Inflation Protected

Highlights Uncertainty & Yields: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation. Bond Portfolio Strategy: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Model Bond Portfolio Changes – Governments: Upgrade countries that are more responsive to changes in the level of overall global bond yields and with room to cut interest rates (the US & Canada) to overweight, while downgrading sovereign debt with a lower “global yield beta” and less policy flexibility (Germany, France, Japan) to underweight. Model Bond Portfolio Changes – Credit: Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight. Feature Chart of the WeekOn The Verge Of Global ZIRP On The Verge Of Global ZIRP On The Verge Of Global ZIRP The title of this report is a quote from a worried BCA client this morning, discussing his daily commute into Manhattan from the New York suburbs. We can think of no better analogy for the mood of investors in the current market panic. After having enjoyed a decade of riding the gravy train of recession-free growth and robust returns on risk assets, all underwritten by accommodative monetary policies, worries about a deflationary bust following the boom have intensified. The global spread of COVID-19, the ebbs and flows of the US presidential election and, now, a stunning collapse in oil prices – markets have simply been unable to process the investment implications of these unpredictable events all at once. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. It is clear that global government bonds have been a preferred hedge, with yields collapsing to record lows worldwide. While most of the market attention has been on the breathtaking fall in US yields that has pushed the entire Treasury curve below 1% as the market has moved to discount a swift move to a 0% fed funds rate. New lows were also hit yesterday in countries that had been lagging the Treasury rally: the 10-year German bund reached -0.85% yesterday, while the 10-year UK Gilt fell to an intraday all-time low of 0.08% with some shorter-maturity Gilt yields actually dipping into negative territory (Chart of the Week). The common driver of yesterday’s yield declines was the 25% plunge in global oil prices after the weekend collapse of the OPEC 2.0 alliance between Russia and Saudi Arabia. The inflation expectations component of global bond yields fell accordingly, continuing the correlation with energy prices seen over the past decade. Yet the real component of global bond yields has also been falling, with markets increasingly pricing in an extended period of weak growth and negative real interest rates – especially in the US. Collapsing US Treasury Yields Discount A Recession, Not A Financial Crisis Chart 2Re-opening Old Wounds Re-opening Old Wounds Re-opening Old Wounds While this latest plunge in US equity markets has been both rapid and powerful, the damage only takes us back to levels on the S&P 500 last seen as recently as January 2019 (Chart 2). The turmoil, however, has reopened old wounds in markets that had suffered their own crises over the past decade, with European bank stocks hitting new all-time lows and credit spreads on US high-yield Energy bonds and Italian sovereign debt (versus Germany) sharply blowing out. The backdrop remains treacherous and global equity markets will likely remain under pressure until the number of new COVID-19 cases peaks outside of China (especially in the US). If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. Bank funding indicators like Libor-OIS spreads and bank debt spreads have widened a bit over the past week but remain at very subdued levels (Chart 3). This is in sharp contrast to classic risk aversion indicators like the price of gold and the value of the Japanese yen versus the Australian dollar, which are closing in on the highs seen during the 2008 global financial crisis and 2012 European debt crisis. Chart 3A Growth Downturn, Not A Systemic Crisis A Growth Downturn, Not A Systemic Crisis A Growth Downturn, Not A Systemic Crisis We interpret this as investors being far more worried about a deep global recession than another major financial crisis. That is also confirmed in the pricing of US Treasury yields, especially when looking at the real yield. Chart 4Does The UST Market Think R* Is Negative? Does The UST Market Think R* Is Negative? Does The UST Market Think R* Is Negative? Chart 5Another Convexity-Fueled Bond Rally Another Convexity-Fueled Bond Rally Another Convexity-Fueled Bond Rally The entire TIPS yield curve is now negative for the first time, even with the real fed funds rate below the Fed’s estimate of the “r*” neutral real rate (Chart 4). The combination of low and falling inflation expectations, and plunging real yields, indicates that the Treasury market now believes that the neutral real funds rate is not 0.8%, as suggested by the Fed’s estimate of r*, but is somewhere well below 0%. With the fed funds rate now down to 0.75% after last week’s intermeeting 50bps cut, the Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. The Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. Yet that may be too literal an interpretation of the incredible collapse of US Treasury yields. The power of negative convexity is also at work, driving intense demand for long-duration bonds that puts additional downward pressure on yields. Large owners of US mortgage backed securities (MBS) like the big commercial banks have seen the duration of their MBS holdings collapse as yields have fallen. The result is that banks are forced to buy huge amounts of Treasuries (or receive US dollar interest rate swaps) to hedge their duration exposure of negative convexity MBS, hyper-charging the fall in Treasury yields – perhaps over $1 trillion worth of buying, by some estimates.1 This is a similar dynamic to what occurred last summer in Europe, when sharply falling bond yields triggered convexity-related demand for duration from large asset-liability managers like pension funds, further fueling the decline in bond yields (Chart 5). Yet even allowing that some of the Treasury yield decline has been driven by a mechanical demand for duration, a 10-year US Treasury yield of 0.56% clearly discounts expectations of a US recession, as well – which appears justified by the recent performance of some critical US economic data. In Charts 6 & 7, we show a “cycle-on-cycle” analysis of some key US financial and indicators and how they behave before and after the start of the past five US recessions. The charts are set up so the vertical line represents the start of the recession, and we line up the data for the current business cycle as if the latest data point represents the start of a recession. Done this way, we can see if the current data is evolving in a similar fashion to past US economic downturns. Chart 6The US Business Cycle Looks Toppy The US Business Cycle Looks Toppy The US Business Cycle Looks Toppy Chart 7COVID-19 Will Likely Trigger A Confidence-Driven US Recession COVID-19 Will Likely Trigger A Confidence-Driven US Recession COVID-19 Will Likely Trigger A Confidence-Driven US Recession The charts show that the current flat 10-year/3-month US Treasury curve and steady decline in corporate profit growth are both accurately following the path entering past US recessions. Other indicators like the NFIB Small Business confidence survey, the Conference Board’s leading economic indicator and consumer confidence series typically peak between 12-18 months prior to the start of a recession, but appear to be only be peaking now. The same argument goes for initial jobless claims, which are usually rising for several months heading into a recession but remain surprisingly steady of late – a condition that seems unlikely to continue as more companies suffer virus-related hits to their sales and profits and begin to shed labor. Net-net, these reliable cyclical US data suggest that the Treasury market is right to be pricing in elevated recession risk – especially with US cases of COVID-19 starting to increase more rapidly and US financial conditions having tightened sharply in the latest market rout. Bottom Line: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation – most notably in the US. Allocation Changes To Our Model Bond Portfolio The stunning fall in global bond yields has already gone a long way. Yet it is very difficult to forecast a bottom in yields, even with central banks easing monetary policy to try and boost confidence, before there is evidence that the global COVID-19 outbreak is being contained (i.e. a decreasing total number of confirmed cases). By the same token, corporate bonds (and equities) will continue to be under selling pressure until the worst of the viral outbreak has passed. We raised our recommended overall global duration stance to neutral last week – a move that was more tactical in nature as a near-term hedge to our strategic overweight corporate bond allocations in our Model Bond Portfolio amid growing market volatility. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. This week, we are making the following additional changes to our model bond portfolio to reflect the growing odds of a global recession: Downgrade global corporates to underweight versus global governments Maintain a neutral overall portfolio duration, but favor countries within the government bond allocation that are more highly correlated to changes in to the overall level of global bond yields. Chart 8Favor Higher-Beta Bond Markets With Room To Cut Rates Favor Higher-Beta Bond Markets With Room To Cut Rates Favor Higher-Beta Bond Markets With Room To Cut Rates Given how far yields have declined already, we think raising allocations to “high yield beta” countries that can still cut interest rates, at the expense of reduced weightings toward low beta countries that have limited scope to ease policy, offers a better risk/reward profile than simply raising duration exposure across the board. Such a nuanced argument is less applicable to global corporates, where elevated market volatility, poor investor risk appetite and deteriorating global growth momentum all argue for continued near-term underperformance of corporates versus government bonds. Specifically, we are making the following changes to our recommended allocations, presented with a brief rationale for each move: Upgrade US Treasuries and Canadian government bonds to overweight: Both Treasuries and Canadian bonds are higher beta markets, as we define by a regression of monthly yield changes to changes in the yield of the overall Bloomberg Barclays Global Treasury index (Chart 8). The Fed cut 50bps last week as an emergency measure and has 75bps to go before reaching the zero bound, which the market now expects by mid-year. Additional bond bullish moves after reaching the zero bound, like aggressive forward guidance, restarting quantitative easing and even anchoring Treasury yields in a BoJ-like form of yield curve control, are all possible if the US enters a recession. Meanwhile, the Bank of Canada (BoC) followed the Fed’s cut with a 50bp easing the next day and signaled that additional rate cuts are likely to prevent a plunge in Canadian consumer confidence. The collapsing oil price likely seals the deal for additional rate cuts by the BoC in the next few months. Downgrade Japanese government bonds to maximum underweight: Japanese government bonds (JGBs) are the most defensive low-beta market in model bond portfolio universe, thanks to the Bank of Japan’s Yield Curve Control policy that anchors the 10yr JGB yield around 0%. This makes JGBs the best candidate for a maximum underweight stance when global bond yields are not expected to rise in the near term, as we expect. Downgrade Germany and France to Underweight: The ECB meets this week and will be under pressure to ease policy given recent moves by other major central banks. A -10bps rate cut is expected, which may happen to counteract the recent increase in the euro versus the US dollar, but there is also possibility that ECB will increase and/or extend the size and scope of its current Asset Purchase Program. Given the ECB’s lack of overall monetary policy flexibility, and low level of inflation expectations, we see limited scope for the lower-beta German and French government bonds to outperform their global peers. Remain overweight UK and Australia: While both Australian government bonds and UK Gilts have a “median” yield beta in our model bond portfolio universe, both deserve moderate overweights as there is still the potential for rate cuts in both countries. The Reserve Bank of Australia (RBA) cut the Cash Rate by -25bps last week and they are still open to cut further to boost a sluggish economy hurt by wildfires and weak export demand from China. The RBA will stay more dovish for longer until we will see clear signs of a rebound of the Chinese economy from the COVID-19 outbreak. The Bank of England (BoE) will likely cut its policy rate later this month, or even before the next scheduled policy meeting, as COVID-19 is starting to spread through the UK. Downgrade US High-Yield To Underweight: US junk bonds had already taken a hit during the global market selloff in recent weeks, but the collapse in oil prices pummeled the market given the high weighting of US shale producers in the index (Chart 9). With additional weakness in oil prices likely as Russia and Saudi Arabia are now in a full-fledged price war, US high-yield will come under additional spread widening pressure focused on the weaker Caa-rated segment that contains most of the energy names. We recommend a zero weight in the Caa-rated US junk bonds, within an overall underweight allocation to the entire asset class. Downgrade euro area investment grade and high-yield corporates to underweight: COVID-19 is now spreading faster in Germany and France, after leaving Italy in a full-blown national crisis. The export-oriented economies of the euro area were already vulnerable to a global growth slowdown, but now domestic growth weakness raises the odds of a full-blown recession – not a good environment to own corporate bonds, especially with the euro now appreciating. Downgrade emerging market (EM) USD-denominated sovereigns and corporates to underweight: EM debt remains a levered play on global growth, so the increased odds of a global recession are a problem for the asset class – even with sharply lower interest rates and early signs of a softening in the US dollar (Chart 10). Chart 9Downgrade US Junk Bonds To Underweight Downgrade US Junk Bonds To Underweight Downgrade US Junk Bonds To Underweight Chart 10Still Not Much Broad-Based Weakness In The USD Still Not Much Broad-Based Weakness In The USD Still Not Much Broad-Based Weakness In The USD We will present the new specific model bond portfolio weightings, along with a discussion of the risk management implications of these changes, in next week’s report. Bottom Line: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Upgrade high-beta countries with room to cut interest rates (the US & Canada) to overweight, while downgrading lower-beta countries with less policy flexibility (Germany, France, Japan) to underweight. Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.wsj.com/articles/fear-isnt-the-only-driver-of-the-treasury-rally-banks-need-to-hedge-their-mortgages-1158347080 Recommendations Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Fed: Low inflation expectations mean that the Fed is unconstrained when it comes to easing policy. Rate cuts will continue until either the funds rate reaches zero, or financial markets signal that enough stimulus has been delivered. Spread Product: Investors with 12-month investment horizons should neutralize allocations to spread product versus Treasuries, including high-yield where the recent oil supply shock will weigh heavily on returns. Investors should also downgrade exposure to MBS with the goal of re-deploying into corporate credit once the current risk-off episode runs its course. Feature Risk off sentiment prevailed in financial markets again last week, as COVID-19 continues to spread throughout the world. Most recently, the city of Milan has been placed under quarantine and New York state has declared a state of emergency. It is difficult to have much certainty about the virus’ ultimate economic impact, but the prospect of US recession looms larger and larger. In bond markets, the 10-year Treasury yield has fallen to 0.54% and the yield curve is pricing-in 91 bps of Fed rate cuts over the next 12 months (Chart 1). If those expectations are met, it would bring the funds rate down to 0.18%, only slightly above the zero-lower-bound. Chart 1Market Priced For A Return To The Zero-Lower-Bound Market Priced For A Return To The Zero-Lower-Bound Market Priced For A Return To The Zero-Lower-Bound On the bright side, there is ample evidence that global economic growth was trending up before the virus struck in late January, and we remain confident that a large amount of pent-up demand will be unleashed once its impact fades. However, we have no clarity on how much longer COVID-19 might weigh on growth. For this reason, we recommend a much more defensive US bond portfolio allocation, even for investors with 12-month horizons. Specifically, investors should keep portfolio duration close to benchmark and reduce spread product allocations to neutral. The market is sending the message that more rate cuts are needed. We will be quick to re-initiate a below-benchmark duration recommendation when we think that bond yields are close to bottoming. In the below section titled “How To Call The Bottom In Yields”, we discuss the factors that will help us make that decision. A State Of Monetary Policy Emergency The Fed took quick action last week, delivering an inter-meeting 50 basis point rate cut as the stock market tumbled on Tuesday morning. Alas, the market is sending the message that those 50 bps won’t be enough. Fed funds futures are pricing-in another 82 bps of easing by the end of next week’s FOMC meeting, followed by further cuts in April (Table 1). Table 1Expectations Priced Into The Fed Funds Futures Curve When And Where Will Bond Yields Trough? When And Where Will Bond Yields Trough? Of course, easier monetary policy is not the solution to what ails the global economy. At his press conference last week, Fed Chair Powell justified the emergency cut by saying that it will help “avoid a