US Inflation Will Decelerate After A Spike In Q2, US Inflation Will Decelerate After A Spike In Q2, US Inflation Will Decelerate Investors remain focused on whether the recent bout of US inflation is transitory. However, this is not the correct question to be asking at the present juncture. The US core CPI rose by 10.6% at an annualized pace in Q2 relative to the first quarter (Chart 1). It is almost inevitable that inflation will come down from such high levels. The key question investors should be asking is whether inflation will decline more or less than what is already baked into market expectations. As Chart 2 shows, investors expect US inflation to come down rapidly over the next two years. The 5-year/5-year forward TIPS breakeven inflation rate – a good proxy for where investors expect inflation to be over the long haul – has sunk to 2.11% (Chart 3). This is below the Fed’s comfort zone of 2.3%-to-2.5%.1 Globally, long-term inflation expectations remain subdued (Chart 4). Chart 2Inflation Is Expected To Moderate Over The Coming Years Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 3Inflation Expectations Have Fallen Back Below The Fed's Target Zone Inflation Expectations Have Fallen Back Below The Fed's Target Zone Inflation Expectations Have Fallen Back Below The Fed's Target Zone Chart 4Long-Term Inflation Expectations Remain Subdued Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation       Inflation Will Fall, But… Our sense is that US inflation will come down fast enough to allow the Fed to maintain a highly dovish policy stance, but not as fast as market expectations currently imply. Broad-based inflationary pressures would make the Fed nervous. However, that is not what we are seeing. Wages have accelerated markedly in only a few relatively low-skilled sectors such as retail trade and leisure and hospitality (Chart 5). For the economy as a whole, wage growth is broadly stable (Chart 6). The expiration of extended unemployment benefits, the reopening of schools, and increased immigration should also boost labor supply in the fall. Chart 5Faster Wage Growth Has Been Confined To A Few Low-Wage Sectors Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 6No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now No Sign Of A Wage-Price Spiral... For Now     On the price front, more than two-thirds of the increase in the core CPI in June stemmed from pandemic-afflicted sectors (Chart 7). The price of the median item within the CPI index rose by just 2.2% year-over-year in June, somewhat below the pre-pandemic pace of inflation (Chart 8). Chart 7Most Of The Recent Increase In Inflation Is Pandemic-Related Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 8The Median Price In The CPI Basket Is Up Only 2.2% The Median Price In The CPI Basket Is Up Only 2.2% The Median Price In The CPI Basket Is Up Only 2.2% … Not As Fast As The Market Expects While inflation will fall as pandemic effects recede, investors are overestimating how fast this will happen. US growth has undoubtedly peaked, but at a very high level. Economists surveyed by Bloomberg estimate that US GDP rose by 9.0% in Q2. Growth is expected to slow to 7.1% in Q3 and 5.1% in Q4, while averaging 4.2% in 2022 (Table 1). By any standard, these are very strong, above-trend growth rates. Table 1Growth Is Peaking, But At A Very High Level Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 9Nearly 90% Of US Seniors Have Had At Least One Shot Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation The current Delta-variant wave is unlikely to slow US growth by very much. Although vaccination rates among younger people are at middling levels, they are quite high for the elderly who are most at risk of serious illness. Close to 89% of Americans above the age of 65 have received at least one shot, and nearly 80% are fully vaccinated (Chart 9). The 65+ age group accounts for four-fifths of all Covid deaths in the United States. Widespread vaccination coverage for older Americans will take pressure off the hospital system, allowing the economy to remain open. Fiscal Support In The US And Abroad As we noted last week, Senate Democrats are likely to use the reconciliation process to both raise the debt ceiling and pass President Biden’s $3.5 trillion American Jobs and Families Plan. They are also likely to move forward on Biden’s proposed $600 billion in infrastructure spending, with or without Republican support. Meanwhile, much of the fiscal stimulus that has already been undertaken has yet to make its way through to the economy. US households are sitting on about $2.5 trillion in excess savings, about half of which stems from increased government transfers (Chart 10). Chart 10A Lot Of Excess Savings Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 11Inventories Are At Low Levels Inventories Are At Low Levels Inventories Are At Low Levels   Satiating that demand has not been easy for many companies. Retail sector inventories are at record lows (Chart 11). The number of homes that have been authorized for construction but where building has yet to begin has increased by 62% since the start of the pandemic (Chart 12). By limiting production, supply-chain bottlenecks will push some spending towards the future. This will keep growth from decelerating more than it otherwise would. Outside the US, fiscal policy will remain supportive. All 27 EU countries ratified the €750 billion Next Generation fund on May 28th. The allocations from the fund for southern European countries are relatively large (Chart 13). Most of the money will be spent on public investment projects with high fiscal multipliers. Chart 12Growing Backlog Of New Home Construction Projects Growing Backlog Of New Home Construction Projects Growing Backlog Of New Home Construction Projects Chart 13EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large EU Fiscal Policy: Allocations To Southern European Countries Are Relatively Large Chart 14Economic Growth In China Was Slow In H1 Economic Growth In China Was Slow In H1 Economic Growth In China Was Slow In H1 The Japanese government is contemplating sending stimulus checks to low-income citizens in advance of the general election due by October 22nd. It is an understandable move. Covid cases are rising again. As a result, the authorities have declared a state of emergency in Tokyo and barred spectators from attending the Olympic games in and around the city. Fortunately, the Japanese vaccination campaign has accelerated after a slow start. A third of the population has now received at least one shot. The government intends to vaccinate all eligible people by November.  Looking at quarter-over-quarter growth rates, Chinese growth averaged just 3.8% on an annualized basis in the first half of 2021 (Chart 14). Growth should pick up in the second half of the year thanks in part to increased fiscal spending. As of June, local governments had used only 28% of their annual bond issuance quotas, compared with 61% over the same period last year and 65% in 2019. Most of the proceeds from local government bond sales will likely flow into infrastructure projects.   Resumption Of The Dollar Bear Market Will Keep Inflation From Falling Too Far As a countercyclical currency, the US dollar usually weakens when global growth is strong (Chart 15). Short-term real interest rate differentials have moved sharply against the dollar, a trend that is unlikely to change anytime soon given the Fed’s dovish bias (Chart 16). While inflation in the US is not as sensitive to currency fluctuations as in most other countries, a weaker dollar will still lift tradeable goods prices (Chart 17). Chart 15The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 16Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Rate Differentials Are A Headwind For The Dollar Chart 17The Dollar And Inflation Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Structural Forces Turning More Inflationary Not only are cyclical forces likely to turn out to be less disinflationary than investors believe, but many of the structural factors that have suppressed inflation over the past 40 years are reversing direction: Chart 18Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 18). Looking out, the ratio could even decline as more companies shift production back home in order to gain greater control over supply chains of essential goods. Baby boomers are leaving the labor force en masse. As a group, baby boomers hold more than half of US household wealth (Chart 19). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Continued spending against a backdrop of diminished production could be inflationary. Despite a pandemic-induced bounce, underlying productivity growth remains anemic (Chart 20). Slow productivity growth could cause aggregate supply to fall short of aggregate demand. Social stability is in peril, as exemplified by the recent dramatic increase in the US homicide rate. In the past, social instability and higher inflation have gone hand in hand (Chart 21). Perhaps most importantly, policymakers are deliberately aiming to run the economy hot. A tight labor market will eventually lift wage growth to a greater degree than what we have seen so far (Chart 22). Not only could higher wage growth push up inflation through the usual “cost-push” channel, but by boosting labor’s share of income, a tight labor market could spur aggregate demand. Chart 19Baby Boomers Have Accumulated A Lot Of Wealth Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Chart 20Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Trend Productivity Growth Has Been Disappointing Chart 21Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step Historically, Social Unrest And Higher Inflation Move In Lock-Step     Chart 22A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages A Tight Labor Market Eventually Bolsters Wages Investment Implications Chart 23Positive Earnings Revisions Are At High Levels Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation The path to higher rates is lined with lower rates. The longer central banks keep interest rates below their neutral level, the more economies will overheat, and the more rates will eventually need to rise to bring inflation back down. For now, we are still in the warm-up phase to higher inflation. With long-term inflation expectations below target, central banks will be able to maintain accommodative monetary policies. This is good news for stocks, at least in the short-to-medium term. The recent wobble in equity markets has occurred despite a strong second quarter earnings season. According to the latest available data from I/B/E/S, 90% of S&P 500 companies have reported earnings above analyst expectations. Earnings have surprised on the upside by an average of 19.2%, compared to a historical average of 3.9%. Positive earnings revisions are at record high levels (Chart 23). Full year 2021 S&P 500 EPS estimates have risen 16% since the start of the year. Analysts have also raised their estimates for 2022 and 2023 (Chart 24). We continue to recommend that asset allocators favor stocks over bonds over a 12-month horizon.   