tightening of financial conditions which can weigh on activity, and it will help boost household and business confidence.” This is a fair assessment of what monetary policy can hope to accomplish in the current environment. At most, monetary policy can limit the damage in financial markets, which is a worthwhile goal given the strong historical correlation between financial conditions and economic growth (Chart 2). Chart 2Fed Must Do Its Best To Support Financial Conditions Fed Must Do Its Best To Support Financial Conditions Fed Must Do Its Best To Support Financial Conditions What’s more, with inflation expectations at very low levels – as we go to press the 10-year TIPS breakeven inflation rate is a mere 1.03% – there is no reason for the Fed to resist easing policy, even if the expected benefits from easing are small. Chart 3Markets Demand More Easing Markets Demand More Easing Markets Demand More Easing From our perch, the only possible reason for the Fed to refrain from cutting rates quickly all the way back to zero would be to preserve some monetary policy ammunition for when it is needed most. The Fed probably doesn’t see things this way. In conventional economic models it is the level of interest rates that influences economic activity. Therefore, the way to get the most bang for your stimulus buck is to cut rates to zero as quickly as possible. However, if monetary policy is primarily influencing the economy via its impact on financial conditions and investor sentiment, as Chair Powell claimed, then it would be advisable to only deliver rate cuts when financial conditions are tightening rapidly. That is, don’t cut rates if the stock market is rebounding, save your ammo for when equities are in free fall and panic is widespread. We can’t know for certain what the Fed will do between now and the next FOMC meeting. But we can say that, with inflation pressures low, there are no constraints against cutting rates back to the zero bound. The safest takeaway for bond investors is to assume that rate cuts will continue until either (i) the fed funds rate hits zero or (ii) we see signs that the markets and economy are no longer calling for further stimulus. Those signs would be (Chart 3): Yield curve steepening, particularly at the short end. Stocks outperforming bonds. A rising gold price. A falling US dollar. Bottom Line: More rate cuts are coming, and they won’t stop until either the fed funds rate hits zero or financial markets signal that sufficient stimulus has been delivered. We can’t be certain whether that will occur with more or less than the 91 bps of rate cuts that are currently priced for the next 12 months. As such, we recommend keeping portfolio duration close to benchmark. How To Call The Bottom In Yields The US economy is on the cusp of entering a downturn of uncertain duration that will likely be followed by a rapid recovery. Given that outlook, the next big call to make is: When will bond yields put in a bottom? We identify four catalysts that we will monitor to make that call. 1. Virus Panic Abates This is the most important catalyst that could lead us to re-initiate a below-benchmark duration recommendation. The pattern of past viral outbreaks is that bond yields tend to fall until the number of daily new cases reaches zero. This is precisely what happened during the 2003 SARS epidemic (Chart 4A). As for COVID-19, the number of daily new cases looked like it was approaching zero a few weeks ago, but then reversed course as the virus moved on from China to the rest of the world (Chart 4B). One ray of hope is that the number of new cases in China is approaching zero. This suggests that it will also be possible for other countries to contain the virus, but right now it is unclear how long that will take. Chart 4AYields Will Bottom When New Cases Reach Zero Yields Will Bottom When New Cases Reach Zero Yields Will Bottom When New Cases Reach Zero Chart 4BNew COVID-19 Cases Still ##br##Rising New COVID-19 Cases Still Rising New COVID-19 Cases Still Rising   In sum, we will keep tracking the global daily number of new cases and will shift to a below-benchmark duration recommendation as it approaches zero. 2. Global Economic Data Improve (Especially China) Chart 5Waiting For A Global Growth Rebound Waiting For A Global Growth Rebound Waiting For A Global Growth Rebound China is where the COVID-19 outbreak started and it is also where we are now seeing the impact in the economic data. The Global Manufacturing PMI dropped from 50.4 to 47.2 in February, due in large part to the plunge in China’s index from 51.1 to 40.3 (Chart 5). In order to call the bottom in US bond yields we will need to see evidence that China can come out the other side of the economic downturn. This means seeing an improvement in the Chinese and Global Manufacturing PMIs. We would also like to see improvement in other global growth indicators such as the CRB Raw Industrials index (Chart 5, panel 2) and the relative performance of cyclical versus defensive equity sectors (Chart 5, bottom panel). Aggressive Chinese stimulus (both monetary and fiscal) might help speed this process along. China’s credit impulse is on the rise (Chart 5, panel 2), and our China Investment Strategy service observed that recently announced policy initiatives related to infrastructure, housing and the automobile sector resemble those that led to a V-shaped Chinese economic recovery in 2016.1  We will be inclined to shift back to below-benchmark portfolio duration when the Global Manufacturing PMI, CRB Raw Industrials index and the relative performance of cyclical versus defensive equities move higher. 3. The US Economic Data Worsen Chart 6Waiting For Weaker US Data Waiting For Weaker US Data Waiting For Weaker US Data While the Global and Chinese economic data are currently in the doldrums, we still haven’t seen COVID’s impact on the US economy. The US ISM Manufacturing PMI is in expansionary territory and the Services PMI is at a healthy 57.3 (Chart 6). Meanwhile, US employment growth has averaged +200k during the past 12 months (Chart 6, panel 2) and the US Economic Surprise Index is above 60 (Chart 6, bottom panel)! Until the US economic data take a hit, another downleg in US bond yields is likely. Looking ahead, if the Global and Chinese economic data are improving as the US data are weakening, financial markets will extrapolate from the Chinese experience and start to price-in an eventual US recovery. Therefore, bond yields will probably start to move higher while the US economic data are still weak. For this reason, one catalyst for us to re-initiate below-benchmark portfolio duration will be when the US economic data weaken. 4. Technical Signals Table 2The 3-Month Golden Rule When And Where Will Bond Yields Trough? When And Where Will Bond Yields Trough? We don’t recommend relying on technical trading rules when forming a 12-month investment view, but technical signals can help add discipline to investment strategies, especially when calling tops and bottoms. One framework with a decent track record is our Golden Rule of Bond Investing applied to a shorter 3-month investment horizon.2 While this 3-month rule doesn’t work as well as when it is applied to a 12-month horizon, we still find that if you correctly predict whether the Fed will deliver a hawkish or dovish surprise relative to market expectations during the next three months, you will make the right duration call 63% of the time (Table 2). The 3-month Golden Rule worked better for dovish surprises than for hawkish surprises in our sample but delivered solid results in both cases. The median 3-month excess Treasury index return versus cash was -1.09% (annualized) when there was a hawkish Fed surprise, compared to +2.56% (annualized) when there was a dovish Fed surprise. For context, the median annualized 3-month excess Treasury index return versus cash during our sample period was +1.79%. Until the US economic data take a hit, another downleg in US bond yields is likely. The overnight index swap curve is currently priced for 94 bps of rate cuts during the next three months, which would essentially take the funds rate back to the zero bound. As of now, we cannot rule out this possibility and are therefore not inclined to look for higher yields during the next 3 months. Momentum, Positioning & Sentiment Other technical signals can also help call tops and bottoms in bond yields. One such signal comes from our Composite Technical Indicator, an indicator that is based on yield changes, investor sentiment surveys and positioning in bond futures markets. Right now, the indicator is sending a strong “overbought” signal with a reading below -1 (Chart 7). Chart 7Technical Treasury Signals Technical Treasury Signals Technical Treasury Signals In isolation, an overbought signal from our Composite Technical Indicator is not a strong reason to call for higher yields. We found that, historically, a reading below -1 from our indicator precedes a 3-month move higher in the 10-year Treasury yield only 53% of the time (Table 3). Table 3Technical Treasury Indicator Performance (1995 – Present) When And Where Will Bond Yields Trough? When And Where Will Bond Yields Trough? One reason for the Composite Technical Indicator’s mediocre performance is that, even at low levels, the market can always become more overbought. But we can partially control for this by combining the overbought signal from our indicator with simple momentum measures that might signal a trend reversal. For example, a reading below -1 from our Composite Technical Indicator combined with a 1-week increase in the 10-year yield precedes a higher 10-year yield during the next three months 58% of the time. If we wait for a 2-week increase in the 10-year yield the rule’s success rate rises to 60%, and it rises to 71% if we wait for the 10-year yield to break above its 4-week moving average. At present, our Composite Technical Indicator shows that Treasuries are extremely overbought, but momentum measures are sending no signals about an imminent trend change (Chart 7, bottom 3 panels). Bottom Line: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Some Quick Notes On TIPS, MBS And Spread Product Allocations Along with raising recommended portfolio duration to benchmark on a 12-month horizon, we also recommend neutralizing exposure to spread product in US bond portfolios. This includes reducing exposure to high-yield corporate bonds. High-yield remains attractively valued but will continue to sell off as long as risk-off market sentiment prevails. The looming oil price war will also weigh heavily on the sector, which is highly exposed to the US shale energy space. Once again using the SARS epidemic as a comparable, we see that – like Treasury yields – junk excess returns bottomed when the number of daily new cases approached zero (Chart 8). We could still be relatively far from this point, so taking risk off the table makes sense.  New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. We also recommend moving MBS allocations to underweight. New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. This spike is not yet fully reflected in MBS spreads, which remain relatively tight (Chart 9) Chart 8Too Soon To Call For Peak Junk Spreads Too Soon To Call For Peak Junk Spreads Too Soon To Call For Peak Junk Spreads Chart 9Downgrade MBS Downgrade MBS Downgrade MBS . Going forward, even after the economic fallout from COVID-19 has passed and it is time to increase exposure to spread product, we will likely continue to recommend an underweight allocation to MBS because better opportunities will be available in investment grade and high-yield corporate bonds where spreads will be much more attractive. On TIPS, last weekend’s oil supply shock – combined with the demand shock from COVID-19 – will conspire to keep long-maturity TIPS breakeven inflation rates well below their “fundamental fair value” for some time yet. But for investors with longer time horizons we see exceptional value in TIPS relative to nominal Treasuries. Even before yesterday’s big drop in oil, the 10-year TIPS breakeven inflation rate was 52 bps cheap relative to the fair value reading from our Adaptive Expectations Model (Chart 10).3 Chart 10TIPS Offer A Ton Of Long-Run Value TIPS Offer A Ton Of Long-Run Value TIPS Offer A Ton Of Long-Run Value Investors with 12-month investment horizons should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?”, dated February 26, 2020, available at cis.bcaresearch.com 2  For more details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 3 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Making New Lows Making New Lows Making New Lows While the number of daily new COVID-19 cases is falling in China, the virus is spreading rapidly to the rest of the world. It is now clear that the outbreak will not be contained, though much uncertainty remains about the magnitude and duration of the global economic fallout. US bond yields have dropped dramatically, with the 10-year yield threatening to break below 1% for the first time ever (Chart 1). Interest rate markets are also pricing-in a rapid Fed response, with more than 100 bps of rate cuts priced for the next year and a 50 bps rate cut discounted for March. On Friday, BCA released a Special Alert making the case that stock prices have fallen enough to buy the market, even on a tactical (3-month) horizon. It is too early to make a similar call looking for higher bond yields. While risk assets will get near-term support from a dovish monetary policy shift, bond yields will stay low (and could even fall further) until global economic recovery appears likely. On a 12-month horizon, our base case scenario is that the Fed will not have to deliver the 110 bps of cuts that are currently priced. We therefore expect bond yields to be higher one year from now. But investors with shorter time horizons should wait before calling the bottom in yields.  Feature 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 176 basis points in February, dragging year-to-date excess returns down to -255 bps. Coronavirus fears pushed spreads wider in February, and the average spread for the overall investment grade index moved back above our cyclical target (Chart 2).1 As for specific credit tiers, Baa spreads are 9 bps above target and Aa spreads are 3 bps cheap. A-rated spreads are sitting right on our target, and Aaa debt remains 5 bps expensive. Looking beyond the economic fallout from the coronavirus, accommodative monetary conditions remain the key support for corporate bonds. Notably, both the 2-year/10-year and 3-year/10-year Treasury slopes steepened in February, and both remain firmly above zero. This suggests that the market believes that the Fed will keep policy easy. As we discussed two weeks ago, restrictive Fed policy – as evidenced by an inverted 3-year/10-year Treasury curve and elevated TIPS breakeven inflation rates – is required before banks choke off the supply of credit, causing defaults and a bear market in corporate spreads.2 Bottom Line: Corporate spreads will keep widening until coronavirus fears abate, but COVID-19 will not cause the end of the credit cycle. Once the dust settles, a buying opportunity will emerge in investment grade corporates, with spreads back above our cyclical targets. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Table 3BCorporate Sector Risk Vs. Reward* Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields 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 271 basis points in February, dragging year-to-date excess returns down to -379 bps. The junk index spread widened 110 bps on the month and is currently 37 bps below its early-2019 peak. Ex-energy, the average index spread widened 93 bps in February. It is 71 bps below its 2019 peak. High-yield spreads were well above our cyclical targets prior to the COVID-19 outbreak and have only cheapened further during the past month. More spread widening is likely in the near-term, but an exceptional buying opportunity will emerge once virus-related fears fade. This is especially true relative to investment grade corporate bonds. To illustrate the valuation disparity between investment grade and high-yield, we calculated the average monthly spread widening for each credit tier during this cycle’s three major “risk off” phases (2011, 2015 and 2018). We then used each credit tier’s average option-adjusted spread and duration to estimate monthly excess returns for that amount of spread widening (Chart 3, bottom panel). The results show that, in past years, Baa-rated corporates behaved much more defensively than Ba or B-rated bonds. But now, because of the greater spread cushion and lower duration in the junk space, estimated downside risk is similar. In other words, the valuation disparity between investment grade and junk means that investment grade corporates offer much less downside protection than usual compared to high-yield. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in February, dragging year-to-date excess returns down to -60 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, driven by a 7 bps widening of the option-adjusted spread that was partially offset by a 6 bps reduction in expected prepayment losses (aka option cost). The 10-year Treasury yield has made a new all-time low, and the 30-year mortgage rate – at 3.45% – is only 14 bps above its own (Chart 4). At these levels, an increase in mortgage refinancing activity is inevitable, and indeed, the MBA Refi index has bounced sharply in recent weeks. MBS spreads, however, have not yet reacted to the higher refi index (panel 3). The nominal spread on 30-year conventional MBS is only 9 bps above where it started the year, and expected prepayment losses are 5 bps lower.3 Some widening is likely during the next few months, and we recommend that investors reduce exposure to Agency MBS. Even on a 12-month horizon, MBS spreads offer good value relative to investment grade corporate bonds for now (bottom panel), but investment grade corporates will cheapen on a relative basis if the current risk-off environment continues. This is probably a good time to start paring exposure to MBS, with the intention of re-deploying into corporate credit when spreads peak. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 86 basis points in February, dragging year-to-date excess returns down to -99 bps. Sovereign debt underperformed duration-equivalent Treasuries by 270 bps in February, dragging year-to-date excess returns down to -367 bps. Foreign Agencies underperformed the Treasury benchmark by 162 bps on the month, dragging year-to-date excess returns down to -189 bps. Local Authority debt underperformed Treasuries by 14 bps in February, dragging year-to-date excess returns down to +47 bps. Domestic Agency bonds underperformed by 5 bps in February, dragging year-to-date excess returns down to -7 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. We continue to see little value in USD-denominated Sovereign debt, outside of Mexico and Saudi Arabia where spreads look attractive compared to similarly-rated US corporate bonds (Chart 5). The Local Authority and Foreign Agency sectors, however, offer attractive combinations of risk and reward according to our Excess Return Bond Map (see Appendix C). Our Global Asset Allocation service just released a Special Report on emerging market debt that argues for favoring USD-denominated EM sovereign debt over both USD-denominated EM corporate debt and local-currency EM sovereign bonds.4 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 80 basis points in February, dragging year-to-date excess returns down to -114 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 11% on the month to 88%, remaining below its post-crisis mean (Chart 6). For some time we have been advising clients to focus municipal bond exposure at the long-end of the Aaa curve, where yield ratios were above average pre-crisis levels. But last month’s sell-off brought some value back to the front end (panel 2). Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all back above their average pre-crisis levels at 85%, 83% and 86%, respectively. 20-year and 30-year maturities are still cheapest, at yield ratios of 93% and 94%, respectively. Investors should adopt a laddered allocation across the municipal bond curve, as opposed to focusing exposure at the long-end. Fundamentally, state and local government balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-steepened dramatically in February, with yields down at least 30 bps across the board. The 2/10 Treasury slope steepened 9 bps on the month, reaching 27 bps. The 5/30 slope also steepened 9 bps to reach 76 bps. February’s plunge in yields was massive, but the fact that it occurred without 2/10 or 5/30 flattening signals that the market expects the Fed to respond quickly and that any economic pain will be relatively short lived. In fact, the front-end of the curve is now priced for 110 bps of rate cuts during the next 12 months (Chart 7). That amount of easing would bring the fed funds rate back to 0.48%, less than two 25 basis point increments off the zero lower bound. Though the drop in 12-month rate expectations didn’t move the duration-matched 2/5/10 or 2/5/30 butterfly spreads very much, the 5-year note remains very expensive relative to both the 2/10 and 2/30 barbells (bottom 2 panels). The richness in the 5-year note will reverse if the Fed delivers less than the 110 bps of rate cuts that are currently priced for the next year. At present, we view less than 110 bps of easing as the most likely scenario, and therefore maintain our position long the 2/30 barbell and short the 5-year bullet. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 159 basis points in February, dragging year-to-date excess returns down to -232 bps. The 10-year TIPS breakeven inflation rate fell 24 bps to 1.42%. The 5-year/5-year forward TIPS breakeven inflation rate fell 21 bps to 1.50%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s inflation target. We have been recommending that investors own TIPS breakeven curve flatteners on the view that inflationary pressures will first show up in the realized inflation data and the short-end of the breakeven curve, before infecting the long-end.5 However, recent risk-off market behavior has caused long-end inflation expectations to fall dramatically, while sticky near-term inflation prints have supported short-dated expectations. Case in point, the 2-year TIPS breakeven inflation rate declined 16 bps in February, compared to a 24 bps drop for the 10-year (Chart 8). Inflation curve flattening could continue in the near-term but will reverse when risk assets recover. As a result, we recommend taking profits on TIPS breakeven curve flatteners and waiting for a period of re-steepening before putting the trade back on. Fundamentally, we note that the 10-year TIPS breakeven inflation rate is 38 bps cheap according to our re-vamped Adaptive Expectations Model (bottom panel).6 Investors should remain overweight TIPS versus nominal Treasuries on a 12-month horizon. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +26 bps. The index option-adjusted spread for Aaa-rated ABS widened 7 bps on the month. It currently sits at 33 bps, right on top of its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector has weathered the recent storm so well, and why it is actually up versus Treasuries so far this year. ABS also offer higher expected returns than other low-risk spread sectors such as Domestic Agency bonds and Supranationals. For as long as the current risk-off phase continues, consumer ABS are a more attractive place to hide than Domestic Agencies or Supranationals. However, once risk-on market behavior re-asserts itself, consumer ABS will once again lag other riskier spread products. In the long-run, we also remain concerned about deteriorating consumer credit fundamentals, as evidenced by tightening lending standards for both credit cards and auto loans, and a rising household interest expense ratio (bottom 2 panels). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 42 basis points in February, dragging year-to-date excess returns down to +1 bp. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month. It currently sits at 76 bps, below its average pre-crisis level (Chart 10). In a recent Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.7 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds in risk-adjusted terms (Appendix C), and that the macro environment is close to neutral for CMBS spreads. Both CRE lending standards and loan demand were close to unchanged during the past quarter, as per the Fed’s Senior Loan Officer Survey (bottom 2 panels).  Agency CMBS: Overweight Agency CMBS performed in line with the duration-equivalent Treasury index in February, leaving year-to-date excess returns unchanged at +35 bps. The index option-adjusted spread widened 2 bps on the month to reach 56 bps. Agency CMBS offer greater expected return than Aaa-rated consumer ABS, while also carrying agency backing (Appendix C). An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 110 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 28, 2020) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields 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 February 28, 2020) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields 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 50 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 50 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) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of February 28, 2020) Too Soon To Call The Bottom In Yields Too Soon To Call The Bottom In Yields   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more information on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “The Credit Cycle Is Far From Over”, dated February 18, 2020, available at usbs.bcaresearch.com 3 Expected prepayment losses (or option cost) are calculated as the difference between the index’s zero-volatility spread and its option-adjusted spread. 4 Please see Global Asset Allocation Special Report, “Understanding Emerging Markets Debt”, dated February 27, 2020, available at gaa.bcaresearch.com 5 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com  6 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 7 Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Duration: The coronavirus outbreak will cause our preferred global growth indicators to move lower during the next couple of months. Bond yields will also stay low until the daily number of new cases approaches zero, at which point a sell-off is likely. Monetary Policy: A preemptive rate cut designed to offset the economic impact of the coronavirus is unlikely. In fact, investors should short August 2020 fed funds futures and maintain below-benchmark portfolio duration on the view that the Fed will keep the policy rate stable in 2020. TIPS: Our improved Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate will rise by 19 bps during the next 12 months, bringing it up to 1.84%. Investors should remain overweight TIPS versus nominal Treasuries in US bond portfolios. Recovery Delayed A little more than two months into the year and, despite elevated market volatility, a couple trends have become apparent. First, it is now clear that global economic growth bottomed near the end of last year. Second, any lift that bond yields might have received from that rebound has been more than offset by the spike in uncertainty surrounding the 2019 novel Coronavirus (2019-nCoV) outbreak. Case in point, the US Economic Surprise Index recently jumped deep into positive territory, but the 10-year Treasury yield remains muted, below its level from three months ago (Chart 1). Chart 1Bond Yields Have De-Coupled From The Economic Data Bond Yields Have De-Coupled From The Economic Data Bond Yields Have De-Coupled From The Economic Data It’s not just the Surprise index that is signaling a growth upturn. Our three preferred global growth indicators – the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index – have all decisively bottomed (Chart 2). Chart 2Global Growth Indicators Hooking Up Global Growth Indicators Hooking Up Global Growth Indicators Hooking Up The Global PMI moved up to 50.4 in January, from a July low of 49.3. As of January, 45% of countries now have PMIs above 50 compared to 34% in August (Chart 2, top panel). The US ISM Manufacturing PMI shot higher in January, from 47.8 to 50.9. It is moving closer to the Services PMI, which remains very healthy at 55.5 (Chart 2, panel 2). The CRB Raw Industrials index is also now well off its 2019 low (Chart 2, bottom panel). The overall message from our three favorite indicators is that economic growth remains sluggish, but is clearly on an improving trend. A trend we would have expected to continue until the 2019-nCoV outbreak hit. Our Global Investment Strategy team estimates that the virus could trim 1.6% from global growth in the first quarter, cutting the IMF’s Q1 global GDP growth projection of 3.3% in half.1 The hit to growth will unwind once the virus’ spread is contained, but it is difficult to know how long that will take. In the meantime, we anticipate some weaker readings from our preferred global growth indicators during the next couple of months. The coronavirus could trim 1.6% from global GDP growth in the first quarter. However, it’s important to note that bond yields have already de-coupled from trends in the global growth data and are now taking their cues from news about 2019-nCoV. We noted in last week’s report that this also happened during the 2003 SARS crisis.2 Bond yields fell initially but then recovered sharply once the number of daily new SARS cases hit zero. If we map this experience to the present day, we see that the number of confirmed 2019-nCoV cases continues to rise, but the daily number of new cases has rolled over (Chart 3). Further, our China Investment Strategy team points out that it might be more market-relevant to focus on cases outside of Hubei province where the virus started, and which has now been quarantined.3 Already, we see that the daily number of new cases outside Hubei province is approaching zero (Chart 3, bottom panel). Chart 3Tracking The Coronavirus Tracking The Coronavirus Tracking The Coronavirus Bottom Line: The coronavirus outbreak will cause our preferred global growth indicators to move lower during the next couple of months. Bond yields will also stay low until the daily number of new cases approaches zero, at which point a bond sell-off is likely. Will The Fed Respond? Chart 4Go Short August 2020 Fed Funds Futures Go Short August 2020 Fed Funds Futures Go Short August 2020 Fed Funds Futures Markets have already moved to price-in a Federal Reserve reaction to the 2019-nCoV outbreak. Our 12-month Fed Funds Discounter is down to -43 bps, meaning that the overnight index swap curve is priced for 43 bps of rate cuts during the next year (Chart 4). Last Monday our Discounter hit -51 bps, meaning that the market was looking for slightly more than 2 rate cuts during the next year. Turning to the fed funds futures market, we also see that investors are pricing-in significant odds of a rate cut between now and the end of the summer (Chart 4, bottom 2 panels). Odds of a March rate cut are low, but the futures market is priced for a 30% chance of a rate cut between now and the end of the April FOMC meeting. Investors also see 52% chance of a rate cut between now and the end of the June FOMC meeting and 72% chance of a cut between now and the end of the July meeting. But will the Fed actually respond to the nCoV outbreak by easing policy? Other central banks have taken different approaches to that question during the past week. The Reserve Bank of Australia left its policy rate unchanged on Tuesday, noting that “it is too early to determine how long-lasting the impact [from the coronavirus] will be.” In contrast, the Bank of Thailand did cut rates last week while citing the nCoV outbreak as one of several reasons for the move. The market is priced for 72% chance of a rate cut between now and August. But perhaps the most interesting example is last week’s rate cut in the Philippines. There, the central bank cited “a firm outlook for the domestic economy”, but ultimately concluded that the “manageable inflation environment allowed room for a preemptive reduction in the policy rate.” Chart 5A High Bar For Rate Cuts A High Bar For Rate Cuts A High Bar For Rate Cuts If the Fed were to justify a rate cut in the coming months, it would have to use a similar logic as the Philippines. Something along the lines of: The domestic US economy is solid, but inflation is low enough that an additional rate cut carries little risk. A proactive rate cut could also help lean against any potential headwinds from the coronavirus. Our sense is that the Fed will not be eager to make that argument, and that things will have to get a lot worse before a rate cut is considered. The Fed was well aware that the US/China trade war could have negative economic effects in 2019, but it didn’t cut rates until after the S&P 500 dropped by 20% and the yield curve became deeply inverted (Chart 5). We would monitor those same two indicators to assess the odds of a rate cut this year. So far, neither suggests that a cut is forthcoming. Investors should consider shorting the August 2020 fed funds futures contract. If the economic fall-out from 2019-nCoV only lasts for a few months, then the Fed will stand pat through July and the August contract will earn an un-levered 18 bps between now and the end of August. Our Golden Rule of Bond Investing also dictates that below-benchmark portfolio duration positioning will profit if the Fed delivers less than the 43 bps of rate cuts that are currently priced for the next 12 months. Towards A Better Breakeven Model At BCA we track long-maturity TIPS breakeven inflation rates very closely. Not only because TIPS are an interesting investment vehicle in their own right, but also because elevated long-maturity TIPS breakevens (above 2.3%) will be an important trigger for us to recommend a more defensive US bond portfolio – favoring Treasuries over spread product.4 For those reasons, it’s extremely important for us to have a framework for forecasting long-maturity TIPS breakeven inflation rates. A little more than one year ago, we unveiled a framework for thinking about TIPS breakevens based on the concept of adaptive expectations.5 We also applied that framework to a fair value model for the 10-year TIPS breakeven inflation rate. We still think that the adaptive expectations framework is the best way to think about breakevens, but this week we present an improved application of that framework, i.e. a new model for forecasting the 10-year TIPS breakeven inflation rate. Adaptive Expectations The theory of adaptive expectations essentially says that today’s long-run inflation expectations are formed based on peoples’ recent experiences with inflation. For example, the 10-year TIPS breakeven inflation rate is currently 1.67%, well below the 2.3%-2.5% range that we view as consistent with the Fed’s target. We posit that today’s inflation expectations are depressed because realized inflation has been so low during the past decade (CPI inflation has averaged only 1.75% during the past 10 years). This experience makes it very difficult for investors to believe that inflation might be high (say, above 2%) during the next decade. Building A Better Model To apply the adaptive expectations theory to a specific model, we need to make a decision about which specific inflation measures to use. For this week’s report, we tested annualized rates of change of headline CPI ranging from 1 year to 10 years. We also looked at survey measures of long-run inflation expectations from the Survey of Professional Forecasters and the University of Michigan. The 10-year TIPS breakeven inflation rate is 50 bps below 1-year headline CPI inflation. To test the different measures, we looked at the difference between the 10-year TIPS breakeven inflation rate and each inflation measure. We then looked at how successfully each difference predicted changes in the 10-year TIPS breakeven inflation rate during the subsequent 12 months. We identified the following three measures as the best performers (Charts 6A & 6B): Chart 6A10-Year TIPS Breakeven Versus Fair Value 10-Year TIPS Breakeven Versus Fair Value 10-Year TIPS Breakeven Versus Fair Value Chart 6BDeviation From Fair Value Deviation From Fair Value Deviation From Fair Value The 1-year rate of change in headline CPI The 6-year rate of change in headline CPI Median 10-year inflation expectations from the Survey of Professional Forecasters Table 1 shows the results of our test on 1-year headline CPI inflation. It shows that, historically, when the 10-year TIPS breakeven inflation rate has been more than 25 bps above the 1-year rate of change in headline CPI it has tended to fall during the next 12 months. At present, the 10-year breakeven is about 50 bps below the 1-year rate of change in headline CPI. Table 1Deviation Of 10-Year TIPS Breakeven Inflation Rate From 1-Year Rate Of Change In Headline CPI How Are Inflation Expectations Adapting? How Are Inflation Expectations Adapting? Table 2 shows the results of our test on 6-year headline CPI inflation. Here, we see that the 10-year TIPS breakeven inflation rate becomes much more likely to fall when it exceeds 6-year CPI inflation by more than 10 bps. The current deviation is +14 bps. Table 2Deviation Of 10-Year TIPS Breakeven Inflation Rate From 6-Year Annualized Rate Of Change In Headline CPI How Are Inflation Expectations Adapting? How Are Inflation Expectations Adapting? Finally, Table 3 shows the results of our test on median 10-year inflation expectations from the Survey of Professional Forecasters. In this case, the 10-year breakeven rate has rarely exceeded the survey measure historically. But we find evidence that the breakeven is much more likely to rise when it is more than 50 bps below the survey measure. Currently, the 10-year TIPS breakeven inflation rate is 56 bps below the survey measure. Table 3Deviation Of 10-Year TIPS Breakeven Inflation Rate From SPF* 10-Year Median Inflation Forecast How Are Inflation Expectations Adapting? How Are Inflation Expectations Adapting? Making A Prediction Chart 7Our New Adaptive Expectations Model Our New Adaptive Expectations Model Our New Adaptive Expectations Model The final step is to combine our three chosen factors into a model that will predict the future 12-month change in the 10-year TIPS breakeven inflation rate. This model is presented in Chart 7, and it tells us that, based on the current deviation of the 10-year TIPS breakeven inflation rate from our three different inflation measures, the 10-year breakeven should rise by 19 bps during the next 12 months. This would bring the rate up to 1.84% (Chart 7, bottom panel). We will continue to experiment with different inflation measures in the coming weeks (i.e. core and trimmed mean measures) in an effort to improve our model further. Bottom Line: Our improved Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate will rise by 19 bps during the next 12 months, bringing it up to 1.84%. Investors should remain overweight TIPS versus nominal Treasuries in US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “From China To Iowa”, dated February 7, 2020, available at gis.