Chart 24Analysts Have Been Revising Up Earnings Estimates This Year Analysts Have Been Revising Up Earnings Estimates This Year Analysts Have Been Revising Up Earnings Estimates This Year Chart 25The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth The Gains Of Recent Winners Have Not Been Fully Mirrored In Relative Earnings Growth Chart 26Bank Shares Thrive In A Rising Yield Environment Bank Shares Thrive In A Rising Yield Environment Bank Shares Thrive In A Rising Yield Environment Tech stocks have outperformed the broader market over the past seven weeks. However, unlike during the pandemic, 12-month forward EPS estimates for tech have not risen in relation to other sectors (Chart 25). As long-term bond yields move back up, tech shares will underperform. In contrast, banks will benefit from higher yields (Chart 26).     Along the same lines, US stocks have outpaced other stock markets by more than one would have expected based on relative EPS trends. Notably, EM earnings have moved sideways versus the US since mid-2019. Yet, US stocks have outperformed EM by 17% over this period. Today, the forward P/E ratio for EM stands at 13.8, compared to 22.1 for the US (Chart 27). The combination of a weaker US dollar, faster sequential Chinese growth, increased vaccine supplies, and favorable valuations should all help EM stocks later this year. Go long the Vanguard FTSE Emerging Markets ETF (VWO) versus the Vanguard S&P 500 ETF (VOO).   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 27Wide Valuation Gap Between US And Non-US Markets Wide Valuation Gap Between US And Non-US Markets Wide Valuation Gap Between US And Non-US Markets Footnotes 1 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Special Trade Recommendations Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation Current MacroQuant Model Scores Investors Are Asking The Wrong Question About Inflation Investors Are Asking The Wrong Question About Inflation

Highlights Global Yields: Falling global bond yields, led by US Treasuries, are an oversized response to some modest cooling of growth momentum. Global growth will remain above-trend over the next year, which will keep global inflation rates elevated and maintain pressure on central banks (outside of Europe and Japan) to withdraw monetary accommodation. Stay below-benchmark on duration exposure, and underweight US Treasuries, in global bond portfolios. ECB Strategy Review: The ECB’s new monetary policy framework is a dovish move, as it gives the central bank the leeway to maintain accommodative policy settings even if euro area inflation temporarily rises above 2%. Maintain overweights to European government bonds, both in the core and the Periphery. Model Portfolio Benchmark: We are formally including inflation-linked bonds (ILBs) in our model bond portfolio custom performance benchmark index. Stay neutral ILBs in the US, overweight ILBs in Europe and Japan, and underweight ILBs in the UK, Canada, and Australia. Letting Some Air Out Of Reflation Trades Chart of the WeekA Bear-Market Correction For Bond Yields A Bear-Market Correction For Bond Yields A Bear-Market Correction For Bond Yields The growth acceleration narrative that drove much of the performance of global financial markets in 2021 has frayed a bit, led by US bond yields. The 10-year US Treasury yield declined to an intraday low of 1.25% last week, but has since recovered to 1.36%. That is well off the 2021 intraday high of 1.78% seen in late March. The yield decline has been concentrated in longer-maturity bonds, resulting in a bullish flattening of the US Treasury yield curve. While the inflation expectations component of yields has drifted lower, the big surprise move has been a fall in US real yields, with the benchmark 10-year TIPS yield falling back to -1% (Chart of the Week). This positive price action in bonds has led to investors questioning their faith in the so-called US Reflation Trade. US small-cap stocks – a proxy for the companies that would benefit as the US economy recovers from the pandemic - have been underperforming large-caps since March. Economically-sensitive commodity prices have lost much of the sharp upward momentum seen earlier this year, with the price of copper peaking in May and lumber futures prices down more than 40% over the past month. Technology-laden growth stocks have been outperforming value stocks since May, as investors have sought the reliable earnings of the US tech giants. Markets are likely getting a bit more jittery about the near-term growth outlook given the global spread of the Delta COVID-19 variant, which raises the risk of a reversal of “reopening momentum”. Yet nominal economic growth in the major developed economies is still projected to be above the pace seen during the pre-pandemic years - when global bond yields were much higher than current levels - until at least the end of 2022, according to Bloomberg consensus forecasts of real GDP growth and headline inflation (Chart 2). This suggests that global bond yields will begin climbing again, led by the US, as persistent above-trend growth limits how much US realized inflation cools after the Q2 spike, which would go a long way towards reestablishing the bond-bearish reflation narrative. Some pullback in US reflation trades was inevitable, given crowded positioning and a growing number of US data releases disappointing versus highly elevated expectations (Chart 3). Yet forward-looking US indicators like the Conference Board leading economic indicator and the Goldman Sachs financial conditions index are still pointing to strong US growth in the second half of 2021. Chart 2Nominal Growth Expected To Remain Above Pre-COVID Pace Nominal Growth Expected To Remain Above Pre-COVID Pace Nominal Growth Expected To Remain Above Pre-COVID Pace Chart 3No Reason To Be Pessimistic On US Growth No Reason To Be Pessimistic On US Growth No Reason To Be Pessimistic On US Growth The reflation narrative has also been challenged by policy tightening in China. Last week, the reserve requirement ratio (RRR) for Chinese banks was cut by 50bps, while the credit data for June showed a stabilization of the credit impulse that has been declining since October (Chart 4). Our China strategists are not convinced that the RRR cut was the start of a full-blown easing cycle, but any additional positive policy surprises from China would help boost global growth expectations and breathe new life into the reflation narrative. For global bond markets, however, the Fed’s next moves remain critical. The FOMC minutes released last week reinforced the message from the June policy meeting, that the Fed has moved incrementally towards starting the process of monetary policy normalization. Lower real US real bond yields are the part of the reflation trade unwind that is most inconsistent with a Fed inching towards QE tapering in 2022 as the US labor market continues to tighten. The fall in US Treasury yields now looks overdone, with the 5-year/5-year forward Treasury yield now below the range of median longer-term fed funds rate forecasts from the New York Fed’s Primary Dealer Survey (Chart 5). Once the overhang of short positioning in the Treasury market is fully worked off, likely in the next month or two, Treasury yields will begin to rise again driven by steady US growth and Fed tightening expectations. Chart 4Is China Moving Towards Fresh Stimulus? Is China Moving Towards Fresh Stimulus? Is China Moving Towards Fresh Stimulus? Chart 5UST Yields Have Fallen Too Far UST Yields Have Fallen Too Far UST Yields Have Fallen Too Far Bottom Line: Falling global bond yields, led by US Treasuries, are an oversized response to some modest cooling of growth momentum. Global growth will remain above-trend over the next year, which will keep global inflation rates elevated and maintain pressure on central banks (outside of Europe and Japan) to withdraw monetary accommodation. Stay below-benchmark on duration exposure, and underweight US Treasuries, in global bond portfolios. The ECB Finds A New Way To Stay Dovish The ECB unveiled the results of its strategic review last week, with some noteworthy tweaks to the policy framework. The central bank shifted to a symmetric inflation target of 2%, a change from the prior goal of aiming for inflation “just below” 2%. While that may seem like a small distinction, it does the give the ECB some leeway in tolerating temporary bouts of inflation above the 2% target. This removes one of the rigidities of the prior framework, where the 2% level was considered to be a ceiling, a breach of which would force the ECB to tighten policy. Of course, the ECB has not had to deal with a +2% inflation rate for some time (Chart 6). The last time euro area headline inflation, core inflation and inflation expectations (using 5-year/5-year forward euro CPI swaps) were all at or above 2% was back in 2012. Today, headline inflation is at 1.9%, while core inflation is a mere 0.9% and inflation expectations are at 1.6%. ECB President Christine Lagarde noted in the press conference announcing the strategy change that policymakers wanted to break out of the current situation where a too-rigid interpretation of the inflation target could result in sustained low longer-run inflation expectations when actual inflation was persistently low. Lagarde noted that the ECB needed room to “act forcefully” if needed when inflation expectations were too low, especially give the constraint of the lower bound on policy rates. Yet with nominal policy rates already in negative territory and the ECB balance sheet now nearly €8 trillion, there is limited scope for any new policy that could be considered sufficiently “forceful”. Our measure of the market-implied path of the real ECB policy rate, derived from the forward rates from overnight index swaps and CPI swaps, shows that the market already expects negative real rates to persist in the euro area well into the next decade (Chart 7). The ECB has had to resort to cutting nominal rates below 0%, as well as embarking on massive bond buying programs and cheap bank funding programs (TLTROs), in order