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “Contagion”, dated February 4, 2020, available at usbs.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, “Recovery, Temporarily Interrupted”, dated February 5, 2020, available at cis.bcaresearch.com 4 For more details on why TIPS breakeven inflation rates are an important trigger for our spread product allocation please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1The 2003 SARS Roadmap The 2003 SARS Roadmap The 2003 SARS Roadmap The bond market impact from the coronavirus has already been substantial. The 10-year Treasury yield has fallen back to 1.51%, below the fed funds rate. Meanwhile, the investment grade corporate bond index spread is back above 100 bps, from a January low of 93 bps. The 2003 SARS crisis is the best roadmap we can apply to the current situation. Back then, Treasury yields also fell sharply but then rebounded just as quickly when the number of SARS cases peaked (Chart 1). The impact on corporate bond excess returns was more short-lived (Chart 1, bottom panel). Like in 2003, we expect that bond yields will rise once the number of coronavirus cases peaks, but it is difficult to put a timeframe on how long that will take. The economic impact from the virus could also weigh on global PMI surveys during the next few months, delaying the move higher in Treasury yields we anticipated earlier this year. In short, we continue to expect higher bond yields and tighter credit spreads in 2020, but those moves will be delayed until markets are confident that the virus has stopped spreading. Feature 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 80 basis points in January. The sector actually outpaced the Treasury benchmark by 7 bps until January 21 when the impact of the coronavirus started to push spreads wider. As stated on page 1, we expect the impact of the coronavirus on corporate spreads to be short lived. Beyond that, low inflation expectations will keep monetary conditions accommodative. This in turn will encourage banks to ease credit supply, keeping defaults at bay and providing a strong tailwind for corporate bond returns.1 Yesterday’s Fed Senior Loan Officer survey showed a slight easing of C&I lending standards in Q4 2019, reversing the tightening that occurred in the third quarter (Chart 2). We expect that accommodative Fed policy will lead to continued easing of C&I lending standards for the remainder of the year. Despite the positive tailwind from accommodative Fed policy and easing bank lending standards, investment grade corporate bond spreads are quite expensive. Spreads for all credit tiers are below our targets (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Contagion Contagion Table 3BCorporate Sector Risk Vs. Reward* Contagion Contagion 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 111 basis points in January. Junk outperformed the Treasury benchmark by 30 bps until January 21 when the coronavirus outbreak sent spreads sharply wider. Once the negative impact of the coronavirus passes, junk spreads will have plenty of room to tighten in 2020. In fact, the junk index spread is now at 390 bps, 154 bps above our target (Chart 3).3 While spreads for all junk credit tiers are currently above our targets, Caa-rated bonds look particularly cheap. We analyzed the divergence between Caa and the rest of the junk index in a recent report and came to two conclusions.4 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for 2019’s Caa spread widening that make us inclined to downplay any negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of 2019’s underperformance (bottom panel). Absent significant further declines in the oil price, this sector now has room to recover.   MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 53 basis points in January. The sector was only lagging the Treasury benchmark by 7 bps as of January 21, when the coronavirus outbreak sent spreads wider. The conventional 30-year zero-volatility spread widened 8 bps in January, driven by a 7 bps widening of the option-adjusted spread (OAS) and a 1 bp increase in expected prepayment losses (aka option cost). The fact that expected prepayment losses only rose by a single basis point even though the 30-year mortgage rate fell by 23 bps is notable. It speaks to the high level of refi burnout in the mortgage market, which is a key reason why we prefer mortgage-backed securities over investment grade corporate bonds in our portfolio. Essentially, most homeowners have already had at least one opportunity to refinance during the past few years, so prepayment risk is low even if rates fall further. Competitive expected compensation is another reason to move into Agency MBS. The conventional 30-year MBS OAS is 49 bps, only 7 bps below the spread offered by Aa-rated corporate bonds (Chart 4). Also, spreads for all investment grade corporate bond credit tiers are below our cyclical targets. Risk-adjusted compensation favors MBS even more strongly. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 14 basis points in January. The index was up 2 bps versus the Treasury benchmark until January 21, when the coronavirus outbreak hit. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, and Foreign Agencies underperformed by 28 bps. Local Authorities, however, bested the Treasury benchmark by 60 bps. Domestic Agency bonds underperformed Treasuries by 2 bps in January, while Supranationals outperformed by 2 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Local Authorities and Foreign Agencies, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6  Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 33 basis points in January (before adjusting for the tax advantage). They were up 39 bps versus the Treasury index before the coronavirus outbreak hit on January 21. The average Aaa-rated Municipal / Treasury (M/T) yield ratio swung around during the month, but settled close to where it began at 77% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Yield ratios have tightened a lot since then, but value remains at long maturities. Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all below average pre-crisis levels at 62%, 65% and 78%, respectively. But 20-year and 30-year yield ratios stand at 89% and 93%, respectively, above average pre-crisis levels. Fundamentally, state and local balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in January. Treasury yields declined across the curve, and the 2/10 slope flattened from 34 bps to 18 bps. The 5/30 slope flattened from 70 bps to 67 bps. Despite the significant flattening, the 2/10 slope remains near the middle of our target 0 – 50 bps range for 2020, and we anticipate some bear-steepening once the coronavirus is contained.8 The front-end of the curve also moved in January to price-in 57 bps of Fed rate cuts during the next 12 months (Chart 7). At the beginning of the year the curve was priced for only 14 bps of rate cuts. We expect that the Fed would respond with rate cuts if the coronavirus epidemic worsens, leading to inversion of the 2/10 yield curve. However, for the time being the safer bet is that the virus will be contained relatively quickly and the Fed will remain on hold for all of 2020. Based on this view, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. The position offers positive carry and looks attractive on our yield curve models (see Appendix B).9  TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate fell 12 bps on the month and currently sits at 1.66%. The 5-year/5-year forward TIPS breakeven inflation rate fell 16 bps on the month and currently sits at 1.71%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target since mid-2018 (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. It takes time for expectations to adapt to a changing macro environment, but even accounting for those long lags, our Adaptive Expectations Model pegs the 10-year TIPS breakeven inflation rate as 31 bps too low (panel 4).10 It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor long-term inflation expectations. As a result, the actual inflation data will lead expectations higher, causing the TIPS breakeven inflation curve to flatten.11 ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 14 bps on the month. It currently sits at 26 bps, below its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector performed so well in January when other spread sectors struggled. ABS also offer higher expected returns than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends are slowly shifting in the wrong direction. The consumer credit delinquency rate remains low, but has put in a clear bottom. This is also true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). 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 43 basis points in January. The index option-adjusted spread for non-agency CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level (Chart 10). In last week’s Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle, and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.12 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds from a risk/reward perspective (see our Excess Return Bond Map in Appendix C), and that the macro environment is only slightly unfavorable for CMBS spreads. Specifically, CRE bank lending standards are just in “net tightening” territory. But both lending standards and loan demand are very close to neutral (bottom 2 panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in January. The index option-adjusted spread tightened 4 bps on the month to reach 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 57 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Contagion Contagion Contagion Contagion Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 31, 2020) Contagion Contagion 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 January 31, 2020) Contagion Contagion 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 33 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 33 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) Contagion Contagion Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Excess Return Bond Map (As Of January 31, 2020) Contagion Contagion ​​​​​​​ Footnotes 1 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2  For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3  For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4  Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 9 For further details on our recommended yield curve trade please see US Bond Strategy Weekly Report, “The Best Spot On The Yield Curve”, dated January 21, 2020, available at usbs.bcaresearch.com 10 For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 11  Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 12  Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Duration: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. TIPS: We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. High-Yield: Investors should add (or increase) exposure to the high-yield energy sector, within an overweight allocation to junk bonds. Junk energy spreads are attractive, and exposure to the sector will mitigate the impact of a potential oil supply shock. Feature Only a month ago, investors were becoming more optimistic about a global growth rebound and the US/China phase 1 trade deal was pushing political risk into the background. Both of those factors caused the 10-year Treasury yield to rise throughout December, hitting an intra-day Christmas Eve peak of 1.95% (Chart 1). But since then, softer global PMI data and the US/Iranian military conflict brought global growth concerns and political risk back to the fore, breaking the uptrend in yields. Chart 1Bond Bear On Pause Bond Bear On Pause Bond Bear On Pause Global growth and political uncertainty are two of the five macro factors that we identify as important for US bond yields.1 And despite the recent setback, we think both factors will push yields higher in the coming months. Global Growth We have found that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index are the three global growth indicators that correlate most strongly with US bond yields. One reason for the recent pullback in yields is the disappointing December data from the Global and US Manufacturing PMIs. The ISM Manufacturing PMI moved deeper into recessionary territory. The Global Manufacturing PMI had been in a clear uptrend since mid-2019, but fell back to 50.1 in December, from 50.3 the month before (Chart 2). The US and Chinese PMIs also declined in December, though they remain well above the 50 boom/bust line (Chart 2, panels 3 & 4). The Eurozone and Japanese PMIs, meanwhile, are still in the doldrums (Chart 2, panels 2 & 5). More worrying than the small tick down in Global PMI is the US ISM Manufacturing PMI moving deeper into recessionary territory, from 48.1 to 47.2. However, we have good reason to think that stronger data are just around the corner (Chart 3). Chart 2Global PMI Ticks Down Global PMI Ticks Down Global PMI Ticks Down Chart 3ISM Manufacturing Index Will Rebound ISM Manufacturing Index Will Rebound ISM Manufacturing Index Will Rebound First, the difference between the new orders and inventories components of the ISM index often leads the overall index at turning points, 2016 being a prime example (Chart 3, top panel). Much like in 2016, a gap is opening up between new orders-less-inventories and the overall ISM. Second, the non-manufacturing ISM index remains strong despite the weakness in manufacturing (Chart 3, panel 2). With no contagion to the service sector of the economy, we’d expect manufacturing to pick back up. Third, the ISM Manufacturing index has diverged sharply from the Markit Manufacturing PMI, with the Markit index printing well above the ISM (Chart 3, panel 3).2 The ISM index has been more volatile than the Markit index in recent years, and should trend toward the Markit index over time. Fourth, regional Fed manufacturing surveys have generally been stronger than the ISM during the past few months. A simple regression model of the ISM index based on data from regional Fed surveys suggests that the ISM index should be at 49.7 today, instead of 47.2 (Chart 3, bottom panel). Finally, unlike the PMI surveys, the CRB Raw Industrials index has increased quite sharply in recent weeks (Chart 4). We should note that it is not the CRB index itself but rather the ratio between the CRB index and gold that tracks bond yields most closely, and this ratio has actually declined lately due to the strength in gold. Nonetheless, a sustained turnaround in the CRB index would mark a big change from 2019 and would send a strong bond-bearish signal. Chart 4CRB Sends A Bond-Bearish Signal CRB Sends A Bond-Bearish Signal CRB Sends A Bond-Bearish Signal Political Uncertainty The second factor that sent bond yields lower during the past few weeks was the military conflict between the US and Iran. Tensions appear to have de-escalated for now, and we would expect any flight-to-quality flows to unwind during the next few weeks.3 But while we see policy uncertainty easing in the near-term, sending bond yields higher, we reiterate our view that US political uncertainty is the number one risk factor that could derail the 2020 bear market in bonds.4 Specifically, we see two looming US political risks. The first relates to President Trump’s re-election odds. For now, Trump’s approval rating is in line with past incumbent presidents that have won re-election (Chart 5). But if his approval doesn’t keep pace in the coming months, he will try to do something to change his fortunes. That could mean re-igniting the trade war with China, or once again ramping up tensions with Iran. A Bernie Sanders or Elizabeth Warren victory would send a flight-to-quality into bonds. The second risk is that one of the progressive candidates – Bernie Sanders or Elizabeth Warren – secures the Democratic nomination for president. Right now, both trail Joe Biden in the polls and betting markets (Chart 6), but things could change rapidly as the primary results come in during the next few months. The stock market would certainly sell off if an Elizabeth Warren or Bernie Sanders presidency seems likely, sending a flight to quality into bonds.5 Chart 5Trump’s Approval Rating Must Rise Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Chart 6Democratic Nomination Betting Odds Democratic Nomination Betting Odds Democratic Nomination Betting Odds Bottom Line: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. Playing An Oil Supply Shock In US Bond Markets US/Iranian military tensions are easing for now, but could flare again in the future. For that reason, it’s worth considering how US bond markets would respond in the event of a conflict between the US and Iran that removed a significant amount of the world’s oil supply from the market, causing the oil price to spike. The first implication is that US bond yields would fall. Even though it’s tempting to say that the inflationary impact of higher oil prices would push yields up, this effect would not dominate the flight-to-quality into US bonds that would result from the increase in political uncertainty. Case in point, Chart 1 shows that, while the inflation component of yields was stable as tensions flared during the past few weeks, it didn’t come close to offsetting the drop in the 10-year real yield. Beyond the impact on Treasury yields, there are two other segments of the US bond market that would be materially impacted by an oil supply shock: the TIPS breakeven inflation curve and corporate bond spreads. Buy TIPS Breakeven Curve Flatteners Table 1CPI Swap Curve Sensitivity To Oil Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock When considering the impact of an oil supply shock on TIPS breakeven inflation rates, we first look at how the cost of inflation protection is influenced by changes in the oil price. Table 1 shows the sensitivity of weekly changes in different CPI swap rates to a $1 increase in the price of Brent crude oil. We use CPI swap rates instead of TIPS breakeven inflation rates because data are available for a wider maturity spectrum. Our analysis applies equally to the TIPS breakeven inflation curve. Two conclusions are apparent from Table 1. First, the entire CPI swap curve is positively correlated with the oil price, a higher oil price moves CPI swap rates higher and vice-versa. Second, the sensitivity of CPI swap rates to the oil price is greater at the short-end of the curve than at the long-end. This is fairly intuitive given that higher oil prices are inflationary in the short-term but could be deflationary in the long-run if they hamper economic growth. Chart 7Coefficients Stable Over Time Coefficients Stable Over Time Coefficients Stable Over Time Chart 7 shows that our two main conclusions are not dependent on the chosen time horizon. The 2-year CPI swap rate is positively correlated with the oil price for our entire sample period, as is the 10-year rate except for a brief window in 2014. The 2-year rate’s sensitivity is also consistently higher than the 10-year’s. Based on this analysis, we can suggest two good ways to hedge against the risk of an oil supply shock that sends prices higher: Buy inflation protection, either in the CPI swaps market or by going long TIPS versus duration-equivalent nominal Treasuries. Buy CPI swap curve (or TIPS breakeven inflation curve) flatteners.6 But we can introduce one more wrinkle to our analysis. Oil prices can rise because of stronger demand or because a shock suddenly removes supply from the market. It’s possible that the cost of inflation protection behaves differently in each case. Fortunately, the New York Fed has made an attempt to distinguish between those two scenarios. In its weekly Oil Price Dynamics Report, the Fed decomposes Brent oil price changes into demand-driven changes and supply-driven changes.7 It does this by looking at how other financial assets respond to oil price changes each week. Chart 8 shows the cumulative change in the Brent oil price since 2010, along with the New York Fed’s supply and demand factors. According to the Fed, demand has pressured the oil price higher since 2010, but this has been more than offset by greater supply. Chart 8Supply & Demand Oil Price Decomposition Supply & Demand Oil Price Decomposition Supply & Demand Oil Price Decomposition Using the New York Fed’s supply and demand series, we look at how CPI swap rates respond to higher oil prices in three different scenarios. First, we identify 252 weeks when demand and supply both contributed to higher oil prices. Second, we identify 95 weeks when higher oil prices were driven solely by demand. Finally, and most pertinently, we identify 92 weeks when higher oil prices were driven only by supply (Table 2). Table 2Weekly Change In CPI Swap Rate When Brent Oil Price Increases Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios are consistent with our results from Table 1. CPI swap rates across the entire curve move higher more than half the time, with greater increases at the short-end of the curve. However, the scenario we are most interested in is the ‘Supply Driven’ scenario. Presumably, a military conflict with Iran that took oil supply off the market would lead to less supply and also a decrease in global demand. Results for this scenario are more mixed. The 1-year CPI swap rate still rises 60% of the time, but rates further out the curve are somewhat more likely to fall. With this in mind, CPI swap curve or TIPS breakeven curve flatteners look like the best way to hedge against an oil supply shock, better than an outright long position in inflation protection. This is good news, since we have previously argued that owning TIPS breakeven curve flatteners is a good idea even without an oil supply shock.8 Corporate bond excess returns respond positively to changes in the oil price. We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. Buy Energy Junk Bonds Table 3Corporate Bond Sensitivity To Oil Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Corporate bonds are the second segment of the US fixed income market that could be materially impacted by an oil supply shock, particularly bonds in the energy sector. To assess the potential value of corporate bonds as a hedge, we repeat the above analysis but use weekly corporate bond excess returns versus duration-matched Treasuries instead of CPI swap rates. Table 3 shows that investment grade and high-yield corporate bond returns both respond positively to changes in the oil price. Further, we see that energy bonds are more sensitive to the oil price, outperforming the overall index when the oil price rises, and vice-versa. Chart 9 shows that, while oil price sensitivities vary considerably over time, they are almost always positive. Also, energy sector sensitivity has been consistently above that of the benchmark index since 2014. Chart 9Betas Mostly Positive Betas Mostly Positive Betas Mostly Positive Going one step further, we once again use the New York Fed’s supply and demand decomposition to identify weeks when supply and/or demand was responsible for higher oil prices. Because we have more historical data for corporate bonds than for CPI swaps, this time we identify 340 weeks when both supply and demand drove the oil price higher, 123 weeks when only demand drove it higher and 142 weeks when only supply was responsible for the higher oil price (Table 4). Table 4Weekly Corporate Bond Excess Returns (BPs) When Brent Oil Price Increases Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios show that higher oil prices boost excess returns to both investment grade and high-yield corporate bonds more than half the time. Energy bonds also tend to outperform their respective benchmark indexes in the ‘Demand & Supply Driven’ scenario, but perform roughly in-line with the benchmark in the ‘Demand Driven’ scenario. But once again, it is the ‘Supply Driven’ scenario that we are most interested in. Here, we see that an oil supply disruption that leads to higher oil prices also leads to lower corporate bond excess returns. This is true for both the investment grade and high-yield indexes and for energy bonds in both rating categories. However, we also note that high-yield energy debt significantly outperforms the overall junk index during these “risk off” periods. In contrast, investment grade energy debt is not a clear outperformer. Chart 10HY Energy Spreads Are Very Attractive HY Energy Spreads Are Very Attractive HY Energy Spreads Are Very Attractive These results line up with our intuition. When oil prices are driven higher by demand it could simply be a sign of strong economic growth and not any specific trend related to the energy sector. As such, we’d expect all corporate bonds to perform well in those scenarios, but wouldn’t necessarily expect energy debt to outperform. However, supply disruptions in the Middle East directly benefit US shale oil players, whose debt is principally found in the high-yield energy sector. The investment grade energy sector is less exposed to the US shale space, and its documented outperformance in the ‘Supply Driven’ scenario is weaker as a result. We already recommend an overweight allocation to high-yield bonds and a neutral allocation to investment grade corporates. Within that overweight allocation to high-yield bonds, we recommend shifting some exposure toward the energy sector for two reasons. First, high-yield energy was severely beaten-down last year and is ripe for a rebound if global economic growth recovers, as we expect (Chart 10). Second, our analysis suggests that an allocation to energy will help mitigate losses in the event of a renewed flaring of US/Iranian tensions that removes oil supply from the market. Bottom Line: We recommend that investors initiate TIPS breakeven curve flatteners (or CPI swap curve flatteners) and add exposure to the high-yield energy sector. Both positions look attractive on their own terms, but will also help hedge the risk of an oil supply disruption if US/Iranian tensions flare back up in the months ahead.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The others are: the output gap, the US dollar and sentiment. For more details please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 The Markit index is used in the construction of the Global PMI shown in Chart 2, 3 For more details on the politics behind the US/Iran conflict please see Geopolitical Strategy Special Alert, “A Reprieve Amid The Bull Market In Iran Tensions”, dated January 8, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets”, dated September 13, 2019, available at gis.bcaresearch.com 6 In the TIPS market, an example of a breakeven curve flattener would be to buy 2-year TIPS and short the 2-year nominal Treasury note, while also buying the 10-year nominal Treasury note and shorting the 10-year TIPS. 7 https://www.newyorkfed.org/research/policy/oil_price_dynamics_report 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Softer PMIs In December Softer PMIs In December Softer PMIs In December A bond bear market looked to be underway in December, with the 10-year Treasury yield reaching as high as 1.93% just before Christmas. But two developments during the past week drove it back down to 1.80%, and could prevent yields from rising during the next month or two. Five macro factors are important for US bond yields (global growth, the output gap, the US dollar, policy uncertainty and sentiment). Two of those factors flipped from sending bond-bearish to bond-bullish signals during the past week. First, policy uncertainty had been ebbing due to the US/China phase 1 trade deal, but it ramped up again due to US military conflict with Iran. Second, our preferred global growth indicators had been showing tentative signs of bottoming, but reversed course in December. The Global Manufacturing PMI fell from 50.3 to 50.1 in December, and the US ISM Manufacturing PMI fell from 48.1 to 47.2 (Chart 1). We continue to forecast higher bond yields in 2020, but recent events have likely postponed any significant sell-off. Stay tuned. Feature 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 119 basis points in December and by 619 bps in 2019. In our 2020 Key Views report, we argued that the credit cycle will remain supportive for corporate bonds this year, but that we prefer to take credit risk in the high-yield space where valuation is more attractive.1 With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. This accommodative stance will encourage banks to keep the credit taps running, leading to tight spreads. The third quarter’s tightening of C&I lending standards is a risk to our view (Chart 2), especially if this month’s survey reveals that the tightening continued into Q4. We don’t think that will be the case, given that the yield curve – another indicator of monetary conditions – steepened sharply in the fourth quarter. As stated above, valuation is the main hurdle for investment grade corporates. Spreads for all credit tiers are below our targets (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher.  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Setbacks Setbacks Table 3BCorporate Sector Risk Vs. Reward* Setbacks Setbacks 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 202 basis points in December, and by 886 bps in 2019. The index option-adjusted spread tightened 34 bps on the month and currently sits at 335 bps, 102 bps above our target (Chart 3). With attractive valuation, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months. One notable development from last year is that the Ba and B credit tiers outperformed the Caa credit tier. This is unusual in an environment of positive excess junk returns. We analyzed the divergence between Caa and the rest of the junk index in a recent report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for 2019’s Caa spread widening that make us inclined to downplay any negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of 2019’s underperformance (bottom panel). The conflict between the US and Iran should boost oil prices during the next few months, benefiting the US shale sector and causing some of this divergence to unwind. MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 34 basis points in December, and by 56 basis points in 2019. The conventional 30-year zero-volatility spread tightened 10 bps on the month, driven by an 8 bps tightening of the option-adjusted spread (OAS) and a 2 bps decline in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is 45 bps (Chart 4). This is only 7 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers are below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance. This burnout will keep refi activity low, and MBS spreads tight. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 54 basis points in December, and by 252 bps in 2019. Sovereign debt outperformed duration-equivalent Treasuries by 175 bps on the month, and by 697 bps in 2019. Local Authority and Foreign Agency bonds outperformed the Treasury benchmark by 41 bps and 73 bps, respectively, in December, and by 287 bps and 341 bps, respectively, in 2019. Domestic Agency bonds and Supranationals both performed in line with Treasuries in December, but outperformed by 51 bps and 36 bps, respectively, in 2019. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Local Authorities and Foreign Agencies, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 51 basis points in December, and by 57 bps in 2019 (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 6% in December, and currently sits at 78% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Yield ratios have tightened a lot since then, but value remains at long maturities. Specifically, 2-year, 5-year and 10-year M/T yield ratios are all below average pre-crisis levels at 66%, 68% and 78%, respectively. But 20-year and 30-year yield ratios stand at 87% and 91%, respectively, above average pre-crisis levels. Fundamentally, state and local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Long-dated Treasury yields rose in December, while the Fed’s forward guidance kept short-maturity yields low. The result is that the 2/10 slope steepened 17 bps in December and the 5/30 slope steepened 11 bps (Chart 7). Looking back on 2019 we find that, despite August’s curve inversion scare, the 2/10 slope steepened 13 bps on the year and the 5/30 slope steepened 19 bps. In our 2020 Key Views report, we argued that the 2/10 Treasury slope will stay positive in 2020, in a range between 0 bps and 50 bps.8 We also expect further modest steepening during the next few months as the Fed continues to hold down the front-end of the curve in an effort to re-anchor inflation expectations, even as improving global growth pushes long-dated yields higher. Despite our outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers positive carry (bottom panel), due to the extreme overvaluation of the 5-year note. It also looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in December, and by 42 bps in 2019. The 10-year TIPS breakeven inflation rate rose 16 bps on the month and currently sits at 1.78%. The 5-year/5-year forward TIPS breakeven inflation rate rose 14 bps on the month and currently sits at 1.86%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target since mid-2018 (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. It takes time for expectations to adapt to a changing macro environment, but even accounting for those long lags, our Adaptive Expectations Model pegs the 10-year TIPS breakeven inflation rate as 16 bps too low (panel 4).9 It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor long-term inflation expectations. As a result, the actual inflation data will lead expectations higher, causing the TIPS breakeven inflation curve to flatten.10 Any politically-driven increase in oil prices will only exacerbate TIPS breakeven curve flattening. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in December, but outperformed the benchmark by 69 bps in 2019. The index option-adjusted spread for Aaa-rated ABS widened 6 bps on the month. It currently sits at 37 bps, 3 bps above its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products, and also offers more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate remains low, but has put in a clear bottom. This is also true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating credit metrics make consumer ABS even less appealing. Stay underweight. 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 11 basis points in December, and by 233 bps in 2019. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 71 bps, below its average pre-crisis level but somewhat above levels seen during the past two years (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 16 basis points in December, but outperformed the benchmark by 91 bps in 2019. The index option-adjusted spread widened 4 bps on the month, and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 22 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Setbacks Setbacks Setbacks Setbacks Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 3, 2020) Setbacks Setbacks 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 January 3, 2020) Setbacks Setbacks 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 33 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 33 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) Setbacks Setbacks Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of January 3, 2020) Setbacks Setbacks Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 9 For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Below-Benchmark Duration In 2020 H1. Improving global growth and the de-escalation of US/China trade tensions will put upward pressure on bond yields in the first half of 2020, making below-benchmark portfolio duration appropriate. US political risks could re-assert themselves as we head into 2020 H2, leading to a risk-off environment that causes bond yields to fall. We will likely recommend increasing portfolio duration in mid-2020 if the political situation plays out as we expect, or if the 5-year/5-year forward Treasury yield and 12-month Fed Funds Discounter reach our targets. Barbell Your Treasury Portfolio. The 2/10 Treasury slope will steepen modestly in the coming months, but will remain in a range between 0 bps and 50 bps in 2020. Any steepening will be concentrated in the real yield curve. The TIPS breakeven inflation curve is likely to flatten. Our valuation models suggest that a barbelled Treasury portfolio is the best way to position for this environment. Specifically, we recommend shorting the 5-year bullet and buying a duration-matched barbell consisting of the 2-year note and 30-year bond. Overweight Spread Product. Low inflation expectations will keep the Fed on hold in 2020. This accommodative monetary environment will keep defaults low and credit spreads tight. Spread product will outperform Treasuries in duration-matched terms. Favor High-Yield Versus Investment Grade. Appropriate valuation measures show that high-yield corporate spreads are very attractive in the current environment, while investment grade corporate spreads are tight compared to our fair value estimates. Overweight Mortgage-Backed Securities. Agency MBS look attractive compared to investment grade corporate bonds, especially in risk-adjusted terms. The risk of a refinancing surge in 2020 is minimal and mortgage lending standards are more likely to ease than tighten. MBS spreads have room to tighten in 2020. Overweight TIPS Versus Nominal Treasuries. TIPS breakeven inflation rates are well below our target range of 2.3%-2.5%. It will take some time, and likely an overshoot of the Fed’s 2% inflation target, for them to reach that range as expectations adapt only slowly to rising core inflation. But even if they don’t make it back to target, breakevens should still grind higher as the economy recovers in 2020. Feature BCA published its 2020 Outlook on November 22. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer six key US fixed income views for 2020. This report is limited to the six key investment views listed on page 1, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2020” report that will delve into our outlook for the Fed next year. Outlook Summary First, a brief summary of the main economic views presented in BCA’s 2020 outlook:1 The global manufacturing downturn that persisted throughout 2019 is quickly coming to an end. The following factors will cause global growth to rebound in early 2020: China eased economic policy significantly in 2019. Policymakers cut the reserve requirement ratio by 400 basis points, cut taxes by 2.8% of GDP, increased issuance of local government bonds to finance public infrastructure projects, and boosted capex at state-owned enterprises. The Fed cut rates by 75 bps, and other central banks also eased monetary policy in 2019. The global inventory purge that magnified the industrial sector’s pain in 2019 is exhausted. Both the US and China have incentives to de-escalate the trade war in the first half of 2020. Investors should remain invested in risk assets to take advantage of this favorable global macro environment. But 2020 is likely to be the last year of risk asset outperformance. Today’s accommodative monetary policy will revive inflationary pressures in 2021, and central banks will then be forced to lift rates much more aggressively. China will also continue to resist excess leverage. Neither the business cycle nor the equity bull market will withstand those final assaults in 2021. Key View #1: Below-Benchmark Duration In 2020 H1 Improving global growth and the de-escalation of US/China trade tensions will put upward pressure on bond yields in the first half of 2020, making below-benchmark portfolio duration appropriate. US political risks could re-assert themselves as we head into 2020 H2, leading to a risk-off environment that causes bond yields to fall. We will likely recommend increasing portfolio duration in mid-2020 if the political situation plays out as we expect, or if the 5-year/5-year forward Treasury yield and 12-month Fed Funds Discounter reach our targets. In prior research we identified the five macroeconomic factors that determine trends in US bond yields.2 They are: (i) global growth, (ii) the output gap, (iii) the US dollar, (iv) policy uncertainty and (v) sentiment. On global growth, the three measures that correlate most strongly with the 10-year Treasury yield are the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index. As mentioned above, we expect all three of these indicators to move higher in the first half of 2020, but so far we have seen only tentative signs of a rebound. The Global PMI is back above 50 after bottoming at 49.3 in July, but the US ISM remains in contractionary territory and the CRB Raw Industrials index is in a downtrend (Chart 1). All three of these indicators will have to increase for our call to play out. The global manufacturing downturn that persisted throughout 2019 is quickly coming to an end. The same amount of economic growth is more inflationary when the output gap is small than when it is wide. For this reason, we also need some sense of the output gap to make a call on Treasury yields. We have found wage growth to be a useful indicator of the output gap, as evidenced by its strong correlation with the fed funds rate (Chart 2). As long as recession is avoided, strong wage growth will make it difficult for the Fed to aggressively cut rates. The upshot is that Treasury yields will not re-visit their mid-2016 lows until the next recession hits and wage pressures wane. For now, all leading wage growth indicators continue to point up (Chart 2, bottom 2 panels). Chart 1Factor 1: Global Growth Factor 1: Global Growth Factor 1: Global Growth Chart 2Factor 2: The Output Gap Factor 2: The Output Gap Factor 2: The Output Gap   The US dollar is the third important macro factor we consider. A strengthening dollar signals that US yields are de-coupling too far from yields in the rest of the world, making them more likely to fall back down. Conversely, an uptrend in US bond yields is likely to last longer in an environment of dollar weakness. The trade-weighted dollar has been rangebound during the past few months and bullish sentiment toward the dollar has declined significantly (Chart 3). This suggests that US yields have room to move higher. However, we will watch the dollar closely as bond yields rise in 2020 H1. A rapidly appreciating dollar would make us more inclined to fade any increase in US bond yields. The fourth factor we consider is policy uncertainty. It’s no secret that US Treasury securities benefit from flight to safety flows in times of heightened political stress. The tight correlation between the 10-year Treasury yield and the Global Economic Policy Uncertainty index demonstrates this nicely (Chart 4). In fact, it is now clear that uncertainty about the US/China trade war caused US yields to reach lower levels this year than was implied by the economic fundamentals alone. Chart 3Factor 3: The US Dollar Factor 3: The US Dollar Factor 3: The US Dollar Chart 4Factor 4: Policy Uncertainty Factor 4: Policy Uncertainty Factor 4: Policy Uncertainty   We see trade tensions continuing to die down as we head into the New Year. President Trump faces an election in November 2020, and he no doubt realizes that an incumbent President with a strong economy has a good chance of winning re-election. He therefore has a strong incentive to support economic growth. However, by the second half of next year, we see two potential political risks that could flare, causing bond yields to fall. First, if Trump finds himself behind in the polls by mid-summer, then he may change his strategy and re-escalate tensions with China or some other foreign policy target. Second, if one of the progressive candidates – Elizabeth Warren or Bernie Sanders – secures the Democratic nomination, stocks will likely sell off, precipitating a flight-to-quality into US bonds. All in all, we see the ebbing of policy uncertainty in the first half of 2020 helping to push bond yields higher. But risks could flare again in the 2020 H2, sending yields back down. Chart 5Factor 5: Sentiment Factor 5: Sentiment Factor 5: Sentiment The final factor we consider when forecasting bond yields is sentiment, and we find the Economic Surprise Index to be the most useful sentiment measure. Chart 5 shows that positive data surprises tend to coincide with rising Treasury yields and vice-versa. We also know that long periods of positive data surprises are more likely to be followed by disappointments, and vice-versa. Though the Surprise Index’s message can change quickly, it is currently close to neutral, sending no strong signal for bond yields. Considering our five macro factors together, we conclude that a rebound in global growth and waning political uncertainty will send bond yields higher in the first half of 2020. Investors should keep portfolio duration low in this environment. We may recommend increasing portfolio duration as we approach mid-year if political uncertainty looks set to rise, or if the dollar is appreciating strongly, or if yields reach the targets outlined below. Yield Target #1: The Golden Rule Of Bond Investing Our Golden Rule of Bond Investing asserts that you should keep portfolio duration low if you expect the Fed to be more hawkish than market expectations, and high if you expect the Fed to be more dovish.3 At present, the overnight index swap (OIS) curve is priced for 22 basis points of rate cuts over the next 12 months. While economic growth is poised to improve in 2020, the Fed is in no rush to tighten monetary policy with inflation expectations still low. We therefore expect the fed funds rate to stay flat next year. With the market still priced for cuts, this forecast implies that we should maintain below-benchmark portfolio duration, at least until our 12-month Fed Funds Discounter – the change in the fed funds rate priced into the OIS curve for the next 12 months – rises to zero or above. A rebound in global growth and waning political uncertainty will send bond yields higher in the first half of 2020. Investors should keep portfolio duration low in this environment. Table 1 uses our Golden Rule framework to forecast Treasury index returns in different monetary policy scenarios. Our base case of a flat fed funds rate is consistent with Treasury index total returns of +0.67% to +0.88% in 2020, and excess returns versus cash of between -0.91% and -0.70%. The Appendix at the end of this report discusses how our Golden Rule framework performed in 2019 and in years past. Table 1Treasury Return Projections 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Yield Target #2: Long-Run Fed Funds Rate Expectations Chart 6Target 2.25% To 2.5% Target 2.25% To 2.5% Target 2.25% To 2.5% A second catalyst for increasing portfolio duration would be if the 5-year/5-year forward Treasury yield converged with estimates of the longer-run neutral fed funds rate. Once recessionary risks move to the backburner, it would be logical for long-dated forward rates to converge to levels that are consistent with market expectations for the long-run neutral fed funds rate. Indeed, this is precisely what happened in 2014 and 2017/18, the last two periods of strong global growth (Chart 6). At present, the Fed’s median long-run neutral rate estimate is 2.5%. The New York Fed’s Survey of Market Participants estimates a range of 2.19% to 2.50% and its Survey of Primary Dealers estimates a range of 2.25% to 2.56%. A 5-year/5-year forward Treasury yield in the range of 2.25% to 2.5% would be a second catalyst for us to increase recommended portfolio duration. For Treasury yields to move sustainably above 2.5% in this cycle, it will be necessary for investors to revise their long-run neutral rate estimates higher. This could very well occur, but probably not within the next six months. Nonetheless, investors should pay close attention to the price of gold and the US housing market for signals that neutral rate estimates might undergo upward revisions. The gold price tends to rise when investors view monetary policy as becoming increasingly accommodative. This can occur because the Fed is cutting rates while neutral rate estimates are unchanged, or because neutral rate estimates are rising and the fed funds rate is unchanged. Chart 7 shows that a drop in the gold price foreshadowed downward revisions to the neutral rate in 2013. A further breakout in gold in 2020 could signal that the neutral rate needs to be revised higher again. The housing market will also provide important clues about the neutral fed funds rate. Last year, housing activity slowed considerably once the 30-year mortgage rate rose about 4% (Chart 8). Activity bounced back this year after rates fell, but it will be important to see what happens to housing once the mortgage rate rises back to 4% and above. If an above-4% mortgage rate leads to another downdraft in housing, it would send a strong signal that current neutral rate estimates are roughly correct. However, if housing activity continues to improve with a mortgage rate above 4%, it would suggest that upward neutral rate revisions are required. Chart 7Gold Leads The Neutral Rate... Gold Leads The Neutral Rate... Gold Leads The Neutral Rate... Chart 8...And So Does Housing ...And So Does Housing ...And So Does Housing   There is at least one good reason to think that housing activity might not slow once the mortgage rate rises above 4%. There is currently an excess of supply at the upper-end of the housing market, and a lack of supply at the low-end. This has resulted in price deceleration for new homes, as homebuilders shift construction to the lower-end of the market where demand is stronger (Chart 8, bottom panel). This supply side re-adjustment could make the housing market more resilient to higher mortgage rates in 2020. Key View #2: Barbell Your Treasury Portfolio The 2/10 Treasury slope will steepen modestly in the coming months, but will remain in a range between 0 bps and 50 bps in 2020. Any steepening will be concentrated in the real yield curve. The TIPS breakeven inflation curve is likely to flatten. Our valuation models suggest that a barbelled Treasury portfolio is the best way to position for this environment. Specifically, we recommend shorting the 5-year bullet and buying a duration-matched barbell consisting of the 2-year note and 30-year bond. In thinking about how the slope of the Treasury curve will respond as global growth improves in 2020, it’s useful to look at what happened in two recent episodes of strengthening global growth – 2012/13 and 2016/17. Charts 9A, 9B and 9C illustrate how the 2/10 slope responded in those periods, and show the breakdown between changes in the real and inflation components of yields. The actual slope changes are provided in Table 2. In 2012/13, the 2/10 slope steepened dramatically as global growth rebounded, with almost all of the steepening coming from the real yield curve. It’s not difficult to understand why. The economic outlook was improving, but the Fed was still two years away from lifting interest rates. As such, the Fed’s dovish forward guidance kept a firm lid on short-maturity yields even as long-dated yields rose. In contrast, we can look at the 2016/17 episode. The 2/10 slope steepened somewhat early in the 2016/17 global growth recovery, but ended up 45 bps flatter by the time that the Global PMI peaked. This time, both the real and inflation components contributed to curve flattening. The key difference in this episode was that the Fed was quick to turn more hawkish as growth improved. It lifted the funds rate four times, and short-dated yields rose more quickly than those at the long-end. If housing activity continues to improve with a mortgage rate above 4%, it would suggest that upward neutral rate revisions are required. What can be applied from these two episodes to today? One thing that’s clear is that the Fed will not be as quick to tighten policy as it was in 2016/17. As will be discussed in more detail in next week’s report, the Fed wants to keep policy accommodative until inflation expectations are firmly re-anchored around its target. We think the 5-year/5-year forward TIPS breakeven inflation rate needs to rise from its current 1.8% to above 2.3% before that goal is met. However, it’s also conceivable that inflationary pressures will emerge as soon as late-2020, necessitating rate hikes in 2021. If that’s the case, then short-dated