to appear accommodative enough to try, unsuccessfully, to raise inflation expectations back to the 2% target. Chart 6The ECB's Old 'Just Below 2%' Inflation Target Was Not Credible The ECB's Old 'Just Below 2%' Inflation Target Was Not Credible The ECB's Old 'Just Below 2%' Inflation Target Was Not Credible Chart 7Negative ECB Rates Were A Product Of Persistent Sub-2% Inflation Negative ECB Rates Were A Product Of Persistent Sub-2% Inflation Negative ECB Rates Were A Product Of Persistent Sub-2% Inflation The ECB Governing Council realized that it had a credibility problem with its prior one-sided approach to the 2% inflation target, given the persistent undershooting of that level. By moving to allow a tolerance for inflation above 2%, policymakers hope to be perceived as being more flexible – and, thus, more dovish - as even inflation above 2% would not require immediate monetary tightening.This is especially important as the neutral real interest rate (or “r-star”) has likely stopped falling with potential growth in the euro area drifting higher over the past few years, according to the OECD (Chart 8). Euro area r-star should continue to drift higher in the next few years, especially given the potential for faster productivity growth on the back of Next Generation European Union (NGEU) government investments (Chart 9). This opens a window for the ECB to implement an even more accommodative monetary stance without doing anything, by leaving policy rates untouched while the equilibrium interest rate increases. To the extent that inflation also goes up at the same time, that will further depress real interest rates and widen the gap of real rates to r-star. This will help lift euro area inflation expectations closer to the 2% target over time. Chart 8Equilibrium Interest Rates In Europe Have Stopped Falling Equilibrium Interest Rates In Europe Have Stopped Falling Equilibrium Interest Rates In Europe Have Stopped Falling Chart 9NGEU Investments Could Help Boost Potential Growth In Europe NGEU Investments Could Help Boost Potential Growth In Europe NGEU Investments Could Help Boost Potential Growth In Europe In the end, the new ECB framework was a likely compromise between the various Governing Council members, who do not share the same degree of tolerance of higher inflation. For example, it is hard to imagine the Bundesbank being a willing participant to any monetary policy that permits above-target inflation, especially in a year when the German central bank is forecasting domestic inflation to hit a 14-year high of 2.6%. This poses a future communication problem for the ECB, as no guidance was provided about how much of an inflation overshoot above 2% would be tolerated, and for how long. That is likely because there was no agreement yet within the ECB Governing Council on those parameters. The current underlying inflation dynamics in the euro area are still weak, with ample spare capacity in labor markets still dampening wage pressures. Previous episodes of euro area headline inflation climbing above 2% occurred alongside euro area wage growth of at least 3% (Chart 10). With wage growth now slowing to 2.1% after the brief pandemic-fueled spike to 5% in 2020, the euro area needs a sustained period of above-trend growth to absorb spare economic capacity and push up weak domestically-driven inflation. The ECB has given themselves the opening to stay dovish with their new policy framework. Even a forecast of inflation moving above 2% will not necessarily suggest that policy should be tightened in any way, including tapering asset purchases. Our view remains that the Pandemic Emergency Purchase Program (PEPP) will not be allowed to expire without some form of replacement program.1 The ECB simply cannot allow markets to tighten financial conditions through higher bond yields on Italian government bonds or euro area corporate debt, or through a stronger euro – all outcomes that would be likely to unfold if the ECB announced that it was letting the PEPP roll off - with inflation expectations still too low (Chart 11). Chart 10ECB Hawks Do Not Have To Fear An Inflation Overshoot ECB Hawks Do Not Have To Fear An Inflation Overshoot ECB Hawks Do Not Have To Fear An Inflation Overshoot Chart 11The ECB Will Fold The PEPP Into The APP The ECB Will Fold The PEPP Into The APP The ECB Will Fold The PEPP Into The APP We expect the ECB to make an announcement about the future of the PEPP – including the upsizing of the existing Asset Purchase Program (APP) and, potentially, the introduction of more flexibility of the rules governing the APP – at the next ECB meeting on July 22. Some changes to the ECB’s forward guidance, on both rates and future TLTROs, will likely also be unveiled in response to the new policy framework. In the end, the new strategy only confirms what most investors already know – the ECB is going to stay with a highly accommodative monetary policy for a very long time, keeping European interest rates among the lowest in the world for the next several years. Bottom Line: The ECB’s new monetary policy framework is a dovish move, as it gives the central bank the leeway to maintain accommodative policy settings even if euro area inflation temporarily rises above 2%. Maintain overweights to European government bonds, both in the core and the