yields will sniff that out in advance, imparting some flattening pressure to the curve. All in all, we’re looking for modest curve steepening in the first half of 2020. But with the Fed not completely out of the picture – as was the case in 2012/13 – the 2/10 slope will not rise above 50 bps. We would also recommend positioning for curve steepening via real yields. The cost of 2-year inflation protection is currently below the cost of 10-year inflation protection (Chart 9C), but will probably lead the 10-year higher as inflation expectations slowly adapt to the incoming data. We recommend TIPS breakeven curve flatteners. Chart 9ANominal 2/10 Slope Nominal 2/10 Slope Nominal 2/10 Slope Chart 9BReal 2/10 Slope Real 2/10 Slope Real 2/10 Slope Chart 9CInflation Compensation: 2/10 Slope Inflation Compensation: 2/10 Slope Inflation Compensation: 2/10 Slope Table 22/10 Slope Changes During Two Recent Global Growth Upturns 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Interestingly, we also do not recommend the typical 2/10 steepening trade of going long the 5-year bullet against a duration-matched 2/10 barbell. This is because the 2/5/10 butterfly already discounts a huge amount of 2/10 steepening. The 5-year bullet appears 6 bps expensive on our model, meaning that the 2/10 slope needs to steepen by 26 bps during the next six months for a long 5-year, short 2/10 trade to profit (Chart 10).4 Chart 102/5/10 Butterfly Valuation Model 2/5/10 Butterfly Valuation Model 2/5/10 Butterfly Valuation Model Against this valuation backdrop, we recommend owning a duration-matched barbell consisting of the 2-year note and the 30-year bond, while shorting the 5-year note. This heavily barbelled Treasury allocation adds positive carry to a bond portfolio, and will earn positive returns as long as the 5/30 slope steepens by less than 61 bps during the next six months.5 Further, recent correlations suggest that the 5-year yield will rise by more than either the 2-year or 30-year yields if the market starts to price-in fewer Fed rate cuts, as we expect. Table 3 shows that there has been a positive correlation between changes in the 2/5 Treasury slope and our 12-month discounter during the past six months, and a negative correlation between our discounter and the 5/30 slope. Table 3Correlation Of Monthly Changes In 12-Month Discounter With Monthly Changes In Treasury Curve Slopes 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Key View #3: Overweight Spread Product Low inflation expectations will keep the Fed on hold in 2020. This accommodative monetary environment will keep defaults low and credit spreads tight. Spread product will outperform Treasuries in duration-matched terms. In last year’s Key Views report, we presented a method for splitting the economic cycle into three phases based on the slope of the yield curve.6 We observed that spread product excess returns versus Treasuries tend to be highest in Phase 1 of the cycle, when the 3-year/10-year Treasury slope is above 50 bps. Spread product excess returns tend to be low, but still positive, in Phase 2 of the cycle when the slope is between 0 bps and 50 bps, and only turn negative in Phase 3 after the 3-year/10-year slope inverts. By our criteria, we remained in Phase 2 of the cycle throughout all of 2019 and spread product did in fact deliver small, but positive, excess returns relative to Treasuries. We expect to remain in Phase 2 throughout most (if not all) of 2020, and therefore advise investors to maintain overweight allocations to spread product versus duration-matched Treasuries. We are looking for modest curve steepening in the first half of 2020. The principal rationale for our call is that accommodative Fed policy will keep the yield curve positively sloped in 2020. It will also give banks the confidence to continue extending credit. And as long as lending standards are sufficiently easy, defaults will remain low and spreads will stay tight. Yes, there are some early indications that we might be transitioning into a Phase 3 environment, an environment that would merit a more defensive stance. For one thing, some parts of the Treasury curve inverted in August, though the specific measure we use in our credit cycle analysis – the monthly average of daily closes of the 3-year/10-year Treasury slope – remained above zero (Chart 11). Also, commercial & industrial (C&I) lending standards tightened in the third quarter. Chart 11Still In Phase 2 Still In Phase 2 Still In Phase 2 However, we expect both of these warning signs to dissipate in the near future. The yield curve has already re-steepened, and while loan officers indicated that they had tightened overall standards on C&I loans in Q3, they continued to loosen the terms on those loans (Chart 11, panel 3). But most importantly, we continue to observe inflation expectations that are far below the Fed’s comfort zone (Chart 11, bottom panel). As long as this is the case, the Fed will do its best to keep interest rates low and monetary conditions accommodative. In that environment, the yield curve should stay upward sloping and banks will keep the credit taps open. Phase 2 will stay in place and spread product will outperform Treasuries. The poor health of nonfinancial corporate balance sheets is another risk to our positive spread product view. We track corporate balance sheet health using both aggregate top-down data from the US Financial Accounts (Chart 12A) and by looking at the median firm in our own bottom-up sample of high-yield issuers (Chart 12B). In both cases, we see that debt-to-profit and debt-to-asset ratios are elevated, indicating that firms are carrying a lot of debt on their balance sheets relative to history. However, both samples also show that interest coverage ratios are strong. Solid interest coverage is the result of low interest rates and the Fed’s accommodative monetary policy. It tells us that defaults won’t occur until inflation expectations rise and the Fed turns more restrictive. That may not happen until 2021. Chart 12ACorporate Health: Top-Down Corporate Health: Top-Down Corporate Health: Top-Down Chart 12BCorporate Health: Bottom-Up Corporate Health: Bottom-Up Corporate Health: Bottom-Up   The downside is that an extended period of accommodative monetary policy and few defaults means that firms will continue to build up debt and whittle away the equity cushion in corporate capital structures. The end result will be greater losses during the next default cycle. Our Preferred Spread Sectors Within US spread product, we recommend an overweight allocation to high-yield corporate bonds to take advantage of the favorable macro environment. Within investment grade sectors, we advise only a neutral allocation to corporate bonds (see Key View #4), but recommend overweighting Agency Mortgage-Backed Securities (see Key View #5), Agency Commercial Mortgage-Backed Securities, Local Authority and Foreign Agency debt. Chart 13 shows a snapshot of the risk/reward trade-off between investment grade spread products. The vertical axis displays the option-adjusted spread as a simple proxy for 12-month expected excess returns. The horizontal axis displays our own risk measure called the Risk Of Losing 100 bps.7 This measure calculates the spread widening required for each sector to lose 100 bps or more versus duration-matched Treasuries, then adjusts for each sector’s historical spread volatility. Chart 13Excess Return Bond Map: Main Investment Grade Sectors 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart 13 imposes no macro view, but it does reveal that Foreign Agency debt offers an attractive expected return for its level of risk. Agency CMBS and Agency MBS also offer attractive expected returns for their respective risk levels. USD-denominated Sovereign bonds offer high expected returns, but are also the riskiest of the sectors in Chart 13. We recommend an underweight allocation to USD-denominated Sovereigns with the exception of Mexican and Saudi Arabian bonds, which look attractive on a risk/reward basis. Chart 14 replicates Chart 13 but with the USD-denominated Sovereign bonds of different countries. Only Mexico and Saudi Arabia stand out as being attractively priced. Chart 14Excess Return Bond Map: USD-Denominated EM Sovereigns 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart 15Favor Long-Maturity Munis Favor Long-Maturity Munis Favor Long-Maturity Munis We also maintain a positive outlook on Municipal bonds, particularly at the long-end of the Aaa-rated curve. Municipal / Treasury yield ratios look attractive compared to history, especially at long maturities (Chart 15). While many state and local governments face long-run problems related to underfunded pensions, these issues won’t be exposed until revenue growth falters in the next downturn. For now, state & local government balance sheets are healthy enough to keep muni upgrades outpacing downgrades (Chart 15, bottom 2 panels). Key View #4: Favor High-Yield Over Investment Grade Appropriate valuation measures show that high-yield corporate spreads are very attractive in the current environment, while investment grade corporate spreads are tight compared to our fair value estimates. We noted above that, despite the favorable macro environment for spread product, we recommend an overweight allocation to high-yield corporate bonds but only a neutral allocation to investment grade corporates. The reason for the disparity is valuation. Our preferred valuation measure is the 12-month breakeven spread. This is the spread widening required for the sector to lose money versus Treasuries on a 12-month horizon. This measure is superior to the simple index option-adjusted spread because it controls for time-varying index duration. We also re-calculate the investment grade and high-yield bond indexes so that they have constant distribution between the different credit tiers over time. Charts 16A and 16Bshow 12-month breakeven spreads for our re-constituted investment grade and high-yield indexes as percentile ranks versus history. The investment grade spread has been tighter only 11% of the time since 1995, while the high-yield spread has been tighter 67% of the time. Chart 16AIG Valuation IG Valuation IG Valuation Chart 16BHY Valuation HY Valuation HY Valuation   From our analysis of the three phases of the cycle, we also know that spreads tend to tighter in Phase 2 of the cycle than in Phases 1 or 3. Since we are currently in Phase 2, we would expect spreads to be near the bottom of their historical distributions. With this knowledge, we derive spread targets for each corporate credit tier based on the median breakeven spreads witnessed in prior Phase 2 periods. We then use current index duration to calculate option-adjusted spread targets for each credit tier and the overall investment grade and high-yield indexes (Charts 17A and 17B). Notice that all investment grade spreads are below their Phase 2 targets, while high-yield spreads are well above. Chart 17AIG Spread Targets IG Spread Targets IG Spread Targets Chart 17BHY Spread Targets HY Spread Targets HY Spread Targets   We also observe that Caa-rated spreads are extremely cheap relative to target, and have been widening rapidly. We are more inclined to view this as an opportunity to buy Caa-rated bonds than as a warning sign for overall corporate bond performance, as we discussed in a recent report.8 Key View #5: Overweight Mortgage-Backed Securities Agency MBS look attractive compared to investment grade corporate bonds, especially in risk-adjusted terms. The risk of a refinancing surge in 2020 is minimal and mortgage lending standards are more likely to ease than tighten. MBS spreads have room to tighten in 2020. We noted above that Agency MBS offer an attractive trade-off between risk and expected return. Specifically, Chart 13 shows that MBS offer expected returns that are similar to Aa and Aaa corporates, but with less risk of losing 100 bps versus Treasuries. For further evidence of the attractiveness of MBS spreads, we note that while the zero-volatility spread for conventional 30-year Agency MBS is not all that elevated compared to history, it is being held down by very low expected prepayment losses (aka option costs) (Chart 18). The OAS, the best proxy for MBS expected return, stands at 48 bps. This is reasonably elevated compared to history and very close to the spread offered by Aa-rated corporate bonds. Past periods when the MBS OAS was close to the Aa-rated corporate bond spread were followed by MBS outperformance (Chart 18, bottom panel). We recommend an overweight allocation to high-yield corporate bonds but only a neutral allocation to investment grade corporates. The reason for the disparity is valuation. We noted that expected prepayment losses are low, and this is for good reason. Mortgage refinancing activity will remain depressed throughout 2020. First, with the Fed likely to go on hold for 2020 and then lift rates in 2021, the mortgage rate is more likely to rise than fall. Higher mortgage rates will keep refis down. Second, most homeowners have already had multiple opportunities to refinance their mortgages during the past few years, as evidenced by the fact that the MBA Refinance Index didn’t rise that much in 2019, even as the mortgage rate declined 106 bps (Chart 19). Chart 18MBS Spreads MBS Spreads MBS Spreads Chart 19Refi Risk Is Minimal Refi Risk Is Minimal Refi Risk Is Minimal   Tightening bank lending standards for residential mortgages can also lead to wider MBS spreads, but lending standards are more likely to ease than tighten in 2020. FICO scores for approved mortgages have not come down at all since the financial crisis (Chart 19, panel 3), and loan officers consistently claim that lending standards are tighter than the average since 2005 (Chart 19, bottom panel). With standards already so tight, modest easing is more likely than rapid tightening. Key View #6: Overweight TIPS Versus Nominal Treasuries TIPS breakeven inflation rates are well below our target range of 2.3%-2.5%. It will take some time, and likely an overshoot of the Fed’s 2% inflation target, for them to reach that range as expectations adapt only slowly to rising core inflation. But even if they don’t make it back to target, breakevens should still grind higher as the economy recovers in 2020. Our target range for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remains 2.3%-2.5%. But it could take quite some time for that target to be met. The reason is that inflation expectations adapt only slowly to changes in the actual inflation data. We explained this dynamic in a report from last year, and also created a fair value model for the 10-year TIPS breakeven inflation rate based on long-run trends in the actual inflation data.9 At present, our Adaptive Expectations Model pegs fair value for the 10-year breakeven rate at 1.9%, 20 bps above the current level of 1.7%, but well short of our end-of-cycle 2.3%-2.5% target (Chart 20). We could see the 10-year breakeven reaching 1.9% in the coming months as global growth recovers, but it will take a more sustained uptrend in the actual inflation data to move higher than that. A more sustained uptrend in actual inflation could take some time to develop. This year’s increase in core CPI inflation has been concentrated in the core goods component (Chart 21). This component of core inflation tracks import prices with a lag, and it is very likely to fall back down in 2020. Any sustained breakout in core inflation will require more strength from the core services (ex. Shelter and medical care) component (Chart 21, panel 3), something that hasn’t happened yet this cycle. Chart 20Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model Chart 21The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI   Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix: The Golden Rule Of Bond Investing Our Golden Rule of Bond Investing says that we should determine what change in the fed funds rate is priced into the overnight index swap curve for the next 12 months, and then decide whether the Fed will deliver a hawkish or dovish surprise relative to that expectation. We contend that if the Fed delivers a hawkish surprise, then a below-benchmark portfolio duration positioning will pay off. Conversely, if the Fed delivers a dovish surprise, then an above-benchmark portfolio duration positioning will profit. Chart A1 shows how the Golden Rule has performed in every calendar year going back to 1990. We include year-to-date performance for 2019. In 30 years of historical data, our Golden Rule performed well in 22. It provided the wrong recommendation in 8 years, though 3 of those years were during the zero-lower-bound period between 2009 and 2015 when 12-month rate expectations were essentially pinned at zero.10 At the beginning of this year, the market was priced for 7 bps of rate cuts in 2019. The funds rate actually fell by 84 bps, leading to a dovish surprise of 77 bps. Based on a historical regression, we would expect a dovish surprise of 77 bps to coincide with a Treasury index yield that falls by 52 bps. In actuality, the index yield fell by 81 bps, more than our Golden Rule predicted. Chart A2 shows how close changes in the Treasury index yield have been to our Golden Rule’s prediction in each of the past 30 years. This regression between the change in Treasury index yield and the monetary policy surprise is the main source of error in our Treasury return forecasts. Based on our expected -52 bps index yield change, we would have expected the Treasury index to deliver 5.9% of total return in 2019 and to outperform cash by 3.4%. In actuality, the index earned 7.9% of total return and outperformed cash by 5.6%. Charts A3 and A4 show how index total and excess returns have performed relative to our Golden Rule’s expectations in each of the past 30 years. Chart A1The Golden Rule’s Track Record The Golden Rule's Track Record The Golden Rule's Track Record Chart A2Treasury Index Yield Changes Versus Fed Funds Surprises 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart A3Treasury Index Total Returns Versus The Golden Rule’s Predictions 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart A4Treasury Index Excess Returns Versus The Golden Rule’s Predictions 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income   Footnotes 1    Please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com 2   Please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 3   Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4   For more details on our butterfly spread valuation models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5   The 2/5/30 valuation model is not shown in this report. Please see US Bond Strategy Portfolio Allocation Summary, “Mixed Messages”, dated December 3, 2019, for a recent update of all our yield curve models. 6   Please see US Bond Strategy Special Report, “2019 Key Views: Implications For US Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 7   For further details on how this measure is calculated please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 8   Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 9   For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 10  We say the Golden Rule “worked” if a dovish surprise coincided with positive Treasury index excess returns versus cash, or if a hawkish surprise coincided with negative Treasury excess returns versus cash.

Highlights Our take on the key macro drivers of financial markets is quite similar to last year’s, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... because the Fed and other central banks have reset the monetary policy clock, … : At this time last year, we projected that the Fed would be on the cusp of tightening monetary policy enough to induce a recession by the middle of 2020. Three rate cuts later, we now expect that policy won’t become restrictive until 2021. … pushing the inflection points investors care about further out into the future: The next recession won’t begin before monetary policy settings are tight, and stocks won’t peak until about six months before the recession starts. We are keeping close tabs on the trade negotiations and potential election outcomes, but we expect that 2020 will be another rewarding year for riskier assets: The equity bull market is likely to last for all of next year, and spread product will keep cranking out excess returns over Treasuries and cash for a while longer, too. Overweight equities and spread product. Feature Mr. and Ms. X made their annual visit to BCA last month, giving us an opportunity to gather our thoughts for 2020, while reviewing how our calls turned out in 2019. Both BCA and US Investment Strategy got the asset allocation conclusion right – overweight equities and spread product, while underweighting Treasuries – but the Fed did the opposite of what we expected heading into 2019, putting us on the wrong side of the Treasury duration call for most of the year. We still think investors are overly complacent about the potential for future inflation, but we concede that the future remains further off than we initially expected. Monetary policy settings got more accommodative nearly everywhere in the world in 2019, ... Our Outlook 2020 theme, as detailed in the year-end edition of The Bank Credit Analyst, is Heading into the End Game,1 and it is clear that the expansion is in its latter stages. We do not think that the end of the expansion, the equity bull market, or credit’s extended stretch of positive excess returns is at hand, however. The full-employment/low-inflation sweet spot is still in place, and the Fed has no plans to get in the expansion’s way, even if inflation begins to gain some traction. Its biggest policy priority is trying to get inflation expectations back to the 2.3 – 2.5% range consistent with its inflation target. Chart 1Globalization Hits A Wall Globalization Hits A Wall Globalization Hits A Wall Central banks around the world followed the Fed’s lead this year, cutting their policy rates in an attempt to shield their economies from potentially worsening trade tensions. Though no central banker would say it out loud, joining the rate-cutting parade also helped to defend against currency appreciation, as no one wants a strong currency when growth is in such short supply. The upshot is that global central banks are deliberately promoting reflation. That’s a supportive policy backdrop for risk assets, and while it may well lead to a bigger hangover down the road, it will ramp up the party now. Exogenous challenges remain. Trade tensions are a thorn in businesses’, consumers’ and investors’ sides. Even if US-China tensions die down, a belligerent US administration appears bent on using tariffs and other trade barriers as a cudgel to force concessions from other nations. The trade tailwind that boosted economic growth and investment returns across the last two decades has been stilled (Chart 1). Saber rattling by the US, or mischief from the usual rogue-state and non-state suspects, could also keep markets on edge. The looming election could give investors heartburn, and clients around the world remain anxious about the prospects of a Warren administration. Exogenous risks abound, but it is not our base case that a critical mass will coalesce to disrupt our view that generous-to-indulgent monetary policy settings will delay the day of reckoning, and keep the bull market going all the way through the coming year. As The Cycles Turn From our perspective, the practice of investment strategy is properly founded on the study of cycles. The key cycles – the business cycle, the credit cycle, and the monetary policy cycle – determine how receptive the macroeconomic backdrop is for taking investment risk. Investments made when the backdrop supports risk taking have a much better likelihood of generating excess returns over Treasuries and cash than investments made against an unfriendly macro backdrop. We therefore start every investment decision with an assessment of the key cycles. Determining whether the economy is expanding or contracting may seem like an academic debate with little practical application when the official business cycle arbiters don’t even determine the beginning and ending dates of recessions until well after the fact.2 Equity bear markets reliably coincide with recessions, however, and over the last 50 years, they have begun an average of six months before their onset (Chart 2). An investor who recognizes that a recession is at hand has a good chance of outperforming his/her competitors as long as s/he aggressively adjusts portfolio allocations in line with that recognition. Chart 2Bear Markets Rarely Occur Outside Of Recessions, ... Bear Markets Rarely Occur Outside Of Recessions, ... Bear Markets Rarely Occur Outside Of Recessions, ... Our key view, then, is that the start of the next recession is at least 18 to 24 months away. Tight monetary policy is a necessary, albeit not sufficient, condition for a recession (Chart 3), and we consider the Fed’s current monetary policy settings to be easy, especially after this year’s three rate cuts. A recession can’t begin until the Fed reverses those three cuts and, per our estimate of the equilibrium rate, tacks on at least three additional hikes. Tightening along those lines is decidedly not on the Fed’s 2020 agenda. Chart 3... And Recessions Only Occur When Monetary Conditions Are Tight ... And Recessions Only Occur When Monetary Conditions Are Tight ... And Recessions Only Occur When Monetary Conditions Are Tight Our recession judgment compels us to be overweight equities. Even if the next recession begins exactly halfway through 2021, history suggests that 2020 returns will be robust. Over the last 50 years, the S&P 500 has peaked an average of six months before the start of a recession, and returns heading into the peak have been quite strong, especially in the last four expansions (Table 1). Those results are consistent with bull markets’ tendency to sprint to the finish line (Chart 4). Table 1Stocks Don't Quit Until A Recession Is Near 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Chart 4Bull Markets End In Stampedes 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet The Fed Funds Rate Cycle We estimate that the equilibrium fed funds rate is currently around 3¼%, and project it will approach 3½% by the end of next year. If we are correct that the Fed’s main policy aim is to prod inflation expectations higher, it follows that it will remain on hold at 1.75% well into 2020. A desire to avoid even the appearance of meddling in the election may well keep the FOMC sidelined until its November and December meetings. The implication is that monetary policy will have no chance to cross into restrictive territory before the first half of 2021. The bottom line for investors is that the day when the economy and markets will have to confront tight monetary conditions has been indefinitely postponed. The Fed has effectively deferred the inflections in the business cycle and the equity market to some point beyond 2020. A longer stretch of accommodation would also continue to fuel the equity bull market, as Phases I and IV of the fed funds rate cycle, in which the fed funds rate is below our estimate of equilibrium (Chart 5), have been equities’ historical sweet spot. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 2), while Treasuries have shined when it’s tight (Table 3). Chart 5The Fed Funds Rate Cycle 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Table 2Equities Love Easy Policy, … 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Table 3… When They Leave Treasuries Far Behind 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet The Credit Cycle Our 30,000-foot view of the credit cycle is based on the banking mantra that bad loans are made in good times. When an expansion has been going on for a while, loan officers focus more on maintaining market share than lending standards, while managers of credit funds attract more assets, pushing them to find a home for their new inflows. Banks and bond managers are thereby pro-cyclical at the margin, keeping the good times going by lending to increasingly marginal borrowers and/or relaxing the terms on which they will lend. (They’re conversely stingy when real-time conditions are bad.) Lenders’ lagging/coincident focus keeps lending standards and borrower performance closely aligned in real time (Chart 6). Chart 6Standards Are Coincident In Real Time, ... Standards Are Coincident In Real Time, ... Standards Are Coincident In Real Time, ... Standards are a contrarian indicator over longer periods, though, because shoddily underwritten loans eventually show their true colors. We find a solid fit between corporate bond default rates and lending standards in the preceding 20 quarters (Chart 7). Lending standards tightened slightly in 2015, but were still quite easy in an absolute sense. A majority of banks tightened standards in 2016 amidst the oil rout, which could point to marginally better 2020-21 performance, but post-2010 standards have hardly been stringent. Chart 7... And Leading Over Five-Year Periods ... And Leading Over Five-Year Periods ... And Leading Over Five-Year Periods The stock of outstanding loans and bonds is therefore vulnerable. The relaxation of corporate bond covenants so soon after the financial crisis has not escaped the notice of bearish investors and reporters. It is not enough for an investor to identify a vulnerability, however; s/he also has to identify the catalyst that is going to cause a rupture. The challenge is that ultra-accommodative monetary policy delays the formation of negative catalysts. To the utter torment of an observer with an attraction to the Austrian School of Economics’ survival-of-the-fittest ethic, it is not at all easy to default in a ZIRP/NIRP world. The stock of $12 trillion of bonds with negative nominal yields (down from August’s $17 trillion peak) has ginned up a fervent search for yield among large institutional investor constituencies that have to meet a fixed distribution schedule, like life insurers and pension funds. These income-starved investors help explain why nearly any borrower, no matter how sketchy, can draw a crowd of would-be lenders simply by offering an incremental 50 or 75 basis points of yield. Borrowers default when no one is willing to roll over their maturing obligations; they get even more leveraged when lenders are climbing over each other to lend to them. It is also hard to default when central banks are deliberately pursuing reflation. Inflation makes debt service easier, and central banks are all-in for reflation as a means to bolster inflation expectations, defend against further trade tensions, and to ensure currency strength doesn’t undermine exports. The credit cycle is well advanced, and the Austrians may be at least partially vindicated when the ensuing selloff is worse than it would otherwise have been for having been delayed, but it looks to us like it has more room to run. The rapture remains out of reach for Austrian School devotees, who slot between Tantalus and New York Knicks fans on the cosmic persecution scale. Bonds We remain bearish on Treasuries and reiterate our below-benchmark duration recommendation, though we recognize that the 10-year Treasury yield is unlikely to rise beyond the 2.25-2.5% range in the next year. There’s only one more rate cut to price out of the OIS curve, and neither inflation expectations nor the term premium will return to normal levels quickly. The intermediate- and long-term outlook for the Federal budget is grim, given the size of the deficit while unemployment is at a 50-year low (Chart 8), but Dick Cheney will maintain the upper hand over deficit hawks for 2020 and several years beyond. We do think investors are complacent about inflation’s eventual return, though, and continue to advocate for TIPS over nominal Treasuries. It is tough to default in a ZIRP/NIRP world, when several institutional investor constituencies have a voracious appetite for yield. Chart 8The Budget Outlook Is Grim The Budget Outlook Is Grim The Budget Outlook Is Grim Chart 9IG Spreads Are Wafer Thin IG Spreads Are Wafer Thin IG Spreads Are Wafer Thin Our benign near-term view of the credit cycle makes us comfortable continuing to overweight spread product, subject to our US Bond Strategy colleagues’ preferences. They are only neutral on investment-grade corporates, given their scant duration-adjusted spread over Treasuries (Chart 9). They recommend overweighting high-yield corporate bonds instead, given that high-yield spreads still offer ample positive carry. They also recommend agency mortgage-backed securities as a high-quality alternative to investment-grade corporates, noting that their low duration (three years versus nearly eight for corporates) offers better protection against rising rates. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive until early to mid-2021 at the earliest, the bull market should be able to continue through all of 2020. We do not foresee a return to double-digit earnings growth, but the upward turn in leading indicators across a wide swath of countries outside of the US suggests that a revival in the rest of the world could help S&P 500 constituents grow earnings by mid-single digits, via a pickup in non-US demand and some softening in the dollar. Net share retirements could even nudge earnings growth into the high single digits. If earnings multiples hold up (they’ve expanded at a 5.5% annual rate in Phase IV of the fed funds rate cycle, and don’t typically contract until Phase II), S&P 500 total returns could reach the high single digits, easily putting them ahead of prospective Treasury returns. Multiple expansion isn’t required to support an overweight equities recommendation, but we would not be at all surprised if it occurred. Bull markets often get silly as they sprint to the finish line, and it would be unusual if some froth didn’t bubble up before this bull market, the longest of the postwar era, calls it quits. The Dollar We expect the dollar to weaken against other major currencies in 2020. As the rest of the world finds its footing and begins to accelerate, the growth differential between the US and other major economies will narrow. The dollar will attract less safe-haven flows as the rest of the world’s major economies escape stall speed. Though we expect the countercyclical dollar will rally again when the next recession hits, weakening in 2020 is consistent with our constructive global growth view. Putting It All Together We are sanguine about the US economy, which continued to trundle along at a trend pace in 2019 despite a series of headwinds. It withstood 4Q18’s sharp equity selloff and bond-spread blowout that tightened financial conditions and made corporate and investor confidence wobble. It withstood the 35-day federal government shutdown that lasted nearly all of January. It kept marching forward despite the trade war with China, and it overcame, at least for now, the angst over the inverted yield curve. If the economy continued to expand at roughly its trend pace despite those obstacles, it may not really have needed 25-basis-point rate cuts in July, September and October. The thread connecting our macro views and investment recommendations is the idea that monetary policy settings are highly accommodative and are likely to stay that way until the 2020 election. We expect that risk assets will outperform against an accommodating monetary backdrop. The naysayers are as likely to be confounded by central banks in 2020 as they have been throughout the entire ZIRP/NIRP era. The scolds scouring the data to try to find signs of excesses, and the Chicken Littles who have been frightened by clickbait headlines and strategists deliberately pursuing pessimistic outlier strategies, get one thing right. The market selloffs when the equity and credit bull markets end will be worse than they would have been if the Fed and other central banks were not deliberately attempting to reflate their economies. But their timing is likely to be as bad now as it has been all throughout 2019 (and for the entire post-crisis period for card-carrying, sandwich-board-wearing Austrians). You can’t fight the Fed, much less the ECB, the Bank of Japan, the Bank of England, the Swiss National Bank, the Reserve Banks of Australia and New Zealand, and a broad swath of all of the rest of the world’s central banks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the December 2019 Bank Credit Analyst, “Outlook 2020: Heading Into The End Game,” available at www.bcaresearch.com. 2 The NBER’s Business Cycle Dating Committee announced in December 2008 that the last recession began in December 2007. It announced in September 2010 that it had ended in June 2009.