Periphery. Benchmarking Our Inflation-Linked Bond Allocations A little over a year ago, we added inflation-linked bonds (ILBs) to our model bond portfolio.2 At the time, our rationale was that inflation breakevens seemed extraordinarily depressed, far more than was justified by fundamentals, across developed markets. So, to gain exposure to the inevitable rebound in inflation expectations, we made an “opportunistic” addition of ILBs to the portfolio while giving them zero weighting in our model bond portfolio custom performance benchmark. Chart 12Global Inflation Breakevens Have Recovered From The Pandemic Shock Global Inflation Breakevens Have Recovered From The Pandemic Shock Global Inflation Breakevens Have Recovered From The Pandemic Shock Effectively, this constrained us to either a zero or a long-only allocation to ILBs in the portfolio. At the time, such an approach was effective with ILBs extraordinarily cheap in all developed markets. However, with inflation expectations having rebounded and now above pre-pandemic levels across the developed markets, there are grounds for a more nuanced approach (Chart 12). Today, we are formally making inflation-linked bonds part of our custom performance benchmark. With this addition, we can now take positions relative to benchmark, as we do for all other categories included in our portfolio, rather than being restricted to absolute allocations to ILBs. Not only does this approach allow us to take proper short and neutral positions on ILBs, it is also more in line with the practices followed by global fixed income portfolio managers and many of our clients, who maintain a position in ILBs at all times and include them in their own benchmarks when measuring performance. As we have for all the other categories in our Model Bond Portfolio, we are basing the relative size of our allocations off the Bloomberg Barclays Indices. We will now include in our benchmark all the major ILB markets in developed economies – the US, UK, France, Italy, Japan, Germany, Spain, Canada, and Australia (Chart 13). Together, these amount to 98.7% of the $3.8 trillion Bloomberg Barclays World Government Inflation-Linked Index.3 Chart 13World Government Inflation-Linked Bond Index: Market Shares By Country The Reflationary Backdrop Is Still In Place The Reflationary Backdrop Is Still In Place To help inform our ILB allocations, we turn to our Comprehensive Breakeven Indicators (CBIs), which 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. (Chart 14). These indicators suggest that ILBs are still attractive in Europe and Japan while valuations look stretched in the other developed markets – Australia, US, Canada, and the UK. Globally, we think it is too early to position for falling breakevens even though real yields will play an increasingly important part in the continuing cyclical rise in bond yields. With a neutral global allocation to ILBs in mind, we are adding a neutral US TIPS allocation to our model portfolio, while adding a new small overweight to Japanese ILBs. We are introducing a below-benchmark allocation to the large UK ILB market, while staying completely out of smaller and less liquid Australian and Canadian ILBs. We are maintaining our existing European ILB overweights in Germany, France and Italy where our CBIs show that breakevens have the most upside potential. Even though US breakevens do look stretched on our CBIs, it is impossible, given the sheer size of the US and UK ILB markets, to go underweight on both while maintaining an overall neutral allocation globally. We are more willing to be ILB-bearish in the UK, as we currently have the UK on “downgrade watch” given our view that the Bank of England will withdraw monetary accommodation faster than the markets expect over the next couple of years – an outcome that will likely push up real yields and lower UK breakeven inflation rates. As part of this exercise, we are also rebalancing the market weights and updating durations for the existing categories in our benchmark. After this rebalancing, government bonds in total make up 59% of the benchmark, with ILBs making up 11% of that allocation. The rest goes to spread product, which now makes up 41% of the benchmark, falling a single percentage point from before the rebalancing (Chart 15). Our rebalanced benchmark and allocations can be found on pages 14-15. Chart 14Stay Overweight Euro Area Inflation-Linked Bonds The Reflationary Backdrop Is Still In Place The Reflationary Backdrop Is Still In Place Bottom Line: We are formally including inflation-linked bonds in our GFIS Custom Performance Benchmark. Stay neutral ILBs in the US, overweight ILBs in Europe and Japan, and underweight ILBs in the UK, Canada, and Australia. Chart 15GFIS Custom Performance Benchmark: Rebalanced Allocations The Reflationary Backdrop Is Still In Place The Reflationary Backdrop Is Still In Place   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy/US Bond Strategy Special Report, "A Central Bank Timeline For The Next Two Years", dated June 1, 2021, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 3 Bloomberg Ticker: BCIW1A Index. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Reflationary Backdrop Is Still In Place The Reflationary Backdrop Is Still In Place Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns